wmm' mm mm iW \m \v^ TKSc book is DUE on tb'> --«t o^x^ smu.pcu SOUTHERN c : r^,-^ UNIVERSITY OF CALIFORNIA LIBRARY LOS ANGELES, CAUF. INCOME TAX PROCEDURE 1922 Including FEDERAL CAPITAL STOCK TAX, FEDERAL ESTATE TAX, AND SUPPLEMENT TO EXCESS PROFITS TAX PROCEDURE, 1921 By ROBERT H. MONTGOMERY, C. P. A. of Lybrand, Ross Brothers and Montgomery; Attorney- at-Law ; Former President, American Association of Public Accountants; Professor of Accounting, Columbia University New \ ork THE RONALD PRESS COMPANY 1922 ^^ Q>3 G Copyright, 1922, by Robert H. Montgomery PREFACE The 1 92 1 federal tax law is a disappointment to 99 per cent of the citizens of the United States who are intelligent or interested enough to think or talk about it. The -truth of the matter is that Congress did not have the courage to face the issue and enact an understandable tax law. There are only- two kinds of income tax laws : one kind is short and simple and leaves much to the discretion of administrative officers; the other kind is long and complicated and in its endeavor to reach every one of a thousand items of income, to classify every one of a thousand items of deductions, to deny discretion to the Commissioner of Internal Revenue, it omits reference to items of income numbers looi and 1002; it fails to deal with items of deductions numbers lOOi to loio; it neglects to specify how the Commissioner shall settle the omitted items, and thus comes chaos. It is bad enough when there is enacted one law of the "long" type; but when such a law is enacted in 1913, a new one in 1916, the 19 16 law is amended in 19 17, a new lavv is enacted in 19 18, is it any wonder that trouble arose when there was a unanimous demand for another new law in 1921 ? The House of Representatives passed a law of the 19 17 type on August 20, 1921. It attempted to merely amend the 1918 law. The Senate attempted to follow the same course but as it evolved 833 amendments to the House bill and as the House bill amended the 1918 law, the effect of 833 amend- ments to another series of amendments made strong men weep. And so the Senate passed a new bill, ignoring the 1918 draft, which after undergoing the usual changes in conference emerged on November 23, 1921, as the "Revenue Act of 1921." The net result is that we have had five tax laws in less than nine years, and no one is satisfied ! I am strongly of the opinion that we should have another iii IV PREFACE very soon. It should be very short and very simple and it should leave 'it0-tli| Co^^issibner ol^nternal Revenue broad discretion. Then we should have a ten-year tax holiday so far as changes, other than in rates, are concerned. I would increase the salaries of all responsible officers of the Bureau of Internal Revenue and in every way possible make service in the Bureau attractive so that it will be possible for the good men to remain with the Bureau and more good men to be taken on. Even though the income tax is superseded by a general sales tax which administers itself, there are unsettled tax prob- lems involving billions of dollars and the settlement of such problems should only ]>e entrusted to men who have discretion, breadth of vision and high ideals regarding public service. Unexpectedly I have had to rewrite almost entirely 192 1 Income Tax Procedure. I did not at first realize that the important court and Treasury decisions during 192 1, coupled with the new law, made so many radical changes in present procedure and made so many changes of a retroactive nature in former procedure. It may be that in my opening remarks and in the book itself, I am unduly critical and it may be thought that there is a personal note in some of my comments. On the contrary, I benefit personally by the confusion. In my zeal for im- provement in law and procedure I am trying to put myself in the position of the long-suffering taxpayer. In my occa- sional criticisms of the Treasury, I am absolutely impersonal. Surely I cannot pay any higher tribute to the present personnel of the Bureau of Internal Revenue than to suggest that a new law should give them almost unlimited discretion. I only know of one employee of the Bureau whom I would summarily remove; I know of many who are striving conscientiously and intelligently to interpret the regulations (by which they are bound) impartially. In defense of my disagreements with some of the new regulations and rulings, I may say that dur- ing the year 1921 the courts and the Treasury fully justified PREFACE V many of the comments and criticisms appearing in the 191 7 and succeeding editions of Income Tax Procedure. The greatest curse has Ijeen the unsuccessful attempts to administer the laws as written, plus some very unintelligent and unjustified regulations. The new regulations (62) are a vast improvement over previous regulations. They very proj)erly overrule some of the narrow and illegal interpreta-. tions and Solicitor's opinions which have appeared during the year 1921. In themselves, they further justify the criti- cisms which I make of such former rulings. In response to several requests, I have devoted a chapter to the Federal Estate Tax, in the preparation of which I have had the valuable assistance of Orrin R. Judd, C. P. A., Trust Officer of the Columbia Trust Co., to whom my thanks are due. It would be impossible to bring out a new book annually without the help of many associates. To a greater extent than ever before, I acknowledge the invaluable assistance of my partner, Walter A. Staub, C. P. A., and my assistants, J. Marvin Haynes, of the Bar of the District of Columbia, Ham- ilton Howard and Robert Buchanan. I am again indebted to my colleague at Columbia Universit}', Professor Robert Mur- ray Haig, for valuable assistance in the preparation of this volume, and I wish to repeat my expressions of appreciation of his work on former editions which is retained and which has met with the approval of those who have written to me from time to time. I also express my appreciation of the authoritative material contained in the Income and War Tax Services of the Corporation Trust Company, New York, which I used very freely with the company's kind permission. Robert H. Montgomery. no William Street, New York, February 25, 1922. CONTENTS Chapter 1 Introdnctorv Part I — Application and Administration II III IV V VI VII VIII IX X XI XII XIII XIV XV XVI XVII xvm XIX XX XXI XXII XXIII XXIV Application of the Law — Corporations Exempt from Taxation .... Returns — When and How to Make Them Returns of Individuals and Corporations Amendment and Examination of Returns Penalties Rates and Computation of Tax Administration, Assessment and Payment Appeals, Refunds and Abatements of Over-Assessments Information at the Source .... Payment of Tax at Source .... Part II — Income Credits and Exempt Income Income in General Income from Personal Services Income from Business Income from Sales and Exchanges Securities and Other Property Computation of Tax on Exchange Sales of Capital Assets Income from Royalties and Patents Income from Interest — General Income from Interest on Obligation the United States Income from Rents Income from Dividends Income from Stock Dividends Income from Partnerships and Personal Service Corporations vii or s ot PA(iE 3 31 52 75 109 128 154 173 235 291 322 337 371 401 446 535 567 640 661 680 693 703 763 784 Chapter XXV XXVI XXVII XXVIII XXIX XXX XXXI XXXII XXXIII XXXIV CONTENTS Part III — Deductions Deductions and Credits — General Deductions for Expenses Deductions for Interest Deductions for Taxes Deductions for Losses Deductions for Bad Debts Deductions for Depreciation Deductions for Extraordinary lescence and Amortization Obso XXXV XXXVI XXXVII XXXVIII XXXIX XL XLI Deductions for Depletion Deductions for Contnl^utions, Donations, Gifts and Subscriptions .... Part IV — Special Classes of Taxpayers Tax on Undistributed Profits of Corpora- tions ......... Non-Resident Aliens Fiduciaries Insurance Companies Farmers Part V — Miscellaneous Taxes Federal Estate Tax b^deral Capital Stock Tax .... Appendices Appendix A — Supplement to Excess Profits Tax Pro- -1921 B- cedure- -Forms Page 845 851 923 937 975 1030 1050 1 130 1 167 1241 1259 1269 1326 1377 1407 1423 1524 1567 1675 C — Revenue Act of 192 1 1725 Indexes Revised Statutes .... Index to Articles of Regulations 62 General Index Index — Federal Estate Tax Index — Federal Capital Stock Tax Index — Excess Profits Tax 1811 1819 1833 1897 1903 1907 TABLE OF CASES A Albers Brothers Milling Co., City of Oakland, v. (184 Pac. 868) 697, 698 Allen, Altheimer and Rawlings Investment Co., v. (248 Fed. 688, 160 C. C. A. 588; 248 U. S. 578, 63 L. Ed. 430, 39 S. Ct. 20) 670 Altheimer and Rawlings Investment Co., v. Allen, (248 Fed. 688, 160 C. C. A. 588; 248 U. S. 578, 62, L. Ed. 430, 39 S. Ct. 20) 670 Anderson, Brady v. (240 Fed. 665, 153 C. C. A. 463) 222 Anderson, New York Life Insurance Co. v. (263 Fed. 527; 269 Fed. 1021 ) 272 Application of Willniann (112 Atl. 806) 268, 269, 270, 271 Baldwin Locomotive Works i'. McCoach (221 Fed. 59, 136 C. C. A. 660) ^ . . 583, 1608 Baltic Mining Co., Stanton v. (240 U. S. 103, 36 S. Ct. 278, 60 L. Ed. 546) 252, 1 169 Baltimore, Mayor etc., of, Brickill v. (60 Fed. 98, 8 C. C. A. 500) 658, 659 Biwabik Mining Co., United States v. (247 U. S. 116) 1225 Blakeslee, Wright v. (loi U. S. 174, 25 L. Ed. 1048) 289 Blum V. Wardell (270 Fed. 309) 1451 Board of Home Missions -u. City of Philadelphia (266 Pa. 405, 109 Atl. 664) 49 Bradley Constructing Co., Pennsylvania Cement Co. v. (274 Fed. 1003) 222 Brady v. Anderson (240 Fed. 665, 153 C. C. A. 463) 222 Brander v. Brander (4 Ves. Jr. 800 (Am. Ed.) ; 31 Eng. Rep. 414) 783 Brewster, Peopled- rt'/. 7^ Wendell (188 X. Y. Supp. 510) .358, 622 Brewster, Sayre v. (268 Fed. 553) 1476 Brewster, Walsh v. (— U. S.— , 65 L. Ed.—, — S. Ct.— ) 567, 568, 573. 983 Brickill ct al v. Mayor, etc., of Baltimore (60 Fed. 98, 8 C. C. A. 500) 658, 659 Brushaber v. Union Pacific Railroad Co. (240 U. S. i ; 60 L. Ed. 493; 36 S. Ct. 236) 9, 24, 252, 735, 783 Bryce et al. v. Keith (257 I'^d. 133 ) 1021 ix X TABLE OF CASES Burton v. Burton Stock Car Co. (50 N. E. 1029) 658 Butterick Co. v. United States (240 Fed. 539; 248 U. S. 587, 63 L. Ed. 434, 39 S. Ct. 5) 50 C Camp Bird v. Howbert (262 Fed. 114; 252 U. S. 579, 64 L. Ed. 725, 40 S. Ct. 344) 148, 271 Cadwalader v. Lederer (273 Fed. 879, 274 Fed. 753) 1570 Cartier and Holland v. Doyle (Not yet reported) 1664 Chadwick, in re, (5 Fed. Cas. 401, Fed. Cas. No. 2570) 114 Chandler v. Kelsey (205 U. S. 466, 51 L. Ed. 882, 27 S. Ct. 550) 1466 Chesebrough v. United States (192 U. S. 253, 48 L. Ed. 432, 24 S. Ct. 262) 289 Chicago and Alton R.R. v. U. S. (53 Ct. Cls. 41) 177 Chicago Great Western Railway Company, Des Moines Union Railway Co. %'. {lyy N. W. 90) 701, 702 Chicago Title and Trust Co. v. Smietanka (Not reported; see T. D. 3193) 92 Cincinnati Gas and Electric Co. v. Gilligan (Not reported; see B. 29-21-1738. Ct. D. 16) 268 Citv of Oakland v. Albers Brothers Milling Co. (184 Pac. 868) 697, 698 City of Philadelphia, Board of Home INIissions v. (266 Pa. 405, 109 Atl. 664) 49 City of Philadelphia v. Collector (5 Wall. 720, 72 U. S. 720, 18 L. Ed. 614) 288 Cleveland, Cincinnati, Chicago and St. Louis Railway Co., United States v. (247 U. S. 195, 38 S. Ct. 472, 62 L. Ed. 1064) 585, 618 Cliquot's Champagne (3 Wall. 411, 70 U. S. 114, 18 L. Ed. 116) 597 Cofifin and Gillmore, Reeder v. (Not reported; Court of Com- mon Pleas No. 3 (Philadelphia) June Term, 1918, No. 3268) 422, 423 Cohen v. Lowe (234 Fed. 474) 1089, 1123 Coleman, Succession of (85 Sou. (La.) 43) 615, 616 Collector, City of Philadelphia v. (5 Wall. 720, 72 U. S. 720, 18 L. Ed. 614) ." 288 Collector v. Day (11 Wall. 113, 78 U. S. 113, 20 L. Ed. 122) . . 403 Commonwealth, Drexel v. (46 Pa. St. 31 ) 24 Connecticut Mutual Life Insurance Co. v. Eaton (218 Fed. 206) 1059, 1086 Coulby, United States v. (258 Fed. 27, 169 C. C. A. 163) 190 County of Santa Clara v. Southern Pacific Railway Co. (18 Fed. 385; 118 U. S. 394, 30 L. Ed. 118, 6 S. Ct. 1132) .... 220 TABLE OF CASES xi Crews, Missouri, Kansas and Texas Railway Co. v. (54 Tex. Civ. App. 612, 120 S. W. 1150) 598 Crill, Hosack v. (204 Pa. St. 97, 53 Atl. 640) 644 Crocker v. Malley (249 U. S. 223, 63 L. Ed. 573, 39 S. Ct. 270, 2 A. L. R. looi) 93, 1531. 1532 Crutchley, Kemper Military School v. (274 Fed. 125) 274 Cryan v. Wardell (263 Fed. 248) 698, 699 D Darlington, Gray v. (15 Wall. 63, 82 U. S. 63, 21 L. Ed. 45) . . 586 Day, Collector ^;. (11 Wall. 113, 78 U. S. 113, 20 L. Ed. 122) . . 403 Delaski & Thropp Circular Woven Tire Co. v. Iredell (268 Fed. 377) : •• '660 Des Moines Union Railway Co. v. Chicago Great Western Rail- way Co. ( 177 N. W. 90) 701 , 702 Dodge V. Woolsey (18 How. 331, 59 U. S. 331. i Miller 284, 15 L. Ed. 401 ) 252 Dodge -Bros. v. Osborn (240 U. S. 118, 36 S. Ct. 275, 60 T.. Ed. 557) 223, 251 Doerscheeck v. United States (274 Fed. 739) 741 Doyle, Cartier and Holland v. (Not reported) 1664 Doyle, Schwab v. (269 Fed. 321 ) 1458, 1459 Doyle V. Mitchell Brothers Co. (247 U. S. 179, 38 S. Ct. 467, 62 L. Ed. 1054) 460, 482, 583, 584, 585, 613 Drexel v. Commonwealth (46 Pa. St. 31 ) 24 Dulaney, State ex rel. v. Nygaard (183 N. W. 884) 763 Earp's Appeal (28 Pa. St. 368) 783 Eaton, Connecticut Mutual Life Insurance Co. v. (218 Fed. 206) 1059, 1086 Ebersole v. McGrath (271 Fed. 995) 1464 Edwards, Goodrich v. ( — U. S. — , 65 L. Ed. — , — S. Ct. — ) 570, 983, 1621 Edwards, New York Trust Co. ct al. v. (274 Fed. 952; — U. S.— , 66 L. Ed.—, — S. Ct.— ) 735, 736 Edwards zk Wabash Railway Co. (264 Fed. 610) 190, 239 Edwards, Lincoln Chemical Co. v. (272 Fed. 142) 1610, 1661 Ehret Magnesia Mfg. Co. 7>. Lederer (273 Fed. 689) 1582 Eisner v. Macomber (252 U. S. 189, 40 S. Ct. 189, 64 L. Ed. ■521) 696, 763, 814 Eisner, N. Y. Trust Co. v. (— U. S.— , 65 L. Ed.—, — S. Ct.— ) 1476 Eisner, Mente v. (266 Fed. 161 ) 996 Eisner, Peabody v. (247 U. S. 347, 38 S. Ct. 546, 62 L. Ed. 1152) 587, 7^7 xii TABLE OF CASES Eliot V. Freeman et al. (220 U. S. 178, 55 L. Ed. 424, 31 S. Ct. 360) 1531 Eliot National Bank v. Gill (218 Fed. 600, 134 C. C. A. 358) . . 197 Elliott z>. Swartwout (10 Peters 137, 35 U. S. 137, 12 Curtis 46, 9 L. Ed. 373) 288, 289 Evans v. Gore (253 U. S. 245, 64 L. Ed. 887, 40 S. Ct. 550) 366, 402 F Farmers' Loan and Trust Co., Pollock z'. (157 V. S. 429, 39 L. Ed. 759, 15 S. Ct. 673; 158 U. S. 601, 39 L. Ed. 1108, 15 S. Ct. 912) 7, 252, 402 Field, United States v. (255 U. S. 257, 65 L. Ed. 355, 41 S. Ct. 256) 1463 First Trust and Savings Bank z\ .Smietanka (Not reported).. 1347 Fish z'. Irwin ( Not reported ) 141 1 Flint c'. Stone Tracy Co. (220 U. S. 107, 55 L. Ed. 389, 31 S. Ct. 342) V 8, 115 Freeman, ct at., Eliot z-. (220 U. S. 178, 55 L. Ed. 424, 31 S. Ct. 360) 1531 G Gaither v. Miles (268 Fed. 692) 1467 Gauley Mountain Coal Co., Hays z: (247 U. S. 189, 38 S. Ct. 470, 62 L. Ed. 1061 ) 585, 615, 617, 618 Gearin, Miller v. (258 Fed. 225, 169 C. C. A. 293; 250 U. S. 667, 62 L. Ed. 1 197, 40 S. Ct. 13) 697 General Film Corporation, /•// re (274 Fed. 903) ....275, 727, 903 Gibbons z'. Mahon (136 U. S. 540, 34 L. Ed. 525, 10 S. Ct. 1057) 783 Gill, Boston Terminal Co. v. (246 Fed. 664, 158 C. C. A. 620) . . 50 Gill, Eliot National Bank v. (218 Fed. 600, 134 C. C. A. 358) . . 197 Gilligan, Cincinnati Gas and Electric Co. z>. (Not reported; B. 29-21-1738, Ct. D. 16) 268 Gilligan, Park z'. (Not reported; see Corp. Tr. Co. 1921 In- come Tax Service, par. 3067 et seq.) 707, 708, 725, ^26, 727, 762 Gillmore, Coffin and Reeder v. (Not reported; Court of Com- mon Pleas No. 3 (Philadelphia) June Term 1918, No. 3268) 422, 423 Goodrich r. Edwards (— U. S.— , 63 L. Ed.—. — S. Ct.— ) 570, 983. 1621 Gould V. Gould (245 U. S. 151. 38 S. Ct. 53, 62 L. Ed. 211) 238, 367, 721, 870, 1432, 1619 Gore, Evans v. (253 U. S. 245, 64 L. Ed. 887, 40 S. Ct. 550) 366, 402 Grand Rapids, etc., Railway Co., United States v. (239 Fed. 153; 256 Fed. 989) 197 Gray v. Darlington (15 Wall. 63, 82 U. S. 63, 21 L. Ed. 45) . . 586 TABLE OF CASES xiii Great Northern Railway Co. v. J.ynch (Not reported; see T. D. 3147) 520, 1648 Greenport Basin and Construction Co. v. United States (269 Fed. 58) 287, 288, 1581 Guggenheim Exploration Co., United States v. (238 Fed. 231) 583 Gulf and Interstate Railway Co. of Texas, Walker v. (269 Fed. 885) 663, 1020 Gulf Oil Corporation v. Lewellyn (248 U. S. yi, 39 S. Ct. 35, 62, L- Efh 133 ) 586, 717, 762 H Haiku Sugar Co. ct al. v. Johnstone (249 Fed. 103) 810 Hawes v. Oakland (104 U. S. 450, 14 Otto 450, 26 L. Ed. 827) . . 252 Hayden, Suffolk County z'. (3 Wall. 315) 656 Hays V. Gauley Mountain Coal Co. (247 U. S. 189, 38 S. Ct. 470, 62 L. Ed. 1061 ) 585, 615, 617, 618 Herold v. Kahn (159 Fed. 608, 86 C. C. A. 598; 163 Fed. 947, 90 C. C. A. 307) 290 Herold, Mutual Benefit Life Lisurance Co. ■c*. (198 Fed. 199; 201 Fed. 918, 120 C. C. A. 256) 239 Holbrook v. Moore (Not reported; see T. D. 3161) 415 Holland, Cartier and, v. Doyle (Not reported) 1664 Hornby, Lynch v. (247 U. S. 339, 38 S. Ct. 543, 6^ L. Ed. 1149) SSb, 587, 717, 723, 724, 735, 754, 762 Hosack V. Crill (204 Pa. St. 97, 53 Atl. 640) 644 Howbert, Camp Bird v. (262 Fed. 114; 252 U. .S. 579, 64 L. Ed. 725, 40 S. Ct. 344) 148, 271 Howbert, Stratton's Independence z\ {2y U. S. 399, s8 L. Ed. 285, 34 s. Ct. 136) .' ....: 1618 Hubbard v. Kelly (8 W. Va. 46) 264 In re Chadwick (5 Fed. Cas. 401, Fed. Cas. No. 2570) 114 In re General Film Corporation (274 Fed. 903) 275, 727, 903 Indiana Steel Co., Smietanka 7'. ( — U. S. — , 66 L. Ed. — , — S. Ct.— ) 267, 268 Irwin Fish v. (Not reported) 141 1 Iredell, Delaski & Thropp Circular Woven Tire Co. 7'. (268 Fed. 377) 1660 Irwin, Rensselaer and Saratoga R.R. Co. t'. (239 Fed. 739; 249 Fed. 726, i6t C. C. A. 636; 246 U. S. 671, 38 S. Ct. 424, 62 L. Ed. 93 1 ) 700 Tseminger, Wilson 7'. ( 185 V. S. 55, 46 L. VA. 804. 22 S. Ct. 573) 932 xiv TABLE OF CASES J Jackson v. Smietanka (267 Fed. 932; 272 Fed. 970) 415 Johnstone, Haiku Sugar Co. et al v. (249 Fed. 103) 810 Jordan Marsh Co., Suter et al. v. (225 Mass. 34, 113 N. E. 580) 700, 701 K Kahn, Herold v. (159 Fed. 608, 86 C. C. A. 598, 163 Fed. 947, 90 C. C. A. 307) 290 Kansas City Title and Trust Co. et al. Smith v. ( — U. S. — , 65 L. Ed.—, — S. Ct.— ) 682 Keith, Bryce et al. v. (2^7 Fed. 133) 1021 Kellogg, United States v. (274 Fed. 903) 275 Kelly, Hubbard t/. (8 W. Va. 46) 264 Kelsey, Chandler v. (205 U. S. 466, 51 L. Ed. 882, 27 S. Ct. 550) 1466 Kemper Military School v. Crutchley, (274 Fed. 125) 274 Kirkendall, Markle et al. v. (267 Fed. 498) 221, 250 Kirkpatrick, Kountz v. (72 Pa. St. ^76, 13 Am. Rep. 687) .... 599 Kissam et al., McElligott v. (275 Fed. 545) 1462 Kountz V. Kirkpatrick (72 Pa. St. 376, 13 Am. Rep. 687) 599 L La Belle Iron Works v. United States (— U. S.— , 65, L. Ed.—, 41 S. Ct. 528) 256, 1053, 1054, 1583, 1587, 1598, 1603, 1604, 1607, 1609 Lauer v. United States (5 Ct. CI. 447) 264 Lederer, Cadwalader v. (273 Fed. 879, 274 Fed. 753) 1570 Lederer, Ehret Magnesia Mfg. Co. v. (273 Fed. 689) 1582 Lederer, Massey v. (Not reported) 325, 678 Lederer, Northern Trust Co. v. (262 Fed. 52; 252 U. S. 487, 64 L. Ed. 1025, 40 S. Ct. 483) 1476 Lederer, Philadelphia, Harrisburg and Pittsburgh R.R. Co. V. (242 Fed. 492) 268 Lederer v. Stockton (266 Fed. 173; 254 U. S. 625) 625, 1366 Levy V. United States (271 Fed. 942) 136 Lewellyn, Gulf Oil Corp. v. (248 U. S. 71, 39 S. Ct. 35, 63 L. Ed. 133) 586, 717, 762 Lewellyn, United States by, v. Mellon (Not reported; see Corp. Tr. Co. 1921 Income Tax Service, par. 3091 et seq.) . .765, 766 Lincoln Chemical Co. v. Edwards (272 Fed. 142) 1610, 1661 Little Schuylkill Navigation R.R. and Coal Co. v. Philadel- phia and Reading Railway Co. (44 Pa. County Reports 197) 701 Loomis V. Wattles (266 Fed. 876) 266, 267 TABLE OF CASES xv Lowe, Cohen v. (234 Fed. 474) 1089, 1 123 Lowe, Peck and Co. v. (247 U. S. 165, 38 S. Ct. 432, 62 L. Ed. 1049) 527 Lowe, Southern Pacific Co. v. (247 U. S. 330, 38 S. Ct. 540, 62 L. Ed. 1142) 586, 717, 762 Lynch, Great Northern Railway Co. v. (Not reported; see T. D. 3147) 520, 1648 Lynch v. Hornby (247 U. S. 339, 38 S. Ct. 543, 63 L. Ed. 1149) 586, 587, 717, 723, 724, 735, 754, 762 Lynch, Northern Pacific Railway Co. v. (Not reported; see T. D. 3048) 663 Lynch v. Turrish (247 U. S. 221, 38 .S. Ct. 537, 62 L. Ed. 1087) 585, 586, yz'S^ 754 Lynn, Oliver v. { 130 Mass. 143 ) 372 M Macomber, Eisner v. (252 U. S. 189, 40 S. Ct. 189, 64 L. Ed. 521) 696,763, 814 Madison, etc. Railroad Co., Pearce v. (62 U. S. 441 ) 810 Mahon, Gibbons v. (136 U. S. 540, 34 L. Ed. 525, 10 S. Ct. 1057) 783 Mallandaine, Partridge v. (L. R. 18 Q. B. Div. 276) 447 Malley, Thayer v. (Not reported) 1476 Malley, Crocker v. (249 U. S. 223, 63 L. Ed. 573, 39 S. Ct. 270, 2 A. L. R. looi) 93, 1531, 1532 Markle et at. v. Kirkendall (267 Fed. 498) 221, 250 Marks, Snyder v. (109 U. S. 189, 27 L. Ed. 901, 3 S. Ct. 157) . . 250 Martinez v. State ( 16 Tex. App. 122) 598 Massey v. Lederer (Not yet reported) 325, 678 Matter of Osborne (209 N. Y. 450, 50 L. R. A. (N. S.) 510, Am. Ann. Cas. 1915 A. 298, 52 N. Y. Supp. 48; 166 App. Div. 547) ■ • 783 Mayor, etc., of Baltimore, Brickill v. (60 Fed. 98, 8 C. C. A. 500) 658, 659 McClain, Spreckles Sugar Co. v. (192 U. S. 397, 24 S. Ct. 376, 48 L. Ed. 496) 239 McCoach, Baldwin Locomotive Works ?'. (221 Fed. S9> 136 C. C. A. 660) .'.;..'. 583, 1608 McElligott V. Kissam et al. (275 Fed. 545) 1462 McElligott, Towne v. (274 Fed. 960) 775, yy6 McGrath, Ebersole v. (271 Fed. 995) 1464 McHattan et al., United States v. (266 Fed. 602) 221, 222 Mellon, United States by Lewellyn (Not reported; see Corp. Trust Co., 1921 Income Tax Service, par. 3091 et seq.)y6-^, 766 Mente v. Eisner (266 Fed. 161 ) 996 xvi TABLE OF CASES Miles, Gaither v. (268 Fed. 692) 1467 ]\Iiles, Safe Deposit & Trust Co. of Baltimore v. (273 Fed. 822) 550, 1337 Miller v. Gearin (258 Fed. 225, 169 C. C. A. 293; 250 U. S. 667, 63 L. Ed. 1197, 40 S. Ct. 13) 697 Minot V. Paine (99 Mass. loi ) 783 Missouri, Kansas & Texas Railway Co. v. Crews, (54 Tex. Civ. App. 612, 120 S. W. 1150) 598 Mitchell Bros. Co., Doyle z'. (247 U. S. 179, 38 S. Ct. 467, 62 L. Ed. 1054) 460, 482, 583, 584, 585, 613 Mohawk Mining Co. v. Weiss (264 Fed. 502; 254 U. S. 637) . . 1225 Montana Railway Company v. Warren (137 U. S. 348) . . . .657, 658 Moore, Holbrook v. (Not reported; see T. D. 3161 ) 415 Mutual Benefit Life Insurance Co. v. Herold (198 Fed. 199; 201 Fed. 918. 120 C. C. A. 256) 239 N Nashville, Chattanooga & St. Louis Ry. Co. v. U. S. (269 Fed. 351 ; — U. S. — , 65 L. Ed. — , — S. Ct.— ) 1061, 1062, 1063 New York Life Insurance Co. v. Anderson (263 Fed. 527; 269 Fed. 1021) 272 New York Trust Co. et al. v. Edwards (274 Fed. 952; — U. S.-, 66 L. Ed.- -S. Ct.-) 735. 736 New York Trust Co. ct a!, v. Eisner ( — U. S.— , 65 L. Ed. — , — S. Ct.— ) 1476 Northern Pacific Railway Co. v. Lvnch ( Not reported ; see T. D. 3048) '. 663 Northern Trust Co. v. Lederer (262 Fed. 52; 252 U. S. 487, 64 L. Ed. 1025, 40 S. Ct. 483) 1476 Nygaard, State ex rcl. Dulaney v. ( 183 N. W. 884) 76;^ O Oak Ridge Coal Co. v. Rogers (108 Pa. St. 147) 812 Oakland, Citv of, v. Albers Brothers Milling Co. ( 1S4 Pac. 868) ..'. 698 Oakland, Hawes v. (104 U. S. 450. 14 Otto 450, 26 L. Ed. 827) 252 Oliver v. Lynn (130 Mass. 143) 37^ Oregon-Washington Railway & Navigation Co.. United States V. (251 Fed. 211) 374. 520, 1006 Osborn. Dodge Bros. v. (240 U. S. 118, 36 S. Ct. 275, 60 L. Ed. 557) 223, 251 Osborne, Matter of (209 N. Y. 450, 50 L. R. A. (N. S.) 510, Am. Ann. Cas. 1915 A. 298, 52 N. Y. Supp. 48; 166 App. Div. 547) 7^3 TABLE OF CASES xvii P Page, Polk V. (276 Fed. 128) 1519 Paine, Minot v. (99 Mass. loi ) 783 Park V. Gilligan (Not reported; see Corp. Trust -Co. 1921 In- come Tax Service, par. 3067 et seq.) 707, 708, 725, 726, 727, 762 Partridge v. jMallandaine (L. R. 18 Q. B. Div. 276) 447 Peabody v. Eisner (247 U. S. 347, 38 S. Ct. 546, 62 L. Ed. 1152) 587, 717 Pearce v. Madison, etc., Railroad Co. (62 U. S. 441) 810 Peck & Co. V. Lowe (247 U. S. 165, 38 S. Ct. 432, 62 L. Ed. 1049) • 527 Pennsylvania Cement Co. v. Bradley Construction Co. (274 Fed. 1003) 222 People ex rel. Brewster v. Wendell (188 N. Y. Supp. 510) 358, 622 People ex rel. Wilson v. Wendell (188 N. Y. Supp. 273) . .358, 622 Phellis, United States v. (— U. S.— , 66 L. Ed.—, 41 S. Ct. 528) 565, 735, 736, 737, 738, 739, 754, 755, 766, 1649 Philadelphia & Reading Railway Co., Little Schuylkill Rail- road, Navigation & Coal Co. v. (44 Pa. County Reports 197) 701 Philadelphia, City of. Board of Home Missions v. (266 Pa. 405, 109 Atl. 664) 49 Philadelphia, City of, v. Collector (5 Wall. 720, 72 U. S. 720, 18 L. Ed. 614 ) 288 Philadelphia, Harrisburg & Pittsburg Railroad Co. v. Lederer (242 Fed. 492) 268 Philadelphia Knitting Mills, United States v. (268 Fed. 270; 27Z Fed. 657) 871, 872, 875 Polk et al. V. Page (276 Fed. 128) 1519 Pollock V. Farmers' Loan & Trust Co. (157 U. S. 429, 39 L. Ed. 759, 15 S. Ct. 673; 158 U. S. 601, 39 L. Ed. 1108, 15 S. Ct, 912) 7, 252, 402 Putnam, Tax Commissioner v. (227 Mass. 522, 116 N. E. 904, L. R. A. 1917 F. 806) 550, 763, 783 R Rachmil, United States v. (270 Fed. 869) 136 Rau V. United States (260 Fed. 131, 171 C. C. A. 167) 153 Re Chadwick (5 Fed. Cas. 401, P'ed. Cas. No. 2570) 114 Re General Film Corp. (274 Fed. 903) 275, 727, 903 Re Stanfield's Estate (135 N. Y. 292, 31 N. E. 1013) 1349 Reeder v. Coffin & (iillmore ("Not reported; Court of Common Pleas, No. 3 (Philadelphia) June Term 1918, No. 3268) 422, 423 Rensselaer & Saratoga Railroad Co. v. Irwin (239 Fed. 739; 249 Fed. 726, T6r C. C. A. 636; 246 U. S. 671, 38 S. Ct. 424, 62 L. Ed. 93 r ) 700 xviii TABLE OF CASES Rock Island, Arkansas & Louisiana Railroad Co. v. United States (254 U. S. 141) 265, 266, 267 Rockefeller v. United States (274 Fed. 952; — U. S. — , 66 L. Ed.—, — S. Ct.^) 264, .565, 735. 736 Rogers, Oak Ridge Coal Co. v. (108 Pa. St. 147) 812 Ryan, Weiser Valley Land & Water Co. v. (190 Fed. 417, 11 1 C. C. A. 221 ) 599 S Safe Deposit and Trust Company of Baltimore v. Miles (273 Fed. 822) 550, 1337 San Francisco and Portland Steamship Co. v. Scott (253 Fed. • 854) 912 Santa Clara, County of, v. Southern Pacific Railway Co. (18 Fed. 385; 118 U. S. 394, 30 L. Ed. 118, 6 S. Ct. 1132) 220 Sargent Land Co., Von Baumbach v. (242 U. S. 503, 61 L. Ed. 460, 37 S. Ct. 201) 642, 1169 Savings Bank, United States v. (14 Otto 728, 104 U. S. 728, 26 L. Ed. 908, 28 Int. Rev. Rec. 87) 264 Sayre v. Brewster (268 Fed. 553) 1476 Schwab V. Doyle (269 Fed. 321 ) 1458, 1459 Scott, San Francisco and Portland Steamship Co. v. (253 Fed. 854) 912 Sibley, Weeks v. (269 Fed. 155) 193, 194 Siegel, Swarts v. ( 1 17 Fed. 13) 1399 Simpson v. United States (252 U. S. 547, 40 S. Ct. 367, 64 L. Ed. 709) 1454 Skinner, Union Pacific Coal Co. v. (249 Fed. 152, 161 C. C. A. 204; 252 U. S. 570, 40 S. Ct. 392, 64 L. Ed. 721) 587 Smietanka, Chicago Title and Trust Co. v. (Not reported; see T. D. 3193) 92 Smietanka, v. Indiana Steel Co. ( — U. S. — , 66 L. Ed. — , — S. Ct.— ) 267, 268 Smietanka, First Trust and Savings Bank v. (Not yet re- ported) 1347 Smietanka, Jackson v. (267 Fed. 932; 272 Fed. 970) 4i'5 Smith V. Kansas City Title and Trust Co. et al ( — U. S. — , 65 L. Ed.—, — S. Ct.— ) 682 Snyder v. Marks (109 U. S. 189, 27 L. Ed. 901, 3 S. Ct. 157) 250 Southern Pacific Company v. Lowe (247 U. S. 330, 38 S. Ct. 762 540, 62 L. Ed. 1142) 586, 717. Southern Pacific Railway Co. County of Santa Clara v. (18 Fed. 385; 118 U. S. 394, 30 L. Ed. 118, 6 S. Ct. 1132) .... 220 Spreckels Sugar Co. v. McClain (192 U. S. 397, 24 S. Ct. 376, 48 L. Ed. 496) 239 Stanfield's Estate, Re (135 N. Y. 292, 31 N. E. 1013) 1349 TABLE OF CASES xix Stanton v. Baltic Mining Co. (240 U. S. 103, 36 S. Ct. 278, 60 L. Ed. 546) 252, 1169 State ex rcl. Dulaney v Nygaard ( 183 N. W. 884) 763 State, Martinez v. ( 16 Tex. Apps. 122) 598 Stockton, Lederer v. (266 Fed. 173; 254 U. S. 625) 625, 1366 Stone Tracy Co., Flint v. (220 U. S. 107; 55 L. Ed. 389; 31 S. Ct. 342) 8, 115 Stratton's Independence v. Howbert (231 U. S. 399, 58 L. Ed. 285, 34 S. Ct. 136) 1618 Succession of Coleman (85 Sou. (La.) 43) 615, 616 Suffolk County v. Hayden V3 Wall. 315) 656 Suter et al. v. Jordon Marsh Company (225 Mass. 34, 113 N. E. 580) 700, 701 Swarts V. Siegel (117 Fed. 13.) I399 Swartwout, Elliott i'. (10 Peters 137, 35 U. S. 137, 12 Curtis 46, 9 L. Ed. S7s) 288, 289 T Tax Commissioner v. Putnam (227 Mass. 522, 116 N. E. 904, L. R. A. 1917 F. 806) 550, 763, 783 Thacher v. United States (15 Blatch. 15, Fed. Cas. No. 1385 1) 240 Thayer et al. v. Malley (Not reported) 1476 Thomas v. United States (274 Fed. 739) 741 Towne v. McElligott (274 Fed. 960) 775, 776 Turrish, Lynch v. (247 U. S. 221, 38 S. Ct. 537, 62 L. Ed. 1087) ! 585, 586, 735 754 U Union Pacific Coal Co. v. Skinner (249 Fed. 152, 161 C. C. A. 204; 252 U. S. 570, 40 S. Ct. 392, 64 L. Ed. 721) 587 Union Pacific Railroad Co., Brushaber v. (240 U. S. i, 60 L. Ed. 493, 36 S. Ct. 236) 9, 24. 252. 735, 783 United States z: Biwabik Mining Co. (247 U. S. 116) 1225 United States, Butterick Co. v. (240 Fed. 539; 248 U. S. 587, 63 L. Ed. 434. 39 S. Ct. 5) 50 United States, Chesebrough v. (192 U. S. 253, 48 L. Ed. 432, 24 S. Ct. 262) .^ 289 United States, Chicago & Alton R.R. v. (53 Ct. CI. 41) 177 United States zk Cleveland, Cincinnati, Chicago & St. Louis Ry. Co. (247 U. S. 195, 38 S. Ct. 472, 62 L. Ed. 1064) . . . .585. 618 United States v. Coulby (258 Fed. 27, 169 C. C. A. 163) .... 190 United States, Doerscheeck z: (274 Fed. 739) 741 United States v. Field (255 U. S. 257, 65 L. Ed. 355, 41 S. Ct. 256) 1463 United States v. Grand Rapids, etc. Railway Co. (239 Fed. 153; 256 Fed. 989) 197 XX TABLE OF CASES United States, Greenport Basin and Construction Co. v. (269 Fed. 58) 287, 288, 1581 United States v. Guggenheim Exploration Co. (238 Fed. 231) 583 United States v. Kellogg (274 Fed. 903) 275 United States, LaBelle Iron Wks. v. (— U. S.— , 65 L. Ed.— 41 S. Ct. 528) 256, 1053, 1054, 1583, 1587, 1598, 1603, 1604, 1609, 1616, 1621, 1644, 1645 United States, Lauer ^. (5 Ct. CI. 447) 264 United States, Levy v. (271 Fed. 942) 136 United States by Lewellyn v. Mellon (Not reported; sec Corp. Tr. Co. 1921 Income Tax Service, par. 3091 ct scq.) . .765, 766 United States v. McHattan et at. (266 Fed. 602) .221, 222 United States, Nashville, Chattanooga and St. Louis R.R. Co. V. (269 Fed. 351; — U. S.— , 65 L. Ed.—, — S. Ct— ) 1061, 1062, 1063 United States z>. Oregon, Washington Railway and Navigation Co. (251 Fed. 211) 374, 520, 1006 United States v. Phellis (— U. S.— , 66 L. Ed.—, 41 S. Ct. 528) 565- 735. 73^^, 737, 73^, 739, 754, 755, 77^, 1649 United States v. Philadelphia Knitting Mills (268 Fed. 270, 273 Fed. 657) 871, 872, 875 United States v. Rachmil (270 Fed. 869) 136 United States, Ran v. (260 Fed. 131, 171 C. C. A. 167) 153 United States. Rockefeller v. (274 Fed. 952, — U. S. — , 66 L. Ed.—, — S. Ct.— ) 264, 565, 735, 736 United States, Rock Island, Arkansas and Louisiana R.R. Co. V. (254 U. S. 141 ) 265, 266, 267 United States v. Savings Bank (14 Otto 728. 1040 U. S. 728, 26 L. Ed. 908, 28 Int. Rev. Rec. 87) 264 United States, Simpson v. (252 V. S. 547, 40 S. Ct. 367, 64 L. Ed. 709) 1454 United States, Thacher v. (15 Blatch. 15, Fed. Cas. No. 1385 1) 240 United States. Thomas v. (274 Fed. 739) 741 United States v. Vanderbilt (275 Fed. 109) 421 United States v. Woodward ct al. (Not yet reported; see T. D- 3195) 961, 1361 United States, Washington Water Power Co. v. (Not yet re- ported) 1553 United States, Young v. (269 Fed. 58) 287, 288 V A'^anderbilt, United States v. (275 Fed. 109) 421 Virginia v. West Virginia (238 U. S. 202, 59 L. Ed. 1272, 35 S. Ct. 795) 597- 598 Von Baumbach v. Sargent Land Co. (242 U. S. 503, 61 L. Ed. 460, 37 S. Ct. 201) 642, 1 169 TABLE OF CASES xxi W Wabash Railway Co., Edwards v. (264 Fed. 610) 190, 239 Walker v. Gulf and ' Interstate Railway Co. of Texas (269 Fed. 885) 663, 1020 Walsh V. Brewster (— U. S.— , 65 L. Kd.— — S. Ct.— ) 567, 568, 573. 983 Walsh, Willinann t^^ al. v. (i 12 Atl. 804) 268, 269, 270, 271 Wardell, Blum v. (270 Fed. 309) 1451 Warden, Cryan v. (263 Fed. 248) 698, 699 Warren, Montana Railway Co. v. (137 U. S. 348) 657, 658 Washington Water Power Co. v. U. S. (Not yet reported) . . 1553 Wattles, Looniis v. (266 Fed. 876) 266, 267 Weeks V. Sibley (269 Fed. 155) 193, 194 Weiss, Mohawk Mining Co. v. (264 Fed. 502, 254 U. S. 637) . . 1225 Weiser Valley Land and Water Co. -o. Ryan (190 Fed. 417, HI C. C. A. 221) 599 Wendell, People ex rcl. Brewster v. (188 N. Y. Supp. 510) . .358, 622 Wendell, People ex rel. Wilson v. (188 N. Y. Supp. 273) . .358, 622 West Virginia, Virginia v. (238 U. S. 202, 59 L. Ed. 1272, 35 S. Ct. 795) 597, 598 Willmann, Application of (112 Atl. 806) 268, 269, 270, 271 Willmann et al. v. Walsh (112 Atl. 804) 268,269,270, 271 Wilson V. Iseminger (185 U. S. 55, 46 L. Ed. 804, 22 S. Ct. 573) 932 Wilson, People ex rel. v. Wendell (188 N. Y. Supp. 273) . .358, 622 Woodward et al U. S. v. (Not yet reported; see T. D. 3195) 961, 1361 Woolsey, Dodge v. (]8 Flow. 331, 59 U. S. 331, i Miller 284, 15 L. Ed. 401 ) 252 Wright V. Blakeslee (101 U. S. 174, 25 L. Ed. 1048) 289 Y Young V. United States (269 Fed. 58) 287, 288 INCOME TAX PROCEDURE 1922 CHAPTER I INTRODUCTORY In the 192 1 edition oi this book the prophecy was hazarded that whatever Congress might accompHsh in the direction of reforming the federal tax system in the year 192 1, the income tax was reasonably certain to remain our chief source of revenue. The developments of the past twelve months have borne out this forecast. The year 1922 finds the income tax more firmly entrenched than ever before. Extended consid- eration of possible alternatives, such as a high tariff and a general sales tax, has not resulted in displacing the income tax from its primary position in the federal revenue system. Even though a tariff with high rates is passed, as now seems probable, its yield will not compare with the expected yield from the income tax. If a sales tax is passed, as now seems possible, it Avill probably be in addition to the income tax rather than in substitution for it. Yield of the income tax. — During the fiscal year ended June 30, 1 92 1, the income and profits taxes produced about three and one-quarter billions of dollars, a decrease of three- quarters of a billion as compared with the previous year. The exact figures for the past four years are as follows : 1918 $2,839,027,938.57 1919 2,600,783,902.70 1920 3,956,934499-58 1921 3,225.790,65300 The estimated collections of the Bureau of Internal Rev- enue under the new Revenue Act of 1921, for the years ending June 30, 1922 and 1923, are as follows : Income Tax: 1922 1923 Individual $850,000,000 $780,000,000 Corporation 430,000,000 545,000,000 Profits tax 660,000,000 150,000,000 Back taxes 230,000,000 300,000,000 Total income tax $2,110,000,000 $1,775,000,000 .3 4 INTRODUCTORY Miscellaneous: 192J 1923 Estate tax $150,000,000 $150,000,000 Transportation 135,000,000 Tobacco 250,000,000 250,000,000 Automobiles 1 10,000,000 1 10,000,000 Corporation capital stock tax 75,000,000 75,000,000 Other miscellaneous 412,730,000 457,280,000 Total miscellaneous $1,132,730,000 $1,042,280,000 Total $3,242,730,000 $2,817,280,000 This table shows that the income taxes are expected to yield 65 per cent of the total this year, and 69 per cent next year. Last year they yielded approximately 70 per cent. The aboli- tion of the excess profits tax and the readjustment in the in- come tax promises to reduce the collections from income taxes by about one-third of a billion dollars. Distribution of incomes. — Under the authority given in the law/ the Commissioner of Internal Revenue has published statistics compiled from the income tax returns. Number of Personal Returns, Calendar Years 1917, 1918 and 1919, BY Income Classes" 1918 1919 1-516,938 1.924.872 1,496,878 1.569,741 322,2"^^! ^.^80-488 319,356 438,851 69,992] 30,227 [ 162,485 13.320 2.983 1,864 42; i8c Income Classes 1917 $ I. 000 to $ 2,000 1,640,758 2,000 " 3,000 838.707 3,000 " 4,000 374,958 4,000 " 5,000 185.805 5.000 " 10,000 270,666 10,000 " 15,000 65,800 15,000 " 20,000 29,896 20,000 " 25.000 16.806 25,000 " 30,000 10.571 30,000 " 40,000 12.733 40,000 " 50,000 7.087 50,000 " 100,000 12.439 100,000 " 150,000 3,302 150,000 " 200,000 1,302 200,000 " 250,000 703 250.000 " 300,000 342 300,000 " 400,000 380 400,000 " 500,000 179 500,000 " 1 ,000,000 315 1,000,000 an id over 141 Total . . 3.472,890 65 4,425,114 5.332,760 ' Section 258. 'Statistics of Income, Prcliiiiiiiary Report, 1920, page 15; and Statistics ef Income, 1922, page 4. INTRODUCTORY 5 The changes in the groups in the tliree years is of consider- able interest. The total number of persons paying income tax increased from 3,472,890 in 1917, to 4,425,114 in 1918. It will be noted that the entire 19 18 increase occurred among the comparatively small income tax payers, the number of returns filed in every group above the $20,000 line showing an actual decrease in number in 1918 as compared with 191 7. The 1919 figures, on the other hand, show an actual increase all along the line as compared with 1918, and an increase, compared with 19 17, up to incomes of $100,000. Cost of administration. — The cost of collecting the income tax increased from 55 cents per $100 of tax in 1920, to '^z cents in 192 1. This cost is still very low. Larger sums could profitably be spent in improving the administration of the tax, in increasing the number of districts, and in making more attractive the positions in the service. A thoroughly competent administrative force, adequate in size to the task it must perform, would diminish immeasurably the present burdens involved in complying with the law. Income Taxation in the United States Intelligent interpretation of the existing income tax statute is greatly facilitated by a knowledge of its history.^ Indeed the great number of unsettled questions of law and procedure arising under acts in force in earlier years renders a knowledge of these acts almost indispensable to most per- sons who use this book. Consequently it is deemed desirable to trace the development of the statute, giving sufficient in- formation to enable the reader, with the aid of the notes on ^ For a full discussion of the history of the income tax, see Edwin R. A. Seligman, The Income Tax (2nd edition. New York, 1914). For a detailed description of modern income tax systems, see K. K. Kennan, Income Taxation (Milwaukee, 1910). 6 INTRODUCTORY "Former Procedure," to gain a clear conception of the evolu- tion through which it has passed. The present federal income tax is the latest of a series of such taxes to be imposed for national purposes in the United States, and it is not the only income tax being ad- ministered within the country at present, for several states utilize this source of revenue concurrently with the federal government. In fact, important as it is to the federal sys- tem, the taxation of incomes is of scarcely less interest to the several states, for it is now accepted as perhaps the most promising means of bringing about state tax reform. State income taxation. — Because of the unhappy history of early attempts, state income taxes were viewed askance until Wisconsin, with a law introduced in 191 1, demonstrated the practicability of such taxes.* The Wisconsin precedent was quickly followed by other states, including Connecticut, which began to tax corporations on this basis in 1915,^ and Massachusetts, which passed a law of limited application in 1916.^ A recent but important convert to the plan is the state of New York, which in 191 7 imposed a franchise tax on manu- facturing and mercantile corporations and in 19 19 a personal income tax. The New York franchise law was amended in 1 9 19 to make it more general in its scope and to increase the tax to a charge of 43^2 per cent of the net income of cor- porations as reported to the Treasury for federal tax pur- poses^ and was intended to be in lieu of all personal property taxes on those corporations. Its success paved the way for the state income tax of 1919, which imposes progressive rates on the incomes of individuals. The procedure under the New York statutes imposing income taxes on individuals and * Laws of 1911, Chapter 658. "Acts of Conn., 1915, Ch. 292; Bulletin of the National Tax Associa- tion, February, 1916, page 8. 'Acts of Mass., 1916. Ch. 269; Chas. V. Bullock, The Massachusetts Income Tax (Boston, 1916). ' Modified in certain particulars. INTRODUCTORY 7 corporations is treated by the author in a separate volume entitled Nezv York State Income Tax Procedure, 1921/ Evolution of the federal income tax law. — The present federal income tax is a recent development. Income taxes were imposed by the national government during the Civil War, when they were considered to be indirect in their na- ture and consequently beyond the constitutional prohibition.' One was imposed also in 1894; but a year later, when tested, it was declared unconstitutional by the Supreme Court, in the famouse case of Pollock 7'. Farmers' Loan & Trust Company, ^^ on the ground that it was a direct tax and as such could only be imposed if apportioned according to population. Such an apportionment would lead to such monstrous economic consequences as to render a general income tax entirely un- available as a federal financial resource until a constitutional amendment had been secured. The sixteenth amendment was finally passed eighteen years later. It provided that : The Congress shall have power to lay and collect taxes on in- comes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration. The necessary number of states had ratified by February 25, 1913, but as a matter of convenience, March i, 1913, is referred to as the date since which Congress has had the power to tax incomes without apportionment. But even before the acquisition of this definite authority. Congress had passed the corporation excise tax of 1909, which was an income tax in fact although not in form. The evolution of the present statute dates from this act. The 19 13 'Those interested in the iirugrcss of the movement toward the taxation of income by the states will find the following articles valuable: Harley L. Lutz, "The Progress of State Income Tax Smce iQii," The American Economic Review, March 1920; and Alzada Comstock, "Fiscal Aspects of State Income Taxes," in the same journal for June, 1920. A more com- prehensive treatment of the subject will be found in Miss Comstock's State Taxation of Personal Incomes (New York, 1921). ° Seligman, The Income Tax, page 430 et seq. '" 157 U. S. 429, 39 L. Ed. 759; 15 S. Ct. 673; 158 U. S. 601, 39 L. Ed. 1108; 15 S. Ct. 912. 8 INTRODUCTORY law widened the application of the tax to include individuals, and the laws of 1916, 1917, 1918, and 1921, represented defi- nite developments and refinements, the more significant details of which are briefly described in the paragraphs which follow. In general there is evident a distinct trend toward elimination of arbitrary limitations on deductions, acceptance of estab- lished business customs and institutions, and recognition of the accountant's definition of profit and income. The corporation special excise tax of 1909. — The act of August 5, 1909" (hereinafter referred to as "the 1909 law"), provided that every corporation^^ should "be subject to pay annually a special excise tax with respect to the carrying on or doing business by such corporation .... equivalent to one per centum upon the entire net income over and above five thousand dollars received by it from all sources during such year " This law was declared constitutional by the Supreme Court of the United States^^ on the ground that it was an excise and not an income tax within the meaning of the federal Constitution, which, by clause four of article I, section 9, declares that : No capitation or other direct tax shall be laid, unless in pro- portion to the census or enumeration hereinbefore directed to be taken. To all intents and purposes, except that of overcoming the constitutional difficulty, this was, of course, an income tax. The law directed that "net income" should be ascertained by deducting from gross income received certain costs, expenses paid and losses, but in the administration of the law its re- quirements as to income received and expenses paid were "36 Stat, at L., C. 6, page 112; Comp. St. 1910, Supp. 1911, page 946; Pierce Fed. Code, Supp. §1036. ""Every corporation, joint-stock company or association, organized for profit and having a capital stock represented by shares, and every insurance company." ^^ flint v.. Stone Tracy Co., 220 U. S. 107; 55 L. Ed. 389; 31 Sup. Ct. 342. INTRODUCTORY g ignored, and corporations generally paid a tax based on net income as ascertained by commercial practice, i.e., by deduct- ing expenses accrued (whether paid or not) from income earned (whether received or not). The Treasury forms and regulations were designed for and applied to net income, not net receipts. The statute was brief and general in character, leaving to the administration much latitude in interpretation. However, one specific restriction was imposed : that upon deductions for interest paid — a feature which persisted in several later laws. The corporation could deduct interest actually paid on in- debtedness only "to an amount of such bonded or other in- debtedness not exceeding the paid-up capital stock of such corporation .... outstanding at the close of the year."^* xA.lthough passed late in the year, the law applied to the incomes of corporations as of the beginning of the calendar year 1909. Consequently the period during which incomes were affected by this act was four years and two months in length, extending from January i, 1909, to February 28, 191 3, when the 19 1 3 law replaced it. The 191 3 LAW. — Congress, almost immediately after the ratification of the sixteenth amendment, addressed itself to the task of formulating a general income tax law, and an act was finally approved October 3, 191 3, effective as of March i, 1913 (hereinafter referred to as "the 1913 law"). In spite of its many inconsistencies and ambiguities, this law must be acknowledged to have been on the whole an "intelligent and well-considered effort. "^^ It was upheld as constitutional by the Supreme Court.^^ Many of the Treasury's interpreta- tions, however, have not been upheld by the Supreme Court. The personal exemption was high : $3,000 for a single person, with an additional $1,000 for a married couple. The " 1909 law, section 38, second. "Seligman, The Income Tax, page 703. ^'' Brushabcr v. Union Pacific R. R. Co., 240 U. S. i ; 60 L. Ed. 493; 36 Sup. Ct. 236. lO INTRODUCTORY former exmptioii of $5,000 to corporations was, however, eliminated. The rates, compared with recent levels at least, were very low. A normal tax of i per cent applied to the total net income of individuals and corporations. Surtaxes, levied on individuals only, began with a i per cent rate when the net income reached $20,000 and increased gradually to 6 per cent on those portions of incomes which exceeded $500,000.^^ The yield the first year was approximately $71,000,000. Eagerness to prevent evasion and to secure a large yield was responsible for several restrictions upon deductions — re- strictions which caused endless complications and irritations. Thus, individuals in deducting losses CQuld subtract only those which were incurred "in trade." Deductions for depletion of mines, whether owned by individuals or corporations, were restricted, to 5 per cent of the output. Corporations were forced to pay tax on dividends received from other cor- porations whether or not the other corporations w^ere sub- ject to income tax. The restriction upon interest paid by corporations, mentioned as a characteristic of the 1909 law, was continued by the 19 13 law in another form. A corpora- tion could now deduct interest on its indebtedness "to an amount of such indebtedness not exceeding one-half of the sum of its interest-bearing indebtedness and its paid-up capital stock outstanding at the close of the year."^^ The law granted to corporations the privilege of account- ing on the basis of fiscal years rather than calendar years, but withheld it from individuals. Finally, the act adopted the English system of collection at the source, v/hich had proved so effective in preventing evasion in Great Britain. This de- vice, however, was the occasion of so great complaint from those charged with the duty of withholding the tax that after four years' experience it was abandoned in 19 17. i-'e^or a detailed table of the rates, see Chapter VII. is-ii/tjh several provisos including those designed to cover the cases f roor^ Hons with no capital stock and of corporation.'^ with indebted- ^°secured^t^^ collateral which was subject to sale as stock in trade. 1913 law, G (b). "■' INTRODUCTORY I j The 1 916 LAW. — Three years after its establishment the income tax was called upon to produce a much larger revenue. Because of the effects of the European War, receipts from import duties had diminished, while the necessary expendi- tures of the federal government had greatly increased. To assist in meeting this emergency, income tax rates were raised. The normal rate applying both to individuals and corporations was made 2 per cent and the surtax rates upon individual incomes were made to range from i to 13 per cent. The lowest surtax rate applied as before upon income immediately above $20,000, and the highest rate on the portions of income exceeding $2,000,000." This law, passed September 8, 19 16 (hereinafter referred to as "the 19 16 law"), was made applicable to income received after January i, 1916. Consequently the 19 13 law was ef- fective as to income received during a period of two years and ten months, from March i, 19 13, to December 31, 19 15. In general, the 1916 law, although a re-enactment of the 1913 law, was entirely recast in form and changed in a num- ber of particulars. The changes for the most part had the ef- fect of making the statute clearer and more practicable. March I, 19 1 3, was now definitely set as the date from which ap- preciations or depreciations of property values were to be measured for purposes of the tax. Stock dividends were specifically included in taxable net income, whereas the 19 13 law had been silent on this point. Proceeds of life insurance policies transferred upon the death of the insured were de- clared to be exempt only when paid to individual benefi- ciaries. Deductions were liberalized in two important particulars. Losses in transactions entered into for profit but not con- nected with an individual's trade or business were made al- lowable deductions, "to an amount not exceeding the profits arising therefrom. "^° Again, the arbitrary 5 per cent limita- "For a detailed statement of the rates, sec Chapter VII. ^'1916 law, section 5, fifth. 12 INTRODUCTORY tion Upon depletion allowances, a feature of the 191 3 law, was eliminated and the way was opened for the full deduction of items of this character. The 19 1 6 law continued in effect for two years from January i, 191 6, to December 31, 191 7. On October 3, 191 7, the war income tax act was passed and had the force of a supplement to the 19 16 law. The 191 7 LAW.-^ — Although the 1916 law yielded about 360 millions, such a sum was entirely insufificient as the con- tribution from this source toward the tremendous expenses caused by our entry into the war. Consequently an act was passed on the fourth anniversary of the passage of the 191 3 law, October 3, 1917 (hereinafter referred to as "the 1917 law"), which raised the income tax rates to a level never be- fore approached in the history of civilization.^" Thus after a very short period of administrative experience the income tax was put to the most severe test which a government ever had the courage to impose. It is greatly to the credit of both tax- payers and the Treasury that the system stood the test as suc- cessfully as it did. This 191 7 amendment was effective as of January i, 191 7, and remained valid for the period of one year. In form, the 191 7 law was an amendment to the 1916 law, the object apparently being to make possible the speedy re- peal of the former without disturbing the law proper. This policy must now be declared to have been a mistaken one, for the confusion and difficulty caused by operating under the 1916 law, with its elaborate amendments, including two separate schedules of rates and two sets of personal exemptions, more than counterbalanced any advantages of the plan. In addition to the 19 16 taxes, a new normal tax of 2 per cent was imposed on individuals and a new 4 per cent rate on corporations, making the total normal rate 4 per cent, except "For a complete analysis, see Income Tax Procedure, 1918. "Seligman, "The War Revenue Act," Political Science Quarterly, March, 1918, page 18. INTRODUCTORY 13 on the income between $1,000 and $2,000, on which the rate was 2 per cent, and making the corporation tax rate 6 per cent. The surtaxes on individual incomes, which were to be levied in addition to the surtaxes existing under the 1916 law, ranged from I to 50 per cent and applied to all persons with taxable incomes of $5,000 or more. Consequently a tax rate of 67 per cent was applied to all taxable income accruing to an individual in excess of $2,000,000 — 2 per cent normal and 13 per cent surtax under the 19 16 law, plus 2 per cent normal and 50 per cent surtax under the 19 17 law."^ For the purposes of the 191 7 amendment the personal exemption was reduced from $3,000 to $1,000, with $1,000 additional for married couples, and, for the first time, a deduction of $200 was permitted for each dependent. Various other changes were made in the law. The system of collection at source was virtually abandoned and a plan of "information at source" was substituted, thus removing a pro- lific source of irritation and embarrassment. The deduction of gifts by individuals to charitable, religious and educational institutions was permitted to an amount equal to 15 per cent of the net taxable income as calculated without making this deduction. On the other hand, limitations were imposed on several deductions, income and excess profits taxes being made non-deductible, as was interest on money borrowed for the purchase of tax-exempt securities. For the purpose of the new 4 per cent tax on corporations, however, permission was given to deduct the dividends on stock in other corpo- rations. The high rates established as the result of the passage of the 191 7 law were, of course, expected to be temporary. To prevent corporations from avoiding the heavy 19 17 tax through the simple device of postponing declarations of divi- dends until a period of lower rates arrived, Congress wrote a provision into the law which prescribed that dividends should be "taxed to the distributee at the rates prescribed by law for '" For a detailed statement of rates, see Chapter VII. 14 INTRODUCTORY the years in which such profit or surplus was accumulated by the corporation,"'* The years of accumulation could not be arbitrarily selected by the corporation and, under the Treasury interpretation, the precise position of the distributions in the surtax scales of the previous years was determined by adding them to the net income of the current year. This provision was repealed by the 191 8 law,^^ but in the short period during which it was in force it greatly complicated the administration of the law. Nevertheless it was essentially a just provision even though the prescribed method of applying the rates is open to criticism, and, having enacted it. Congress should have evolved some method of safeguarding the interests of the cor- poration which acted under it in good faith. In 1 91 7, also, excess profits taxes were introduced into the federal system. A law of this nature was passed March 3, 191 7, but was repealed by the act of October 3, 191 7, which imposed a heavy levy on supernormal profits as judged by the standard of invested capital. A full treatment of this act as well as of its successor of 1918 will be found in the author's Excess Profits Tax Procedure, 192 1. THE 1918 LAW. — The need for still greater revenues to meet the growing demands of the war, and an anxiety on the part of the Treasury to be relieved of some of the responsi- bility it had assumed by its liberal interpretation of the excess profits tax law of 191 7, united with other causes to bring about a new Revenue Act for 19 18. The law (hereinafter referred to as "the 1918 law") although not finally approved until February 24, 1919, affected incomes arising after January I, 191 8. It remained in force until the eft'ective date of the new Revenue Act of 1921, which, for most of the provisions, is January i, 1921. The 19 1 8 law was a complete statute, which replaced en- tirely the 1916 and 191 7 acts, which had existed concurrently *I9I7 law, section 1210. ° Except in the case of certain stock dividends. See Chapter XXIII. INTRODUCTORY 15 during 19 17. It was a comprehensive law which imposed a new version of profits tax, certain luxury taxes, and other internal revenue charges. Its text alone covered no less than 106 pages in the official edition. The technical task of drafting was well done, the language being for the most part clear, and the arrangement convenient; the form, in general, being greatly superior to that of earlier laws. Rates applied to 19 18 income exceeded even the record schedules of 191 7. The normal rate and the corporation tax rate both were made 12 per cent, with a reduction to 6 per cent on the first $4,000 of the taxable income of a citizen or resident of the United States. These rates stood for one year only. After January i, 1919, the normal rate applying to the taxable income of a citizen or resident of the United States became 8 per cent (4 per cent on the first $4,000) and the corporation tax rate dropped from 12 to 10 per cent. Thus there reappeared a discrimination of 2 per cent against cor- porate incomes similar to that which obtained in the year 191 7. Surtaxes on individual incomes ranged from i to 65 per cent, the highest rate applying to portions of income exceeding $1,000,000. The maximum total rate in 19 18 was, conse- quently, 10 per cent higher than that which obtained in 191 7, and the higher normal rate^® and the steeper progression made the tax much heavier upon moderate incomes than the pre- vious one.^^ The maximum total rate applied to 1919 and 1920 incomes was 73 per cent. The 191 8 law, wliile sufficiently complicated, was neverthe- less more simple and equitable than its predecessor. One set of rates and personal exemptions replaced the double set in force in 1917, and many of the limitations and restrictions which, since the beginning, had hedged about the various de- ductions and caused endless confusion and complication, were '"In the case of earned incomes, the normal rate of 12 per cent was actually no higher for individuals than in 1917, because of the application in that year of the 8 per cent excess profits tax to professions and occupa- tions in addition to the normal income tax of 4 per cent. "For a detailed table of rates, see Chapter VII. l6 INTRODUCTORY removed. Under the igi8 law, for the first time, an individual was permitted to deduct losses which are not incurred in trade. Also for the first time he was required to report upon the basis of his annual accounting period, even though that period did not coincide with the calendar year. Affiliated corporations were required to file consolidated returns.'^ Depreciation allowances were made more liberal. Depletion in the cases of mines and gas and oil wells was placed upon a very generous basis, with a special and rather artificial method provided for establishing "discovery value" in the case of properties owned by prospectors and "wild-catters." Special provision was made for charging off reasonable amortization on equipment which contributed to the prosecution of the war. Corporations for the first time were relieved of the arbitrary limitation on de- ductible interest, which had been in force since 19 13, and of the discriminating tax on dividends received from other cor- porations. Income and excess profits taxes paid to other juris- dictions upon income arising therein were, under certain con- ditions, allowed as credits against the tax. A specific credit of $2,000 was granted corporations. The rule allocating divi- dends to the year earned, established in the 191 7 law, was abandoned.^'' As in the case of previous laws, partnerships were not taxed as such, the individual members, instead, being made liable on their distributive shares. The 1918 law introduced an inno- vation by putting in the same category with partnerships, cer- tain corporations whose income was "to be ascribed primarily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether in- vested or borrowed) is not a material income-producing fac- tor" (section 200). At the end of the taxable year the undis- tributed net income of each of these "personal-service corpora- tions" was assigned for taxation to the stockholders in pro- Section 240. ' Except in the case of certain stock dividends. See Chapter XXIII. INTRODUCTORY 17 portion to their holdings. They were relieved of the federal profits taxes, which would otherwise attach because of the corporate form of the enterprise. Under the 192 1 law this class of personal service corporations was abandoned, effective December 31, 1921. The Revenue Act of 1921 Due to the insistence of business men that the taxes levied by the 191 8 law were unduly burdensome and were not well fitted to post-war conditions, both political parties during the presidential campaign of 1920 committed themselves to a revision of federal taxation. The Revenue Act of 192 1, approved November 23 of that year, is the result of the pledge of the Republican Party. Although it came from the House of Representatives in the form of a series of amend- ments, it finally emerged from Congress as a complete new law. In fact it follows the phraseology of the 1918 law very closely and, while the changes are numerous and fundamental in character, the new law is essentially a rewritten draft of the 19 18 law. Tlie provisions of the Revenue Act of 1921 (hereinafter re- ferred to as "the 192 1 law") are treated fully in the chapters which make up the body of this book, but it is desirable at this point to sketch briefly its main outlines and to make some general observations and criticisms. Modifications made by the 1921 law. — The effective date of the new law is, for most purposes, January i, 1921. Many of the most radical changes, however, do not come into force until one year later, January i, 1922. This includes the sec- tions which abolish the excess profits tax and the personal ser- vice corporation, increase the corporation tax rate, and estab- lish the new class of ''capital gains and losses." In spite of what many considered to be a definite pledge and due largely to the influence of the "agricultural bloc," Con- gress finally declined to repeal the profits tax for 1921 but did l8 INTRODUCTORY agree to abolish it thereafter. With it disappears the personal service corporation, which was, of course, a mere incident of profits taxation, devised to exclude corporations of a par- ticular type from the application of such taxes. When the excess profits tax goes, the income tax rate on corporations rises from lo to 12^ per cent. The change in the rate will cause corporations such as public utility corporations, which make only moderate profits, to pay higher taxes, but the total tax burden on corporate income is expected to be much lighter as will be seen from the statement of official estimates pointed on page 3. At the same time that these changes in the corporation in- come taxes are made, the surtax rates on individual incomes are scheduled for a reduction. A full table of the rates, old and new, is presented in Chapter V^II. It will be noted that the change afifects small taxpayers as well as large ones. The maximum rate remains very high — 50 per cent, as compared with the maximum rate of 65 per cent under the 19 18 law. The new 50 per cent rate applies to all income in excess of $200,000. The old rate, which applied to the increment of income above $200,000, was 60 per cent. Under the new scale, surtaxes do not begin until the $6,000 point is reached and are I per cent for incomes between $6,000 and $10,000. Under the old scale, the surtaxes begin at $5,000 and mount by more rapid steps. According to the estimates^*' these changes will not provide much relief for the individual taxpayers, however, for the government expects to get $780,000,000 next year with the changes in effect as compared with $850,000,000 this year. The most revolutionary change in the new law is the estab- lishment of the new^ division of income to be known as "capital gains." Beginning January i, 1922, profits made by indivi- duals arising from sales or exchanges of property "held for profit or investment," are subject to a maximum rate of 12^ per cent instead of the regular rates which, after that date, '"See page 3. INTRODUCTORY I9 will range as high as 58 per cent (normal plus surtaxes ).^^ The reason for the adoption of some such provision as this is plain, whatever one may think of choosing this particular method of meeting the situation. As everyone knows, many sales of property which have greatly increased in value since March i, 1913, have been postponed or entirely blocked by the unwillingness of prospective sellers to take their profits when they would immediately become subject to heavy surtaxes in the year of realization. The solution adopted was prac- tically to wipe out the offensive surtaxes on profits from this class of transactions. It is too early to predict the effect of the provision. In some cases it will work beneficially; in general it complicates the procedure and discriminates against earned income instead of in favor of it. It will be taken advantage of by those who are able to work out plans of waiving interest and dividends and substituting therefor fixed gains. The advantage to the investor in property conferred in the "capital gain" section is greatly accentuated by the provisions of the section prescribing the basis for determining gain or loss^^ which becomes effective as of January i, 192 1. Not only does this section adopt the so-called Frierson rule (which, in the case of property purchased before March i, 1913, states that a profit or loss must be shown when comparison is made with original cost and be limited to the portion thereof which accrued after March i, 1913), but it also liberalizes the defini- tion of the closed transaction. The law now states positively that no gain or loss on exchanges of property for property shall be recognized unless the property received in the trade "has a readily realizable market value." Even though it has a readily realizable market value, one need not account for the gain in certain cases. This is one : .... When any such property held for investment or for pro- ductive use in trade or business (not including stock-in-trade or other '^ 1921 law, section 206. This is hedged about by several restrictions. Cf. infra, Chapter XVII. ^'' Section 202. 20 INTRODUCTORY property held primarily for sale), is exchanged for property of a like kind or use Other exceptions, covering cases of corporate reorganizations and sales of property to corporations, make it unnecessary to report many gains which have heretofore been subject to tax at the time the transaction was performed. The new law takes an important forward step when it breaks away from the practice of refusing to permit a business loss in one period to affect the income of another accounting period. Section 204 (effective for 192 1) permits, within certain restrictions, a net loss from business suffered in one year to be offset against any net income realized in the two next succeeding years. In other words, such losses may now be used to blot out subsequent gains, but losses are "outlawed" for this purpose after the expiration of two years. This change goes far towards rendering unnecessary any averaging device such as has been often urged as a means of making the income tax more equitable. In addition to the reduced surtax rates, effective in 1922, the personal exemptions are made more liberal, the changes affecting the 1921 returns. In the case of a married person or a head of a family whose income does not exceed $5,000, the exemption is increased from $2,000 to $2,500.^^ The allowance for each dependent is raised from $200 to $400. A new provision regarding gifts requires the recipient, when he disposes of the gift, to account for the gain in the value of the gift in the hands of the donor before he parted with it. Another provision aims to prevent "wash sales" to establish losses. The law also recognizes, at last, reserves for bad debts as proper deductions. The Liberty bond exemptions are consolidated and simplified appreciably by another section. The new^ law provides that personal service corporations shall be taxed as ordinary corporations from January i, 1922, and incorporates a saving clause that if the Supreme Court declares invalid the method of taxing such corporations under For a full statement see 1921 law, section 216 (c). INTRODUCTORY 21 the 19 18 law, they shall be taxed as corporations from Jan- uary I, 1918. The basis of taxation of insurance companies is radically changed, as is that of businesses drawing the major portion of their income from sources within the pos- sessions of the United States. Affiliated corporations are given the option, from January r, 1922, to file separate or consolidated returns. A clause is also inserted validating the requirement of consolidated re- turns (including even partnerships) under the 191 7 law. A Tax Simplification Board has been set up under the new law to investigate the procedure of the Bureau of Internal Revenue and to make recommendations for its simplification. The services to be rendered by this board should be of great value and should materially assist in making the administra- tion of the law more effective. Congress has at last realized that the Treasury should not be allowed to withhold indefinitely from taxpayers any taxes overpaid, without granting some compensation for the delay. The law now provides that the Treasury shall pay interest on taxes refunded. Other changes in the law include a limitation of time for the filing of amortization claims; a provision that returns must be filed in all cases where an individual's gross income exceeds $5,000; a limitation on the deduction of interest paid to carry Liberty bonds; permission to deduct traveling expenses in full ; and a change in the limitation periods for amended returns. Finally there are important changes in administrative features, such as the sections permitting bind- ing agreements between the Treasury and the taxpayer, chang- ing the procedure with reference to appeals and authorizing the Treasury to defer collection in cases of undue hardship. All in all, the new law contains much that is good but also much which is open to serious criticism. It does not bear out the pre-election promises of the Republican Party. It is not a total loss ; but it is a disappointment. Undoubtedly progress is being made toward a more satis- 22 INTRODUCTORY factory statute from the technical point of view, but much still remains to be done. Perhaps the most damning indict- ment which can be urged against the new statute is that it has increased rather than decreased the technical difficulties of arriving at net income. Instead of amplifying, it has com- plicated the problem and it has done so in order to achieve certain objects which in the end are not likely to commend themselves to the people of the country generally. Certainly to set up a new differentiation of income in order to discrim- inate against earnings as compared with property profits, does not seem to constitute real progress toward a permanently satisfactory solution of the problem. Tax-exempt securities. — The high surtaxes on income have been the object of bitter attack recently on the ground that they are operating to force capital into tax-exempt securities. The relative attractiveness of tax-exempt municipal and state bonds has aroused those who are interested in private business undertakings which are dependent upon borrowed capital, and they demand either the exemption of interest on their secur- ities or the elimination of all exemptions. The plain facts are, of course, that the surtax rates are un- reasonably high and that the amounts of tax-exempt securities available for investment are unreasonably large. The reduc- tion of the surtax rates to the more moderate levels of the 1 92 1 law helps the situation somewhat. At the same time the problem of the tax-exempt bond should be vigorously attacked. Active support should be given to the proposed constitutional amendment permitting the states and the federal government to tax the interest on all future issues. Certainly there is no solution in the direction of further extension of the principle of exemption. Tax-exempt securities must be reduced in amount, not increased. Unless this can be accom- plished, the whole future of income taxation at progressive rates is seriously threatened.^* ^' See page 34. , ■ ' INTRODUCTORY 23 Differentiation between earned and unearned income. — There is a growing sentiment in favor of relatively heavier taxation of unearned income. Such a change was recom- mended by the Treasury for the 19 18 act. Largely because of the administrative difficulties involved, the suggestion was not adopted at that time. The question was made more im- portant by the higher rates and lower personal exemptions established by the 1918 law. It seemed probable that with all the time there was at their disposal, Congress between January and December, 1 92 1, would have been able to work out a satisfactory plan. Instead of doing so, they continued old discriminations against earned incomes and included new ones. It cannot be pos- sible that this discrimination in favor of the idle and the rich is intentional; it must be due to the incompetency and inat- tention of Congress. Some maintain that the operation of state and local prop- erty taxes makes a sufficient discrimination between earned and unearned incomes. The burden imposed by local taxation upon property, while nominally comprehending personal prop- erty, usually falls heavily upon real estate only. Therefore a differentiation between earned and unearned incomes in favor of the former would undoubtedly increase the present heavy taxation of real estate in some communities. But where the real estate tax is already inordinately high, the remedy should be sought in a reform of the state as well as the local tax system. Perhaps the greatest difficulty in differentiating between earned and unearned incomes lies in the distinction which will have to be made between income derived by an individual or partnership from the conduct of a business enterprise, and the dividends received by stockholders interested in a corpo- rate enterprise engaged in the same kind of business. This apparent inequality will largely disappear if some means can be devised whereby those closely associated with the manage- ment of a corporation, as the officers and directors of a close 24 INTRODUCTORY corporation, will be deemed to be in active business and en- titled to the rate of tax applicable to earned incomes. This distinction between "lazy" and "industrious" in- comes, to use Gladstone's famous terminology, has been rec- ognized in Great Britain since 1907 and appeals powerfully to the British people's sense of justice. There the differen- tiation is applied in the case of smaller incomes only, which materially simplifies the administrative problem. Inland Revenue officers consider this a simple distinction to establish in practice and the people generally believe it to be sound in principle. Retroactive taxation. — The Revenue Act of 19 18 was not approved by the President until February 24, 1919, two months after the close of the year whose incomes it subjected to tax. President Harding signed the 192 1 law on November 23, 192 1, three months earlier than President Wilson signed the 19 18 law, but still at least eleven months later than it should have been. The legality of this action appears to be beyond ques- tion, ^^ but its practical economic wisdom is quite another matter. It is of the highest importance that taxpayers should know in advance what their tax burden is to be. It is also important that they should not be put to serious inconvenience by being asked to master radical changes in complicated stat- utes within a few weeks before the returns are due. Congress has shown a strong disposition to postpone action on revenue measures and to take advantage of the fact that retroactive legislation of this type is not unconstitutional. In the presence of an overwhelming emergency such as may be occasioned "Decision. "It is clearly .... constitutional as well as expedient, in levying a tax on profits or income, to take as the measure of taxation the profits or income of a preceding year. To tax is legal, and to assume as a standard the transactions immediately prior is certainly not unreasonable, particularly when we find it always adopted in exactly similar cases." (Drcxel v. Coiiinionzvealtli, 46 Pa. St. 31.) See also Brushaber v. Union Pacific R. R. Co., 240 U. S. i ; 36 Sup. Ct. 236; 60 L. Ed. 493. For a full discussion as to the extent to which the laws of 1913 to 1918 were retroactive, see Income Tax Procedure, 1919, pages 30-32. INTRODUCTORY 25 by rapidly changing conditions during a war such legislation may be excused, but under present conditions there is no ade- quate reason why that legislation affecting a current year's income should not be completed early in the year. The Plan of the Book Due to the repeal of the excess profits tax as of January I, 1922, it has been considered unnecessary to issue a separate volume, as in 192 1, dealing with that subject. Instead, all new rulings regarding the excess profits tax are presented in an appendix to this volume. A chapter on the federal estate tax has been added in this edition. The federal capital stock tax chapter which was transferred to Excess Profits Tax Procedure in 1921, reap- pears in this volume as Chapter XLI. Two features of the book's arrangement should perhaps be emphasized. One is the policy of quoting exactly from law and regulations all material of importance in considering ques- tions connected with the preparation of returns. Since the construction often turns upon a single word or punctuation, it seems to the author important to make the precise official language available in convenient and easily recognizable form. The source of all material quoted in the text is plainly in- dicated, the excerpt being labeled "law," "regulation," "de- cision," etc., as the case may be. It should be noted that regulations quoted in the text are taken from official Regula- tions 62 unless otherwise specified. A quoted regulation bearing as a reference merely an article number is to be con- sidered as coming from this source. All material changes in the new regulations as compared with Regulations 45 are commented upon. A regulation with- out comment is the same as the corresponding article in Regulations 45. Since early in 1920 and including rulings issued prior, the Treasury has issued a series of official bulletins containing 26 INTRODUCTORY decisions, opinions and rulings by the Attorney General, Soli- citor of Internal Revenue, and the Committee on Appeals and Review and many "office" decisions. All of these have been carefully reviewed. Those of importance are quoted in full. When the author disagrees with the Treasury his reasons are stated. The following abbreviations are used by the Treasury in these bulletins : Ct. D Court Decision T. D Treasury Decision Op. A. G Opinion of Attorney General S Solicitor's Memorandum O. or L. O Solicitor's Law Opinion Sol. Op Solicitor's Opinion T. B. R Advisory Tax Board Recommendation T. B. M Advisory Tax Board Memorandum A. R. R Committee on Appeals and Review Recom- mendation A. R. M Committee on Appeals and Review Memor- andum 0. D Office Decision Mim Mimeograph letter C. B Cumulative Bulletin ( Xo. i covers 1919 ; No. 2, January-June, 1920; No. 3, July-December, 1920; No. 4, January-June, 1921) 1. T Income Tax Unit E. T Estate Tax Division C. S. T Capital Stock Tax Division A. B. C, etc Represent names of individuals M. N., X. Y. Z., etc.. . . Represent names of corporations, places of business, according to context X Represents a certain number Rulings issued prior to January i, 1922, were cited b}' the Treasury as 1-21-1369, meaning Bulletin No. i of 192 1, Ruling No. 1369. A new series of bulletins has been issued for 1922 in which the method of reference is different. Rul- ings are now quoted as I-3-27, meaning Volume I (of the new series. Bulletin No. 3. Ruling No. 27. The author has indexed all bulletin rulings issued prior to July, 1 92 1, to the pages of the Cumulative Bulletins upon INTRODUCTORY 27 which they appear. Thus C. B. 3, page 23, O. D. 587, shows that the quotation is from Office Decision 587 which will be found in full on page 2;^ of Cumulative Bulletin No. 3 (July- December, 1920). Rulings issued subsequent to July i, 1921, are referred to by number, as the Cumulative Bulletin for July-December, 192 1, is not yet published. 1922 rulings are quoted as shown in the 1922 bulletins. The second feature to which attention should be drawn is the treatment of former procedure. Because of the large num- ber of returns for previous years which are as yet unaudited by the authorities, it is deemed desirable to include in foot- notes the facts concerning the law and procedure which for- merly obtained wherever important changes have been made This makes it possible for the book to serve as a guide when questions arise in regard to old returns. PART I APPLICATION AND ADMINISTRATION CHAPTER II APPLICATION OF THE LAW CORPORATIONS EXEMPT FROM TAXATION The tax is imposed upon "net income,"^ a term minutely described in the law. In the case of individuals^ it means the gross income, which includes earnings from personal services, business and trades, profits from sales of property, interest, rents, royalties, dividends, etc.,^ less deductions for expenses, losses, interest, taxes, depreciation, etc.* The surtax, which commences at an amount in excess of $5,000 for 192 1 and of $6,000 for 1922, is calculated upon the total net income as thus established. To determine the basis for the 8 per cent normal tax^ of an individual, there are certain deductions (or "credits," as they are called) for dividends, interest on Liberty bonds, etc., the personal exemption of $1,000, $2,000, or $2,500, and the exemption for dependents." The first $4,000 of the amount so determined is subject to a normal tax of only 4 per cent' in the case of citizens or residents of the United States. The gross income of corporations includes the same items as for individuals,^ but the deductions are not quite the same.'* The net income of corporations is taxed 10 per cent for the calendar year 1921, in addition to the excess profits tax. The flat rate is increased to 12J/2 per cent for subsequent years. ^Sections 210, 230 (a). ' Section 212 (a). * Section 213. * Section 214. *For the year 1918, the rate was 12 per cent. The rate for 1919 and 1920 was 8 per cent. ' Section 216. ' For the year 1918 the rate was 6 per cent. The rate for 1919 and 1920 was 4 per cent. * Section 233. "The chief differences are deductions which arc perniitlcd individuals for losses not connected with business or trade, and for gifts. 31 32 APPLICATION AND ADMINISTRATION The excess profits tax is repealed as of December 31, 1921. Moreover, there are certain subtractions from corporate in- comes which are allowed under the title of "credits," a device adopted in order to make the meaning of the term "net income" that which is to be taxed for excess profits. For a full dis- cussion of credits see Chapter XII. The various types of taxable income included under the provisions of section 213, and the allowable deductions permit- ted by sections 214 and 234, are discussed in detail in the series of chapters which constitute Parts II and III of this book. Exempt Income in General It is pertinent at this place to discuss in a general way income which is partially or wholly exempt from taxation. Exempt income can be divided into four classes : 1. Income which is exempt from all taxes imposed by the 1 92 1 revenue law because it is received by certain types of corporations or by states or by the political subdivisions thereof. This class is dealt with later in this chapter. 2. Income which is exempt because, geographically, it lies beyond the scope and application of the law. (See Chapter XII.) 3. Income such as is not included in either of the above classes, which is exempt from both normal tax and surtaxes. Such items are not included in gross income. (See Chapter XII.) 4. Income such as is not included in any of the above classes, which is exempt from normal tax but is subject to surtax. (See Chapter XII.) The first class can be called an "exemption of the person," while the other three are "exemptions of the income." No individual" is entirely exempt from the tax merely be- '" This statement includes minors. See Chapter IV. EXEMPT CORPORATIONS 33 cause of his status or character as an individual unless one construes the personal exemption as an exception to this statement. That exemption, of course, operates to relieve entirely from taxation the person whose income is smaller than the specified amounts. If one should receive all his income from interest upon the obligations of a state or of any political subdivision thereof, or upon certain of the obligations of the United States or its possessions or securities issued under the provisions of the Fed- eral Farm Loan Act of July 17, 1916, he would be subject to no income tax and would not be required to make any return. He might receive and enjoy his income as if the tax did not exist. This is true even though, in addition, he receives tax- able income of any amount less than $1,000 (single person) during the year. If he receives more than $1,000 of such ad- ditional taxable income, he would proceed in the same manner as any other taxpayer. Also, taxpayers who receive dividends from the stock of American corporations subject to the income tax, or who receive interest on certain government securities, are exempt from the normal, taxes on such income but are nevertheless required to report such items annually if their total net income is large enough to justify them in making any return at all, or if their gross income exceeds $5,000. Another classification of exempt income has been made as follows :^^ 1. Granted for fiscal or administrative reasons: (a) Deductions necessary to tax true or net income only (ordi- nary and necessary expenses). (b) Credits required to avoid double taxation (dividends, pro- ceeds of insurance policies, and inheritances). 2. Granted for constitutional reasons: Interest from state and municipal obligations; salaries of state and municipal employees. (Amount of state and municipal securities withdrawn from the federal income " Rufus S. Tucker "Exemptions under the Federal Income Tax," Bul- letin of the National Tax Association, Volume 5, page 138. 34 APPLICATION AND ADMINISTRATION tax is at least $4,000,000,000, representing an annual in- come of $160,000,000.^- 3. Granted for reasons of public welfare: (a) Personal exemptions of $1,000 and $2,000, on the ground of inability of such small incomes to pay a direct tax. (b) In Prussia before the war the limit of exemptions was $220 and no European country had as high an exemption as $1,000. Raising the exemption would increase the number of citizens who do not knowingly contribute to the cost of government. 4. Granted to assist certain kinds of enterprise or to encourage certain .forms of investment, presumably — (a) Income from bonds of the United States, its territories and possessions, farm loan bonds, and bonds of the War Fi- nance Corporation. (b) Organizations not operating primarily for profit. Exempt Corporations Certain corporations are expressly exempt from the pro- visions of the law. Types of corporations exempt. — The law groups the ex- empt corporations under fourteen heads : Law. Section 231. That the following organizations shall be exempt from taxation under this title — .... Labor, agricultural or horticultural organiza- tions. — Law. Section 231. . . . . (i) Labor, agricultural, or horticul- tural organizations; Regulation. Agricultural or horticultural organizations exempt from tax do not include corporations engaged in growing agricultural or horticultural products or raising live stock or similar products for profit, but include only those organizations which, having no net in- come inuring to the benefit of their members, are educational or instructive in character and have for their purpose the betterment of the conditions of those engaged in these pursuits, the improvement ""It is estimated that there are outstanding perhaps $10,000,000,000 of fully tax exempt securities." Letter from Secretary of the Treasury Mellon to Chairman Focdney of the Committee on Ways and Means, April 30, 1921. EXEMPT CORPORATIONS 35 of the grade of their products, and the encouragement and promotion of these industries to a higher degree of efficiency. Included in this class as exempt are organizations such as county fairs and like asso- ciations of a quasi-public character, which through a system of awards, prizes, or premiums are designed to encourage the production of better live stock, better agricultural and horticultural products, and whose income, derived from gate receipts, entry fees, donations, etc., is used exclusively to meet the necessary expenses of upkeep and operation. Societies or associations which have for their pur- pose the holding of annual or periodical race meets, from which profits inure or may inure to the benefit of the members or stock- holders, do not come within the terms of this exemption. A corpora- tion engaged in the business of raising stock or poultry, or growing grain, fruits, or other products of this character, as a means of liveli- hood and for the purpose of gain, is an agricultural or horticultural society only in the sense that its name indicates the kind of business in which it is engaged, and it is not exempt from tax. (Art. 512.) The foregoing regulation makes it clear that many so- called mutual organizations are subject to the tax. Ruling. The X Company is a business activity organized for the purpose of affording employment to the members of a certain labor union. It is not a part of the union as such, although it is owned and controlled by the union. Wages are paid to the members employed, and all profits, after paying expenses, are turned into the treasury of the union. Held, that the activities of the company are such as to make it a business enterprise. Hence it does not come within the exemption as a labor organization provided in section 231 (i) of the Revenue Act of 1918, and will, therefore, be required to file returns of net income. (C. B. 2, page 211 ; O. D. 523.) Mutual savings banks. — Law. Section 231 (2) Mutual savings banks not having a capital stock represented by shares; .... Regulation. A Massachusetts savings bank, otherwise exempt, which establishes an insurance department under the statutes of that State, does not thereby become subject to tax upon the income re- ceived by such department. (Art, 513.) Ruling. A savings bank within the accepted meaning of the term contemplates the ordinary institution of that kind as organized and conducted in accordance with the statutes of the various States. Its manner of investing the savings of depositors is restricted. Fur- thermore, the funds are received by deposits ordinarily made, rather 36 APPLICATION AND ADMINISTRATION than by a contract under which there arises a binding duty to make future deposits. Therefore an organization which receives deposits from its members by contract under which there arises a binding duty to make future deposits, and which is operated for the purpose of speculation rather than for savings, is not a mutual savings bank within the meaning of section 231 (2) of the Revenue Act of 1918. (C. B. 4, page 262 ; O. D. 780.) Fraternal beneficiary societies. — Law. Section 231 (3) Fraternal beneficiary societies, orders, or associations, (a) operating under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system; and (b) providing for the payment of life, sick, accident, or other benefits to the members of such society, order, or association or their dependents; .... Regulation. A fraternal beneficiary society is exempt from tax only if operated under the "lodge system," or for the exclusive bene- fit of the members of a society so operating. "Operating under the lodge system" means carrying on its activities under a form of organ- ization that comprises local branches, chartered by a parent organiza- tion and largely self-governing, called lodges, chapters, or the like. In order to be exempt it is also necessary that the society have an established system for the payment to its members or their depend- ents of life, sick, accident, or other benefits. (Art. 514.) The two rulings which follow indicate the Treasury's inter- pretation of the law and regulations. Ruling. The M association is an incorporated society operating under the lodge system throughout the United States, its charter pro- viding for the union of eligible members into a grand fraternal benefici- ary, educational and patriotic society. Assessments are levied upon its members to provide for the payment of sick and death benefits, for disability relief in case of accident and for promoting their social, moral, educational and patriotic advancement. It also derives in- come from subscriptions to a daily and a weekly newspaper which it publishes as well as from job printing and other sources. None of the income inures to the benefit of any private stockholder or individual. Held, that although this society has fraternal and benevolent features it is chiefly a patriotic organization interested in the general welfare of its members and that its powers are so extensive as to pre- clude its classification under paragraph 3, section 231 of the Revenue Act of 1918. (C. B. 3, page 207; O. D. 508.) It would appear from the facts as stated that the Treasury has placed a very narrow interpretation on the law. EXEMPT CORPORATIONS 37 Ruling. A fraternal beneficiary society is a society wliose members have adopted the same or a very similar calling, avocation or profession, or who are working in unison to accomplish some worthy object and who for that reason have bound themselves to- gether as an association or society to aid and assist one another and to promote the common cause. The term "fraternal"' can properly be applied to such an association for the reason that the pursuit of a common object usually has a tendency to create a brotherly feeling among those who are thus engaged. The absence of profit in the opera- tion of such an association is not the test as to whether it is within the exemption as a fraternal beneficiary society, but the want of a fraternal side or object which it is in some manner organized to pro- mote. A fraternal beneficiary society may be a mutual insurance com- pany, but must be something more ; it must be primarily fraternal and also, in order to fall within the exemption provided for by section 231 (3) of the Revenue Act of 1918 must be operated under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system. (See Commercial Travellers Life and Accident Association z'. Rodzvay, 235 Fed. 370.) (C. B. 3, page 236; O. D. 690.) Building and loan associations. — Law. Section 231. . . . . (4) Domestic building and loan as- sociations; substantially all the business of which is confined to making loans to members; and cooperative banks without capital stock or- ganized and operated for mutual purposes and without profits; .... The principal tests applied to a btiilding and loan associa- tion to determine its right to exemption, are whether the mem- bers share in the profits on practically the same footing and that substantially all its btisiness is confined to making loans to members. Regulation. In general, a building and loan association entitled to exemption is one organized pursuant to the laws of any State, Territory, or the District of Columbia, which accumulates funds to be loaned primarily to its shareholders for the purpose of building or acquiring homes. In order to be exempt the association (i) must be mutual, that is, all of its stockholders or members must share in the profits on substantially the same footing; and (2) must be operated so that substantially all of its business is confined to the making of loans to bona fide shareholders. A building and loan association otherwise exempt does not lose its exempt status because — (i) It has paid-up shares wliich are (a) preferred as to earnings, 38 APPLICATION AND AD^^IINISTRATION and (b) have a definite rate of interest which may be higher than the rate of dividends paid on other stock. (2) It borrows money (accepting deposits is held to be a form of borrowing) which it uses for loans to shareholders, the dues, fines, and penalties paid by shareholders being inadequate for this purpose. (3) It makes loans to nonmembers from accumulated funds which are not needed for loans to shareholders. In any such case, however, the burden will be upon the association to show that substantially all of its loans are made to members. (4) The amount of its prepaid or full-paid stock is disproportion- ate to running or installment stock, provided the issuance of such prepaid or full-paid stock is ancillary to the furtherance of the main business of the association; that is, that it is intended to pro- vide a fund from which loans may be made primarily to persons sub- scribing to running" or installment stock to enable them to acquire or build homes. Cooperative banks without capital stock organized and operated for mutual purposes and without profit are exempt. Credit unions such as those organized under the laws of Massachusetts, being in substance and in fact the same as cooperative banks, are likewise exempt from tax. (Art. 515.) The new article paraphrases the old one, no essential change Ijeing made therein. Rulings. Where a large proportion of the loans of an associa- tion are made upon such securities as stocks, automobile notes and personal endorsements and only a small proportion upon real estate, it is held that such an association is not a domestic building and loan association within the meaning of section 231 (4) of the Revenue Act of 1918, and must file returns of annual net income and pay any tax shown to be due thereon. (B. 44-21-1900; O. D. 1088.) A building and loan association which loans its funds to non- members, on endorsed notes, a very small amount only being secured by real estate, and divides the profits among the holders of the paid- up certificates, these being the only members of the association par- ticipating in the management and in the profits, is held to be engaged in business in the nature of a banking business, and does not come within the exemption provided in section 231 (4) of the Revenue Act of 1918. (C. B. 4, page 262; O. D. 768.) A building and loan association which conducts an insurance agency and sells insurance is not entitled to exemption under section 231 (4) of the Revenue Act of 1918. (B. Digest 49-21-1965; O. D. 1 129.) EXEMPT CORPORATIONS Certain cemetery companies. 39 Law. Section 231 (5) Cemetery companies owned and operated exclusively for the benefit of their members or which are not operated for profit; and any corporation chartered solely for burial purposes as a cemetery corporation and not permitted by its charter to engage in any business not necessarily incident to that purpose, no part of the net earnings of which inures to the benefit of any private stockholder or individual; .... Regulation. A cemetery company in order to be exempt must be owned and operated exclusively for the benefit of its lot owners or must not be operated for profit. Any cemetery corporation chartered solely for burial purposes and not permitted by its charter to engage in any business not necessarily incident to that purpose, no part of the net earnings of which inures to the benefit of any private stockholder or individual, is exempt from income tax. A cemetery company of which all lot owners are members, issuing preferred stock entitling the holder to a semiannual dividend of 4 per cent, and whose articles of incorporation provide that the preferred stock shall be retired at par as soon as sufficient funds are realized from sales and that all funds realized in addition thereto shall be used by the company for the care and improvement of the cemetery property, is within the exemption. (Art. 516.) The wording of the new regulation is changed to give effect to the additional requirement of the 192 1 law, that profits do not inure to the benefit of private stockholders or individuals. Ruling. A cemetery company, in order to be exempt under section 231 (5) of the Revenue Act of 1918, must be owned and operated exclusively for the benefit of all lot owners. (B. Digest 39-21-1846; Sol. Op. 120.) Religious, charitable, educational, etc., societies. — Law. Section 231 (6) Corporations, and any com- munity chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals,^' no part of the net earnings of which inures to the benefit of any private stock- holder or individual; Regulation. This exemption applies to corporations, associations, and community chests, funds, or foundations. In order to be exempt, the organization must meet three tests: (o) it must be organized and " [Former Procedure] The societies for the prevention of cruelty to children or animals were included for the first time in the 1918 law. 40 APPLICATION AND ADMINISTRATION operated for one or more of the specified purposes; (&) it must be organized and operated exclusively for such purposes; and (c) no part of its net income must inure to the benefit of private stock- holders or individuals. (i) Charitable corporations include an association for the relief of the families of clergymen, even though the latter make a contribu- tion to the fund established for this purpose; or for furnishing the services of trained nurses to persons unable to pay for them; or for aiding the general ^ody of litigants by improving the efficient admin- istration of justice. Educational corporations may include an associ- ation w^hose sole purpose is the instruction of the public. This is true of an association to promote acquaintance with the Spanish language and literature, although it has incidental amusement features; of an association to increase knowledge of the civilization of another country; and of a Chautauqua association whose primary purpose is to give lectures on subjects useful to the individual and beneficial to the community and whose amusement features are incidental to this purpose. But associations formed to disseminate controversial or partisan propaganda are not educational within the meaning of the statute. Scientific corporations include an association for the scien- tific study of law, to the end of improvement in its administration. (2) Where a religious corporation owns a large quantity of farm land and works it, and also manufactures and sells clothing and other articles for profit, it is not operated exclusively for religious purposes and is not exempt, even though its property is held in common and its profits do not inure to the benefit of individual members of the society. (3) It does not prevent exemption that private individuals, for whose benefit a charity is organized, receive the income of the cor- poration or association. The statute refers to individuals having a personal and private interest in the activities of the corporation, such as stockholders. If, however, a corporation issues "voting shares," which entitle the holders upon the dissolution of the corporation to receive the proceeds of its property, including accumulated income, the right to exemption does not exist, even though the by-laws pro- vide that the shareholders shall not receive any dividend or other return upon their shares. (Art. 517.) This article now includes community chests, funds, or foundations, and literary societies. The inhibition against orchestral societies and against trusts, the income of which is used for religious purposes, is now removed. Rulings. The M Hospital Association was incorporated under the laws of the State of Y to build, own, lease, acquire, and operate a hospital to furnish and provide medical, surgical, and hospital EXEMPT CORPORATIONS 41 services and care to all employees of other corporations, persons, or partnerships with whom contracts may be made. Said services are intended to take care of the needs of sick and injured employees re- quiring and entitled to such care by virtue of membership in said corporations and in conformity to the provisions of the by-laws of the corporation and the care of injured employees as contemplated and provided for m the laws of the State of Y and the rules, regula- tions, and practices now or hereafter promulgated by the State Med- ical Aid Board. The corporation also contemplates hospital services and care for the families of employees and for other persons. The income of the association is received from the corporations with which it has contractual relations, from the Medical Aid De- partment of the State for services to injured employees who do not have contract arrangements, and from direct payments by patients. No patients are treated free, but where destitute patients have been admitted as objects of public charge the services are rendered at cost to the municipal corporation paying for such services. Based upon the foregoing facts, it is held that the M Hospital As- sociation is not a charitable organization within the meaning of sec- tion 231 (6) of the Revenue Act of 1918, and that it will be required to file returns of annual net income and pay any tax shown to be due. (B. 33-21-1769; O. D. 993.) A memorial fund of which the M Corporation is trustee is con- trolled by a board of directors. It is organized not to engage in a charitable undertaking itself, but to distribute its income to chari- table institutions and to worthy individuals. Held, it is not a chari- table corporation or association within the provisions of section 11 (a) Sixth of the Revenue Act of 1916 as amended, or section 231 (6) of the Revenue Act of 1918. To hold such an organization exempt and relieve it from filing returns of income and paying taxes thereon would in effect delegate to it authority to determine what institutions and gifts are charitable, which is not permissible. Consequently, contributions made to such a fund are not deductible under section 5 (a) Ninth of the Revenue Act of 1916 as amended, or section 214 (a) 11 of the Revenue Act of 1918. (C. B. 4, page 264; O. D. 872.) A private corporation without capital stock was organized and is operated under State laws and managed by a board of trustees for the purpose of conducting a school to educate and train men and women in those subjects that will prepare them for practical business and commercial and industrial occupations. It derives its income from tuition fees paid by students attending its courses. After payment of expenses the balance remaining is placed in an operating fund to meet operating expenses in the future. If this operating fund exceeds 42 APPLICATION AND ADMINISTRATION the current year's income, any amount in excess of 25 per cent is placed in a students' loan fund from which deserving students may borrow money for the purpose of pursuing a course of study in the school. No part of the earnings of the school inures to the benefit of any individual or individuals connected with the corporation in any manner whatever, and the by-laws provide that no remuneration of any kind shall be paid to the board of trustees for their services as such. The corporation is held to be exempt from taxation under the pro- visions of section 231 (6). (B. 46-21-1923; O. D. 1102.) A corporation organized for the purpose of conducting a military school for profit, the stock of which is owned entirely by the officers, directors, and teachers of the institution, is not exempt from income tax as an educational institution no part of the net earnings of which inures to the benefit of any private stockholder or individual within the meaning of subdivision 6, section 231, Revenue Act of 1918. The term "private" is not used in the statute in contradistinction to "official," whether the latter be used in a military or an institutional sense, but as the antonym of "public," the supposed beneficiary of the benevolent activities of an institution devoted exclusively to public betterment; private pecuniary profit and gain is the test to be applied, and the officers, directors, and teachers of a military school corporation, owning the stock thereof, are "private stock- holders" within the meaning of the Act. (C. B. 4, page 266; T. D. 3164.) A publishing corporation which is primarily religious in character, but not exclusively so, does not come within the exemption provided in section 231 (6) of the Revenue Act of 1918. (B. Digest 51-21- 1983; O. D. 1 142.) A lyceum and Chautauqua association was organized to take over the assets of a partnership for the purpose of promoting the intel- lectual, social, physical, moral, and nonsectarian religious welfare of the people in the places where it operates and especially in the United States. Its income is received from admission charges to its entertain- ments. The income is used first to defray expenses of operating; sec- ond to the payment of the members of the partnership for assets purchased, and third, to build up a surplus. The members of the partnership whose assets were taken over were made life members of the board of trustees. Held, that the association is engaged in an ordinary business en- terprise and is precluded from exemption under any of the provisions of section 231 of the Revenue Act of 1918. (B. 43-21-1886; O. D. 1077.) EXEMPT CORPORATIONS 43 Chambers of commerce, etc. — Law. Section 231. .... (7) Business leagues, chambers of commerce, or boards of trade, not organized for profit and no part of the net earnings of which inures to the benefit of any private stock- holder or individual; .... Regulation, A business league is an association of persons having some common business interest, which limits its activities to work for such common interest and does not engage in a regular business of a kind ordinarily carried on for profit. Its work need not be similar to that of a chamber of commerce or board of trade. The fact that it engages in a regular business of a kind ordinarily carried on for profit but on a cooperative basis or so as to produce only sufficient income to be self-sustaining, is not ground for exemp- tion. An association engaged in furnishing information to pros- pective investors, to enable them to make sound investments, is not such a league, since its members have no common business interest, and it is not exempt, even though all of its income is devoted to the purpose stated. A clearing house association, not organized for profit, no part of the net income of which inures to any private stock- holder or individual, is exempt provided its activities are limited to the exchange of checks and similar work for the common benefit of its members. An association of persons who are engaged in the business of carrying freight and passengers by boats propelled by steam, which is designed to promote the legitimate objects of such business, and all of the income of which is derived from membership dues and is expended for office expenses and the salary of a secretary- treasurer, is exempt from tax. An incorporated cotton exchange whose shares carry the right to dividends is organized for profit and is not exempt. (Art. 518.) The only change in this regulation is the insertion of the third sentence which contains the substance of a 192 1 ruling (C. B. 4, page 266; O. D. 786). Civic leagues. — Law. Section 231. .... (8) Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare; .... Regulation. A corporation having capital stock and possessing a charter which authorizes it to buy, improve, and sell real estate is organized for profit within the meaning of the statute and is not exempt from tax as a civic league or organization, even though it no longer exercises such powers for profit and is operated exclusively for the promotion of social welfare. (Art. 519.) 44 APPLICATION AND ADMINISTRATION Social clubs. — Law. Section 231. .... (9) Clubs organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, no part of the net earnings of which inures to the benefit of any private stockholder or member; .... Regulation. The exemption applies to practically all social and recreation clubs which are supported by membership fees, dues, and assessments. If a club, by reason of the comprehensive powers granted in its charter, engages in traffic, in agriculture or horticul- ture, or in the sale of real estate, timber, etc., for profit, such club is not organized and operated exclusively for pleasure, recreation, or social purposes, and any profit realized from such activities is sub- ject to tax. (Art. 520.) Rulings. A provision in the by-laws of a country club, that, in the event of the dissolution of the club, the holder of a life member- ship shall participate in the distribution of the assets of the club after its other debts are paid and before any sums are paid to either regular members or shareholders, is not alone sufficient to make the club liable to render income tax returns. (C. B. i, page 202; S. 958.) A club formed for the purpose of providing for the members thereof a suitable meeting place, a library, and a dining room, where meals will be furnished to the members, the income being derived from membership dues and the receipts for food, wine, and cigars purchased by members, and no part of the net earnings inuring to the private benefit of any member, is entitled to exemption from taxation and will not be required to file returns of annual net income. (C. B. 1,203; O. D. 108.) Mutual insurance companies, etc. — Included under this caption are mutual hail, cyclone or fire insurance com- panies, mutual ditch or irrigation companies, and mutual or co-operative telephone companies. For law and regulations, see Chapter XXXVIII, "Insurance Companies." Co-operative associations, etc- — Law. Section 231 (11) Farmers', fruit growers', or like associations, organized and operated as sales agents for the purpose of marketing the products of members and turning back to them the proceeds of sales, less the necessary selling expenses, on the basis of the quantity of produce furnished by them; or organized and oper- ated as purchasing agents for the purpose of purchasing supplies and equipment for the use of members and turning over such supplies and equipment to such members at actual cost, plus necessary expenses; EXEMPT CORPORATIONS 45 The second half of subsection (11) which refers to pur- chasing operations, is a new provision of the 192 1 law. Regulation, (a) Cooperative associations, acting as sales agents for farmers, fruit growers, dairymen, etc., and turning back to them the proceeds of the sales, less the necessary selling expenses, on the basis of the produce furnished by them, are exempt from in- come tax. Thus cooperative dairy companies, which are engaged in collecting milk and disposing of it or the products thereof and dis- tributing the proceeds, less necessary operating expenses, among their members upon the basis of the quantity of milk or of butter fat in the milk furnished by such members, are exempt from the tax. If the proceeds of the business are distributed in any other way than on such a proportionate basis, or if the association deducts more than neces- sary selling expenses, it does not meet the requirements of the statute and is not exempt. The maintenance of a reasonable reserve for de- preciation or possible losses or a reserve required by State statute will not necessarily destroy the exemption. A corporation organized t® act as a sales agent for farmers and having a capital stock on which it pays a fixed dividend amounting to the legal rate of interest, all of the capital stock being owned by such farmers, will not for that reason be denied exemption. (b) Cooperative associations organized and operated as purchas- ing agents for farmers, fruit growers, dairymen, etc., for the purpose of buying supplies and equipment for the use of members and turning over such supplies and equipment to members at actual cost, plus necessary expenses, are also exempt. In order to be exempt under either (o) or (&) an association must establish that it has no net income from its own account. An association acting both as a sales and a purchasing agent is exempt if as to each of its functions it meets the requirements of the statute. (Art. 522.) This article now permits a sales organization to be incor- porated and to pay a fixed dividend on its capital stock without forfeiting its right to exemption. A purchasing agency is now entitled to exemption. Rulings. An incorporated fruit growers' union which conducts its business at a profit, thereby accumulating a fund out of which dividends are paid, is deprived of exemption from tax if it allows persons who are not fruit growers to acquire stock and thus share in the profits. To the extent that it has such stockholders it loses its character as sales agent acting for the mutual benefit of the fruit growers, and accordingly its exemption from tax also. The union may, however, deduct from gross income amounts periodically re- turned to members as a refund of profits on business transacted with 46 APPLICATION AND ADMINISTRATION them, and proportioned to the amount of such business. (C. B. i, page 208; O. D. 64.) A cooperative store managed by a university for the purpose of selling to its students supplies of every kind, and in case of dissolu- tion its property reverting to the trustees of the school, does not come within the class of corporations organized for the exclusive pur- pose of holding title to property, collecting income therefrom, and turning over the entire amount thereof. It is actively engaged in the operation of a business in which profits are realized and will, therefore, be required to file returns of annual net income and to pay any tax thereby shown to be due. (C. B. i, page 208; O. D. 65.) It is hardly possible that any actual profit would accrue to a university store. Before paying tax on an apparent profit from such a project as that described in the last ruling, a university should make sure that all proper charges, such as rent for quarters furnished the store, etc., are deducted. Ruling. A cooperative apartment-owning corporation, which de- rives its income from collecting the expense of operating the apart- ments each month from its members, each of whom is entitled to occupy an apartment in the building, is not exempt from taxation. (B. Digest, 38-21-1832; O. D. 1042.) Corporations serving exempt corporations. — Law. Section 231 (12) Corporations organized for the exclusive purpose of holding title to property, collecting income there- from, and turning over the entire amount thereof, less expenses, to an organization which itself is exempt from the tax imposed by this title ;i* .... Federal land banks. — Law. Section 231. .... (13) Federal land banks and national farm-loan associations as provided in section 26 of the act approved July 17, 1916, entitled "An Act to provide capital for agricultural de- velopment, to create standard forms of investment based upon farm mortgage, to equalize rates of interest upon farm loans, to furnish a market for United States bonds, to create Government depositaries and financial agents for the United States, and for other purposes"; Personal service corporations. — Law. Section 231 (14) Personal service corpora- " [Former Procedure] Such corporations were taxable under the 1913 law, T. D. 2137 (January 30, 1915)- EXEMPT CORPORATIONS 47 tions.'^ This subdivision shall not be in effect after December 31, 1921. Corporations of this type were first distinguished from corporations in general in the 191 8 law, which defined them as follows : 1918 Law. Section 200. .... The term "personal service cor- poration" means a corporation whose income is to be ascribed primarily to the activities of the principal owners or stockholders who are them- selves regularly engaged in the active conduct of the affairs of the cor- poration and in which capital (whether invested or borrowed) is not a material income-producing factor; .... This definition has been re-enacted into the 1921 law. For regulations and procedure, see Chapter XXIV. Establishing a right to exemption. — -A corporation is not exempt from the tax merely because it is not organized and operated primarily for profit. If it does not come within one of the fourteen classes enumerated above, it is taxable even though the purpose of the corporation may not be to operate for the profit of its members or stockholders. Not all of the corporations mentioned in the above classes are unconditionally exempt. In all cases in which a condition is inserted, such as to the effect that no part of the net earn- ings shall inure to the benefit of any private stockholder, the right to exemption must be demonstrated in accordance with the following regulation : Regulation. In order to establish its exemption, and thus be relieved of the duty of filing returns of income and paying the tax, it is necessary that every organization claiming exemption, except per- sonal service corporations, file an affidavit with the collector of the district in which it is located, showing the character of the organiza- tion, the purpose for which it was organized, the sources of its in- come and its disposition, whether or not any of its income is credited to surplus or may inure to the benefit of any private stockholder or individual, and in general all facts relating to its operations which affect its right to exemption. To such affidavit should be attached "* [Former Procedure] As the 14th type of exempt corporation the 1916 law gave the following : "Joint-stock land bank, as to income derived from bonds or debentures of other joint-stock land banks or any federal land bank belonging to such joint-stock land bank." 48 APPLICATION AND ADMINISTRATION a copy of the charter or articles of incorporation and by-laws of the organization, upon receipt of the affidavit and other papers by the Collector, he will inform the organization whether or not it is exempt. If, however, the collector is in doubt as to the taxable status of the or- ganization, he will refer the affidavit and accompanying papers to the Commissioner for decision. When an organization has estab- lished its right to exemption, it need not thereafter make a return of income or any further showing with respect to its status under the law, unless it changes the character of its organization or operations or the purpose for which it was originally created. Collectors will keep a list of all exempt corporations, to the end that they may occasionally inquire into their status and ascertain whether or not they are observing the conditions upon which their exemption is predicated. Personal service corporations are not exempt after De- cember 31, 1921 ; see section 218 of the statute and articles 336-339. (Art. 511.) The new article inserts the statement that the exemption of personal service corporations expires December 31, 1921, as a result of the change in status of these corporations after that date. It also provides that the Commissioner, not the collector, will decide whether corporations are exempt. Ruling. An organization which would otherwise be exempt from taxation but which operates in a nonexempt manner is not en- titled to exemption under the provisions of section 231 of the Revenue Act of 1918; and furthermore, an organization which is ordinarily exempt but which owns property in excess of its needs and carries on industrial pursuits distinct from its exempt activities is not exempt from taxation. (C. B. 4, page 261 ; O. D. 953.) If there is any doubt concerning the status of a corporation under the law, it should file a return (in blank, if desired) and attach thereto a statement setting forth fully the facts mentioned above. This will enable it to avoid the imposition of penalties should the Treasury later hold it to be taxable. Section 231 is applicable to both foreign and domestic cor- porations alike, except that foreign building and loan associa- tions and co-operative banks are not exempt. If doubt exists as to whether a foreign corporation comes within the classes of exempt organizations enumerated, an affidavit showing all the material facts must be presented to the Treasury, which will then examine the claim and determine its status. EXEMPT CORPORATIONS 49 Ruling. In dealing with cases coming under section 231, the character of the corporation must be judged by its articles of incor- poration, constitution, and by-laws rather than by the declarations of its officers or the method by which it conducts or has conducted its business. Accordingly, if the activities of a company are confined to cooperative selling for the benefit of its patrons, but it is granted additional powers by its charter, it will nevertheless be required to file returns and pay the tax if any is shown to be due. (C. B. i, page 194; O. D. 190.) The foregoing ruling may operate to defeat the purpose of the law. The law exempts "organizations" and contains no requirements as to by-laws, etc. An organization which is entitled to exemption on meritorious grounds will get it even though its by-laws are improperly drawn. The following summary of a recent case illustrates the attitude taken by the courts in deciding doubtful questions :^ ■' Exemption of a building owned and used by a church for mission- ary work was contested as not being a "purely public charity" within the meaning of the Pennsylvania constitution. The court sustained the exemption, holding that such a charity was not necessarily one solely controlled by the state as claimed but extended to a private charitable institution not administered for individual gain; that the true test was the character of the objects sought to be attained. Exempt corporations must withhold taxes and furnish information. — A corporation exempt as to its income is not thereby exempt from "the witholding requirements^^ nor from furnishing information in accordance with the pro- visions of the Act^^ . . . ." While under the law only such corporations as are sub- ject to the tax imposed are specifically required to make annual returns of net income, the Treasury under the law may require such returns. It is not an unreasonable requirement. Salaries paid by an exempt corporation are, of course, taxable to the recipient. ^^ ^' Board of Home Missions v. City of Philadelphia, 109 Atl. 664; 266 Pa. 405. " See Chapter XL " See Chapter X. " Section 213. 50 APPLICATION AND ADMINISTRATION Holding companies exempt on certain dividends re- ceived. — The provision of the law which permits corporations to deduct dividends received from other corporations [section 234 (a-6)] operate to exempt the income of the "not doing business" type of holding company from this source.^" This, of course, is not an express exemption of that type of corpora- tion. Practically it amounts to this, however, in the case of a holding company which receives no income except divi- dends from other companies. Even though it has no taxable income a holding company must make a return. Income of states from public utilities. — In addition to exempt corporations, there is another "exemption of the per- son" which should be considered in this chapter. Since the federal government possesses no power to tax income which accrues to states or political subdivisions thereof, the income received by such states from public utilities or from the exer- cise of governmental functions is not taxable. Law. Section 213. That .... the term "gross income" — (b) Does not include the following items, which shall be exempt from taxation under this title: .... (7) Income derived from any public utility or the exercise of any essential governmental function and accruing to any State, Territory, or the District of Columbia, or any political subdivision of a State or Territory, or income accruing to the Government of any possession of the United States, or any political subdivision thereof. Whenever any State, Territory, or the District of Columbia, or any political subdivision of a State or Territory, prior to September 8, 1916, entered in good faith into a contract with any person, the object and purpose of which is to acquire, construct, operate, or maintain a public utility, no tax shall be levied under the provisions of this title upon the income derived from the operation of such public utility, so far as the payment thereof will impose a loss or burden upon such State, Territory, District of Columbia, or political subdivision; but this provision is not intended and shall not be construed to confer upon " [Former Procedure] The societies for the prevention of cruelty were held to be exempt (Buttcrick Co. v. U. S., 240 Fed. 539; appeal dis- missed, 248 U. S. 587; 63 L. Ed. 434; 39 Sup. Ct. 5). Under the 1913, 1916, and 1917 laws, holding companies are held to be taxable. (Boston Terminal Co. V. Gill, 24b Fed. 664; 158 C. C. A. 620.) EXEMPT CORPORATIONS 51 such person any financial gain or exemption or to relieve such person from the payment of a tax as provided for in this title upon the part or portion of such income to which such person is entitled under such contract; .... Regulation. Income derived from any public utility or the ex- ercise of any essential governmental function and accruing- to any State or Territory of the United States, or to any political subdivision thereof, or to the District of Columbia, or income accruing to the Government of any possession of the United States, or any political subdivision thereof, is exempt from tax. See art. 74. The income of State workmen's compensation insurance funds established by State statutes is not taxable. In the case of a public utility acquired, constructed, operated, or maintained by a taxpayer under contract with any State, Territory, or political subdivision thereof, or with the District of Columbia, containing an agreement that a portion of the net earnings of such public utility shall be paid to the State, Ter- ritory, or political subdivision thereof, or the District of Columbia, the amount so paid may be deducted by the taxpayer as a necessary expense in transacting business. (See sec. 214 (a) (i) of the statute. (Art. 87.) The intent of the Act, in so far as corporations are con- cerned, is apparently to permit a corporation, in which a state or local government has a part interest, to deduct the amount of income paid to the state or local government, and to require the tax to be paid only upon the portion which accrues to the corporation or its stockholders or to private persons. The fact that a public tttility may be under contract with any state, territory, or political subdivision thereof, does not imply that salaries and wages paid to officers and employees of such ptiblic utility are exempt from taxation.-^ See Chapter XIV. CHAPTER III RETURNS— WHEN AND HOW TO MAKE THEM The income tax law imposes upon taxpayers the duty of "self-assessment," but Congress empowers the Commissioner of Internal Revenue to require detailed returns so that there may be a check on the taxpayers' methods of computation. Generally speaking, a "return" may be defined as a state- ment of taxable net income or of information. Who shall make returns? — A return shall be made by every individual having a net income of 1. $i,ooo or more if single, or if married and not living with husband or wife;^ 2. $2,000 or more if married and living with husband or wife. 3. $1,000 or more if the head of a family, even though in some cases no tax mayl^e due, and 4. $1,000 or more ($2,000 if married) if a minor and not dependent on the parent. Also, every individual having a gross income for the tax- able year of $5,000 or over, regardless of the amount of his net income, must file a return." By a specific provision, a re- turn is required if the aggregate gross income of husband and wife is $5,000 or over. These requirements are new and will enable the Treasury to scrutinize the deductions which result in reducing a gross income of over $5,000, below $1,000 or $2,000, as the case may be, in which cases no return was heretofore required. ^For cases of changes in marital status, see Chapter XII. Fiduciaries must make returns for individuals, trusts or estates for which they act. See Chapter XXXVII. For returns of non-resident aliens, see Chapter XXXVI. " [Former Procedure] Before 1921, net income was the sole basis for individual returns. If there was no taxable net income, no return was required. 52 RETURNS— WHEN AND HOW TO MAKE THEM 53 Every partnership and corporation^ (not specifically ex- empt),* no matter if it has no net income, is required to file an annual income tax return. Partnerships are not themselves taxable upon the net income so reported, but the returns must nevertheless be made.^ Personal service corporations, for the calendar year 1921 only, are not taxable as such but must make returns.** From January i, 1922, personal service cor- porations are taxed as ordinary corporations, except that no provision seems to have been made for the imposition of the capital stock tax until July i, 1922. In addition to these statements of total net income re- ceived, there are various other returns to be made under the income tax law which give to the Treasury information con- sidered essential to proper administration. The more impor- tant of the various types of returns are considered individually later.' Commissioner may require any returns "necessary." — In addition to making specific provisions for certain returns, the law grants to the Commissioner the broad and inclusive power to require any returns which he may consider necessary. The authority is given in the following sections : Law. Section 1300. That .... every person liable to any tax imposed by this Act, or for the collection thereof, shall keep such records and render, under oath, such statements and returns, and shall ' The term "corporation" includes associations, joint-stock companies, and insurance companies (section i). Corporations must, of course, file excess profits tax returns. Both income and profits tax returns are now made in one return. * The law (section 239) states the requirement positively rather than negatively. Exempt corporations must establish their right to exemption. (See Chapter H.) ' [Former Procedure] Before 1918 no income tax returns were re- (juired from partnerships except upon call from the Commissioner. Excess profits tax returns were required under 1917 law. " For a definition of personal service corporation, see Chapter XXIV. ' Detailed illustrations of returns under the 1918 law for individuals api^ear in the Appendix of Income Tax Procedure, 1920; for corporations in the Appendix of Excess Profits Tax Procedure, 1921. Illustrations of returns covering special features under the 1921 law, for individuals, appear in Chapter VII, and for corporations in Chapter V of the excess profits tax section (Appendix A) of this volume. 54 APPLICATION AND ADMINISTRATION comply with such regulations as the Commissioner, with the approval of the Secretary, may from time to time prescribe. Law. Section 1307. That whenever in the judgment of the Com- missioner necessary he may require any person, by notice served upon him, to make a return or such statements as he deems sufficient to show whether or not such person is liable to tax. Law. Section 1303. That the Commissioner, with the approval of the Secretary, is hereby authorized to make all needful rules and regulations for the enforcement of the provisions of this Act The Treasury requires various special returns which give details regarding complicated calculations, such as those in- volved in ascertaining depletion allowances and income from the appreciation of property A^alues.^ Time for fiUng returns.^ — Returns are due two months and fifteen days after the close of the taxable year, except in the case of non-resident aliens, for whom see Chapter XXXVI. The following section of the law applies to the an- nual returns of both individuals and corporations.^" Law. Section 227. (a) That returns (except in the case of non- resident aliens) 1^ shall be made on or before the fifteenth day of the third month following the close of the fiscal year, or, if the return is made on the basis of the calendar year, then the return shall be made on or before the 15th day of March. 12 .... "Last due date." — Regulation. The last due date is the last day upon which a return is required to be filed in accordance with the provisions of the * Form O revised, (oil and gas) form D (minerals), form E (coal), form F (non-metals), form T (timber). ° For extension of time, see page 55. ^" For corporations, see section 241 (a). " Non-resident alien individual returns under the i(j2i law need not be filed until the fifteenth day of the sixth month following the close of the year (sec Chapter XXXVI). " [Former Procedure] The laws prior to 1918 made March i the date for filing returns, except for taxpayers reporting on the basis of fiscal years. In such cases the return was due sixty days after the close of the fiscal year [1913 law, section G (c) ; 1916 and 1917 laws, section 13 (b)]. To cover the case of individuals who desired to change from a calendar to a fiscal year under the power granted by the 1918 law, the regulations (Art. 441) provided that returns for fiscal years ending during 1918 rnight be made "on or before the fifteenth day of March, igiQ-" RETURNS— WHEN AND HOW TO MAKE THEM 55 statute or the last day of the period covered by an extension of time granted by the collector or Commissioner. When the last due date falls on Sunday or a legal holiday, the last due date for filing returns will be the day following such Sunday or legal holiday (Art. 446, Reg. 45, Art. 447.) Filing date in cases of liquidation. — A concern which goes into Hquidation may file a return before the expiration of its taxable year. Regulation A corporation going into liquidation during any taxable year may upon the completion of such liquidation pre- pare a return covering its income for the fractional part of the year during which it was engaged in business and may immediately file such return with the collector (Art. 651.) Although a liquidating corporation may be a subsidiary of a holding company, the regulations permit the filing of a return immediately after liquidation; but if for the purposes of a consolidated return the holding company desired to with- hold the return until the end of its fiscal year, it could do so. The regulation is permissive, not mandatory. If a return is made for a portion of a taxable year, the exemptions and invested capital must be reduced. ^^ Since this results in a great tax it is advantageous to wait until the close of the year. A corporation which is dissolved before the close of its taxable year has the same time in which to file its final return as if it had continued in existence during its entire taxable year.^* Extensions of time for filing returns. — In the case of both individuals and corporations : Law. Section 227. (a) . . . . The Commissioner may grant a reasonable extension of time for filing returns whenever in his judg- ment good cause exists and shall keep a record of every such exten- sion and the reason therefor. Except in the case of taxpayers who ^^ Excess Profits Tax Procedure, 1921, pages no, 259. "C. B. 4, page 277; O. D. 692. 56 APPLICATION AND ADMINISTRATION are abroad, no such extension shall be for more than six months.^s This authorization is, of course, broad enough' to permit general extensions as well as extensions in the cases of par- ticular taxpayers. Authority has been delegated to the local collectors of internal revenue to make an extension of thirty days only in case of sickness or absence. Power to grant other extensions rests with the Commissioner." Extension of time for joint return. — Ruling. Where a husband and wife file a joint return and an extension of time has been granted to either of them, the benefit of the extension inures to both and it will be unnecessary for the other party to secure additional authority. (C. B. 2, page 203; O. D. 521.) Application to the collector for thirty-day exten- sion IN case of absence or sickness. — In case an extension of not more than thirty days is desired because of absence or sickness, application should be made by letter to the local col- lector with whom the return is to be filed. Law. Section 131 1. [Section 3176, Rev. Stat.] .... If the failure to file a return or list is due to sickness or absence, the collector may allow such further time, not exceeding thirty days, for making and filing the return or list as he deems proper From the above section of the law, it clearly appears that application may be made after the expiration of the period in which the return is normally required to be filed; but the application for such extension must not be delayed beyond the period (thirty days) for which the extension is desired. The conditions which govern extensions of time in cases of individuals and corporations are fully set forth in the follow- ing regulation : " [Former Procedure] Under the 1913 law (section 3176) the Com- missioner was authorized to grant extensions only in case of sickness or absence and even then was limited to thirty days. The 1916 law [sec- tion 14 (c)] introduced this provision: "That the Commissioner of In- ternal Revenue shall have authority, in the case of either corporations or individuals, to grant a reasonable extension of time, in meritorious cases as he may deem proper." The six months' limitation was first introduced in the 191 8 law. '°See page 58. RETURNS— WHEN AND HOW TO MAKE THEM 57 Regulation. It is important that the taxpayer render before the return due date a return as complete and final as it is possible for him to prepare. However, in cases of sickness or absence, collectors are authorized to grant an extension of not exceeding 30 days, where in their judgment such further time is actually required for the making of an accurate return. See article 1002. The application for such extension must be made prior to the due date of the return. The absence or sickness of one or more officers of a corporation at the time the return is required to be filed will not be accepted as a reason- able cause for failure to file the return within the prescribed time, unless it is satisfactorily shown that there were no other principal officers available and sufficiently informed as to the affairs of the corporation to make and verify the return. As a condition of granting an extension of time for filing a return the collector may require the submission of a tentative return and estimate of the tax and the payment of one-fourth of the estimated amount of tax. A tentative return should be made on the usual return form, plainly marked "tentative" at the top, contain a statement as to the estimated amount of tax believed to be due, and be properly executed. No other data need be given. Tentative returns will not be accepted unless per- mission is obtained previous to filing. A copy of the authority for filing the tenative return must be attached thereto when filed. Where a taxpayer has filed a tentative return and has failed to file a com- plete return within the period of the extension requested by him, the complete return when filed is subject to penalties prescribed for delinquency. Where a tentative return has been filed and no time has been fixed within which a complete return must be filed, the col- lector may at any time send notice to the taxpayer to file a complete return within a period of time therein specified by him, and a tax- payer who fails to comply with such request will incur the penalties prescribed by statute for delinquency in filing a return. As to interest see article 1003. Collectors should not grant extensions of time for filing Forms 1096 and 1099. Requests for such extensions should be made to the Commissioner. (Art. 443.) The new article requires applications to collectors for ex- tensions, in cases of absence or sickness, to be made prior to the due date of the returns. The former procedure was to apply for the extension within thirty days after the due date of the return. Forms 1040-T (individuals) and 1031-T (part- nerships) are no longer to be used for tentative returns; the ordinary forms plainly marked "tentative" are to be used. A tentative return will not be accepted unless previous permis- sion to file such a return has been given. 58 APPLICATION AND ADMINISTRATION Applications to Commissioner for other extensions. — Local collectors are not authorized to grant extensions of more than thirty days or in cases other than those of sickness or absence/^ The circumstances under which the Commis- sioner may grant a limited further extension are set forth in the following regulation. Regulation. If before the end of an extension of thirty days granted by the collector an accurate return can not be made, an appeal for a further extension must be made to the Commissioner with a full recital of the causes for the delay. The Commissioner will not grant an additional extension without a clear showing that a complete return can not be made at the end of the thirty day period. The Commissioner will grant no such extension beyond the original due date of the third installment of the tax. Either a complete or a tentative return, as complete as possible and giving a ground for assessment of the tax, must be submitted on or before the due date as extended, and the tax shown to be due must be paid with the sub- mission of the return. If a complete return can not be made at that time, the facts must be submitted to the Commissioner for such further action as he deems warranted. In exceptional circumstances the taxpayer may apply originally to the Commissioner for an ex- tension of time (Art. 444.) Extension of time for filing returns due March 15, 1922.^^ — Under the law collectors may grant extensions of thirty days in case of sickness or absence. The Commissioner grants extensions up to six months "whenever in his judgment good cause exists." In view of the many and complicated problems involved, it has become increasingly difficult for in- dividuals and corporations to prepare their returns by March 15, even when the' law remains unchanged. The 192 1 law was " See page 56. ''Corporations were granted an extension to May 15, 1920. for filing the 1919 returns. Tentative returns had to be filed by March 15 on form 1120, on which was written "Tentative Return." It was only necessary to show the estimated amount of tax due. The return, of course, had to be accom- panied by one-fourth of the estimated tax, together with a statement setting forth the reason why the return could not be completed within the pre- scribed time and a formal request for the extension. In the statement granting this extension, the Commissioner stated that no further extension would be granted except in extraordinary cases. (I. T. M. 2420, dated March 4, 1920.) There was no general extension of time in 1921 but individual extensions were granted in all meritorious cases. RETURNS— WHEN AND HOW TO MAKE THEM 59 not passed until November 23, 192 1. It will- not be possible for taxpayers to secure authoritative interpretations of the law and adjust their accounts before March 15, 1922. It is possible, however, to submit tentative returns which contain merely an estimate of the amount of tax due. Since the gov- ernment can require that at least 25 per cent of the estimate be paid on or before March 15, and since in no event is any audit made of the returns until a year or more later, it may be expected that the Commissioner will freely accept tentative returns on March 15, 1922, and require final returns by, say, May 15. There are corporations with ramifications extend- ing the world over which have never before or since the exist- ence of the federal income tax laws been able to close their books within a 75-day period. The Treasury has not dealt harshly with this class of taxpayers. It does, however, very properly require that, when additional time is required, it shall be asked for in due season and that sound reasons shall be given for the request. When taxpayers live abroad. — Section 227 (a) of the 'law provides that the six months' limitation shall not cover the case of taxpayers who are abroad. American citizens residing abroad, v^'ho, because of war conditions or of absence from the country, have not been able to file their returns for past years, may take advantage of this provision, which oper- ates generally and without request by the taxpayer. The de- tails concerning extensions in such cases a])pear in the follow- ing regulation : Regulation. Where a delinquent return is filed I)y or on behalf of a person who is abroad, an affidavit must be attached to the return, stating the cause of the delay in filing it, in order that the commissioner may determine whether the failure to file the return in time was due to a reasonable cause and whether the return was filed without any unnecessary delay. If the showing justifies the conclusion that the failure to file the return in time was excusable, no penalty will be imposed. The installments of tax which are actually due must be paid at the time of filing the return, and the other installments shall be paid as they fall due. fn case an extension is granted, interest is Co APPLICATION AND ADMINISTRATION payable at the rate of one-half of i per cent per month from the time the tax would have been due if no extension had been granted. (Art. 445-) The extension granted under the old regulation was to allow for the disturbed conditions arising from the war, but the new article is apparently applicable in any case where a taxpayer is abroad and, in consequence, is unable to file his return. The Treasury held^® that the old article 445 applied to domestic corporations which transacted their business and kept their books of account abroad. There appears to be no reason why a similar interpretation should not be applied to the new article. Extension of time for non-resident enemies. — Regulation. An extension of time is hereby granted for such period as may be necessary, not exceeding ninety days after proclama- tion by the President of the end of the war with Germany, for filing returns of income for 1918 and subsequent years and for paying the tax by or for nonresident enemies or allies of enemies, as defined by section 2 of the Trading with the Enemy Act of October 6, 191 7, not holding licenses granted under the provisions of that act. The whole tax shown to be due must be paid at the time of filing the return. This extension, however, does not authorize any delay in filing returns of information. This extension is also subject to the condition that all persons who on October 6, 1917, had or since have had or may hereafter have control of any money or other property for any such enemy or ally of enemy, or who on October 6, 1917, were or since have been or may hereafter be indebted to any such enemy or ally of enemy, shall hold and deliver all said money and property in all respects subject to the Trading with the Enemy Act and to the orders of the President and of the alien property cus- todian thereunder, and shall in due course file returns of income in respect of all such money and property for such period as may elapse or have elapsed prior to the actual delivery of such money and property to the alien property custodian (Reg. 45, Art. 446.) This article does not appear in the new regulations. It is included here as returns under it may be made until Feb- ruary 12, 1922. C. B. 2, page 203; O. D. 443. RETURNS— WHEN AND HOW TO MAKE THEM 6l "Termination of the war" — when ninety day period BEGINS TO RUN. — The Joint Resolution of Congress,^" approved by the President March 3, 192 1, declared: "That in the inter- pretation of any provision relating to the duration or date of the termination of the present war .... the date when the resolution becomes effective shall be construed and treated as the date of the termination of the war . . ." The war was terminated by Joint Resolution of Congress, approved by the President July 2, 1921. The proclamation of the President, declaring the war terminated as at July 2, 1 92 1, was issued on November 14, 192 1. For purposes of amortization"' the Treasury has held that the war terminated on March 3, 1921. The Treasury holds that the ninety-day extension for filing returns in case of taxpayers abroad dates from November 14, 1 92 1. The President's proclamation of November 14, 1 92 1, fixes July 2, 1921, as the date of the termination of the war. However, it can hardly be contended that the ninety- day period runs from July 2, 1921, since the latest date for filing returns under such an assumption would have passed before the proclamation was signed by the President and those concerned were thereby notified. Ruling. Receipt is acknowledged of your letter of March 11, 1921, requesting to be advised whether the joint resolution relating to the termination of the war for certain purposes passed by Con- gress and approved by the President on March 3, 1921, is construed by this office to set running the period of ninety days after the termin- ation of the war granted to nonresident enemies for filing income tax returns for 19 18 and subsequent years under the provisions of Article 446 of Regulations 45 Article 446 of Regulations 45 is based upon the authority vested in the Commissioner by Section 227 of the Revenue Act of 1918 to grant reasonable extensions of time for filing returns whenever in his judgment good cause exists. Since Section 227 does not relate to the duration or date of termination of the present war with Ger- many and Austro-Hungary, it does not fall within the purview of the Joint Resolution approved March 3, 1921, The ninety days men- ' Public No. 64 — 66th Congress. See Chapter XXXH. 62 APPLICATION AND ADMINISTRATION tioned in Article 446 will become effective from the date of the termination of the war with Germany when such date has been established by the President through a proclamation. Article 446 is still in effect and will remain in effect, until revoked either by oper- ation of its own terms, operation of law, or the action of this office. The Joint Resolution approved March 3, 1921, therefore, did not affect the provisions of Article 446 of Regulations 45. (Letter signed by Commissioner Wm. M. Williams, dated April 7, 1921.) Ruling. Receipt is acknowledged of your letter of May 2'i^, 1921, in which you inquire whether office letter of April 7, 192 1, is not in conflict with the opinion of the Solicitor sent you under date of March 22, 1921, in answer to your question as to when the present war was terminated for amortization purposes. In the opinion of the Solicitor, it was held that the termination of the war was March 3, 1921, in view of the Joint Resolution of Congress. In office letter of March 7, i^ii, this office held that Article 446, Regulations 45, did not fall within the purview of the Joint Resolution approved March 3, 1921. Article 187, Regulations 45, is based on Section 214 (a) of the Revenue Act of 1918, which provides, in part, that "at any time within three years after the termination of the present war, the Com- missioner may, and at the request of the taxpayer shall, re-examine the return, and if he then finds as a result of an appraisal or from other evidence that the deduction originally allowed was incorrect the taxes imposed by this title and by Title III for the year or years affected shall be redetermined." Article 187 is, therefore, affected by the date of the termination of the present war. Prior to the approval of the Joint Resolution, the date of the termination of the present war, under Section i of the Act, was to be determined by proclama- tion of the President. The Joint Resolution provided, however, that the date when such resolution becomes eft'ective shall be treated as the date of the termination of the war or existing emergency not- withstanding any provision in any Act of Congress. Article 446, Regulations 45, derives its force and effect from Section 227 (a) of the Revenue Act of 1918, which provides that ''the Commissioner may grant a reasonable extension of time for filing returns whenever in his judgment good cause exists and shall keep a record of every such extension and the reason therefor. Except in the case of taxpayers w^ho are abroad, no such extension shall be for more than six months." Since this Section of the Act does not relate to the duration or date of termination of the present war, it was not affected by the Joint Resolution approved March 3, 1921. There w-as no conflict, therefore, between the ruling of this office made under date of April 7, 1921, and the opinion of the So- RETURNS— WHEN AND HOW TO MAKE THEM 63 Hcitor sent you under date of March 22, 1921. (Letter to Prentice- Hall, Inc., signed by E. H. Batson, dated June 7, 1921.) The foregoing ruling liolds that the Joint Resolutions of Congress (March 3, 1921, and July 2, 1921) are not con- trolling. Articles 445 and 446, promulgated by the Com- missioner, both state that the extension is for a period "not exceeding ninety days after proclamation by the President of the end of the war with Germany." Since the proclamation was not issued until November 14, 1921, there is no doubt but that the ninety-day period begins to run from that date. Place for filing returns.— In the case of individuals the law prescribes that: Law. Section 227 (b) Returns shall be made to the col- lector for the district in which is located the legal residence or prin- cipal place of business of the person making the return, or, if he has no legal residence or principal place of business in the United States, then to the collector at Baltimore, Maryland. An individual whose legal residence and principal place of business are not in the same district has the option as to which place he will file his annual return. In the case of corporations, returns must be filed in the dis- trict in which "is located the principal place of business of the corporation. Law. Section 241. .... (b) Returns shall be made to the collector of the district in which is located the principal place of business or principal office or agency of the corporation, or, if it has no principal place of business or principal office or agency in the United States, then to the collector at Baltimore, Maryland. Returns filed by mail. — Returns may be delivered either by hand or by mail. Regulation I'f placed in the mails the return should be posted in ample time to reach the collector's office, under ordinary handling of the mails, on or before the date on which the return is required to be filed. If a return is made and placed in the mails in due course, properly addressed and postage paid, in ample time to reach the office of the collector on or before the last due date, no penalty will attach should the return not be actually received by such 64 APPLICATION AND ADMINISTRATION ofl&cer until subsequently to that date. Where a question may be raised as to whether or not the return was posted in ample time to reach the collector's office on or before the due date, the envelope in which the return was transmitted will be preserved by the col- lector and forwarded to the Commissioner with the return. (Art. 446.) This article was heretofore numbered 447. Period for which returns are made. — Returns of net in- come are ordinarily made for the "taxable year.""^ Only in unusual circumstances are returns made for a shorter period, as where corporations are entering or going out of business, individuals or corporations are changing fiscal years, and in case of administrators who have made final accountings of estates. "Taxable year" and "fiscal year" defined. — The terms "taxable year" and "fiscal year" are defined in the law as follows : Law. Section 200. . . . . (i) The term "taxable year" means the calendar year, or the fiscal year ending during such calendar year, upon the basis of which the net income is computed under section 212 or section 232. The term "fiscal year" means an accounting period of twelve months ending on the last day of any month, other than De- cember. The first taxable year, to be called the taxable year 192 1, shall be the calendar year 1921 or any fiscal year ending during the calendar year 1921; .... Fiscal year basis now available to all taxpayers. — By 1917'^ corporations and partnerships had acquired the privilege of reporting on the basis of a fiscal instead of a cal- endar year. The 191 8 law extended the privilege to indi- viduals. The same provision is re-enacted in the 1921 law, which reads : Law. Section 212 (b) The net income shall be com- " Returns may not be made for a period exceeding twelve months (see page 72). " [Former Procedure] The 1917 law, section 8 (e) extended to part- nerships the fiscal year privilege given in the 1913 and 1916 laws to cor- porations. RETURNS— WHEN AND HOW TO MAKE THEM 65 puted upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be)-* .... If the taxpayer's annual accounting period is other than a fiscal year as defined in sec- tion 200 or if the taxpayer has no annual accounting period or does not keep books, the net income shall be computed on the basis of the calendar year. (c) If a taxpayer changes his accounting period from fiscal year to calendar year, from calendar year to fiscal year, or from one fiscal year to another, the net income shall, with the approval of the Com- missioner, be computed on the basis of such new accounting period, subject to the provisions of section 226. -^ A newly organized business, whether incorporated or not, may estabhsh its fiscal year without securing the approval of the Commissioner.'" In such a case the first return may or may not be for less than twelve months, depending upon the date of organization and the month selected as the close of its fiscal period. In order to report on a fiscal year basis it is necessary that the taxpayer keep books of account."^ This is in accordance with the law, which provides that if a taxpayer "does not keep books, the net income shall be computed on the basis of the calendar year." Since the partnership books are the books of each partner, permission to make his personal returns on a fiscal year basis would doubtless be granted to a partner. Fiscal year required if accounts are kept on that BASIS. — A taxpayer who has an existing accounting period which is a fiscal year within the meaning of the statute, is required to make his return on the basis of such a taxable year regardless of the former basis of rendering returns." Recognition of accounting periods as taxable years. — A sharp distinction must be drawn between the procedure which applies in cases which have a fiscal year already established, and cases in which it is desired to change one's accounting " See section 218. " See page 69. " C. B. 2, page 67 ; O. D. 404. ' C. B. 3, page 81 ; O. D. 696. " See page 64. 66 APPLICATION AND ADMINISTRATION l)crio(l and to have the newly established year accepted as the taxable year."^ The 192 1 law re-enacts the provisions of the 1918 law and makes it obligatory for all taxpayers, both individuals and corporations, to report on the basis of their accounting periods, whether these end on December 31 or on the last day of any other month of the year. The procedure is discussed in the fol- lowing paragraph. The case of taxpayers who desire both to establish a new accounting year and to have it recognized for tax purposes is discussed on page 67. Recognition of existing fiscal yeyvr as "taxable" yi:Ai^ — The law provides no formality such as a notice to the collector"" as a condition of the recognition of a fi.scal year already established in the taxpayer's accounts. When any change is made in the taxable 3^ear, section 212 (b), quoted on page 65, provides that the net income "with the approval of the Commissioner" shall be computed on the basis of such ne\v accounting period. But it has been ruled that the Com- missioner's permission need not be specifically sought if the question is merely one of recognition of an existing status.'^ As will be seen from the following regulation, the fiscal year in such cases becomes established as the taxable year through tlie mere act of the taxpayer in reporting on that basis. This point is of particular significance to intlividuals who prior to the passage of the 191S law kept their accounts on a fiscal j^ear basis. Regulation. The return of a taxpayer is made and his income computed for his taxable year, which means his fiscal year, or the ""Taxpayers making their first returns may do so on the basis of fiscal years if they have established such fiscal years. See page 64. ■"' [Former Procedure] Under the 1916 law, section 13 (a), notice was required of the day designated as the closing date of the fiscal year "not less than thirty days prior to the first day of March of the year in which its return would be filed if made on the basis of the calendar year." In the case of a change from a fiscal year to a calendar year, a thirty-day notice was required "prior to March i next following the closing dale of the established fiscal year." (Reg. 33, 1918, Art. 217.) In the absence of notice fiscal year returns were not acceptable. (Ibid., Art. 2op;.) "'{'. !!. -1, page 67; A. R. R. 301. RETURNS— WHEN AND HOW TO MAKE THEM 6/ calendar year if he has nut established a fiscal year. The term "fiscal year" means an accounting period of twelve months ending on the last day of any month other than December. No fiscal year will, however, be recognized unless before its close it was definitely established as an accounting period by the taxpayer and the books of such taxpayer were kept in accordance therewith. The taxable year 1921 is the calendar year 1921 or any fiscal year ending during the calendar year 1921. See sec. 200 of the statute. A person having no such fiscal year must make return on the basis of the calendar year. Except in the case of a first return for income tax a taxpayer shall make his return on the basis (fiscal or calendar year) upon which he made his return for the taxable year immediately preceding unless, with the approval of tlie commissioner, he has changed his accounting period. (Art. 25.) Ruling. An individual who is sole proprietor of a business must compute his income from all sources on the same basis, and unless he maintains personal books of account in which his income from all business and other sources is reflected on the basis of a fiscal year he does not have a fiscal year which can be recognized as the basis upon which his return may be matle. (C. B. 4, page 71 ; O. D. 941.) All taxpayers have been on notice since February, 19 19, that, as stated in section 212 (b) of the 19 18 law, which is re-enacted in the 192 1 law: ". . . . The net income shall be computed upon the basis of the taxpayer's annual accounting l)eriod (fiscal 3'ear or calendar year as the case may be) . . . ." The Commissioner is not given any discretion as to requiring returns on the basis stated. If any taxpayer has been reporting on a calendar year basis when his or its books have been kept on a fiscal year basis, there has been a technical but clear violation of the law which should be adjusted as speedily as possible. Recognition of a changed accounting period as a TAXABLE YEAR. — When taxpayers desire to change from one accounting period already established and recognized for tax purposes to some other period, thev must give a thirty-day written notice and their reasons for the intended change. It is quite proper that changes of this character should be made sub- ject to the approval of the cVimmissioncr, for taxpayers should not be free tu change frequently and arbitrarily from one fiscal 68 APPLICATION AND ADMINISTRATION year to another. The application must be made by the tax- payer directly interested or by his duly authorized agent. If the latter makes the application, the authority to act for the taxpayer must be produced. ^^ When is change in fiscal year "established"? — After having secured the permission of the Commissioner to change the basis of his return, a taxpayer may for various rea- sons wish to continue to report on the basis of the old account- ing period. The taxpayer may discover that it is not practicable to prepare his return on this new basis, or he may discover that there are certain conditions which he failed to consider when he applied for a change. If he fails to report on this new basis, will he be subject to penalties? There appear to be two things required to bring about a change : ( i ) the approval of the Commissioner must be se- cured, and (2) the change must actually be made and a return filed on the new basis. The law says that the Commissioner may approve changes in accounting periods, but it does not provide that he may create new accounting periods; therefore penalties cannot be imposed unless a new accounting period has been fully established. The Treasury has held, however, that if application to make a change is made b)^ the taxpayers and is authorized, the change nmst be made.''^ It is difficult to discover under what provision of the law the Treasury can force a taxpayer to make a change in its accounting period if an intention to change has not been made effective in the taxpayer's books. A taxpayer may apply for authority to change his accounting period with the intention of making such a change if and when the permission is received. In the interval between making the application and receiving the authorization, cir- cumstances may arise which cause the taxpayer to alter his desire to change. There is no provision of the law which can C. B. 4, page 71 ; Mim. 2738. ' C. B. 4, page 71 ; Mim. 2738. RETURNS— WHEN AND HOW TO MAKE THEM 69 force the taxpayer to make the change. An actual change must be made and a return must be filed on the new basis before the taxpayer loses his right to continue the old accounting period. When a corporation has regularly closed its books on December 31, and also for business reasons on some other date in the year, returns are accepted on a calendar year basis.'* Changes made during 191 8 or prior. — If a taxpayer made a change in his accounting period during 191 8, the approval of the Commissioner was not necessary. The Rev- enue Act of 19 1 8 was not approved until February 24, 1919; so any changes made prior to the passage of the law, whether from calendar to fiscal year or vice versa, were confirmed thereby." Fiscal years fixed by state legislatures. — If a state wishes to change the accounting period of public service cor- porations, it is not necessary for taxpa3^ers to secure the per- mission of the Commissioner to report on the new basis."" It seems to follow that, if a state wished to fix the fiscal years of all corporations created by that state, which it could no doubt do, such corporations would be obligated to report on this new basis, and it would not be necessary to secure the permission of the Commissioner. The approval of the Com- missioner appears to be necessary only when the taxpayer voluntarily changes his fiscal year. Return v^hen accounting period is changed. — Law. Section 226. (a) That if a taxpayer, with the approval of the Commissioner, changes the basis of computing net income from fiscal year to calendar year a separate return shall be made for the period between the close of the last fiscal year for which return was made and the following December 31. If the change is from calendar year to fiscal year, a separate return shall be made "C. B. 4, page 69; A. R. R. 501. " C. B. 3, page 81 ; A. R. R. 342. "C. B. I, page 62; O. D. 100. JO APPLICATION AND ADMINISTRATION for the period between the close of the last calendar year for which return was made and the dale designated as the close of the fiscal year. If the change is from one fiscal year to another fiscal year a separate return shall be made for the period between the close of the former fiscal year and the date designated as the close of the new fiscal year The provision found in the 1918 law"' to the effect that in the case of a first return on a fiscal year basis a return should be filed for the period between the beginning of the calendar year in which the fiscal year ends and the end of the fiscal year, was not re-enacted in the 1921 law. This pro- vision was ambiguous and unnecessary. Law. Section 226. .... (b) In all cases where a separate return is made for a part of a taxable year the net income shall be com- puted on the basis of such period for which separate return is made, and the tax shall be paid thereon at the rate for the calendar yiear in which such period is included. (c) In the case of a return for a period of less than one year the net income shall be placed on an annual basis by multiplying the amount thereof by twelve and dividing by the number of months included in such period; and the tax shall be such part of a tax computed on such annual basis as the number of months in such period is of twelve months. "^ The foregoing provision places net income on an annual basis and has the effect of subjecting such income to a higher surta.x rate than was the case imder the former method of computation. The law now subjects the net income to the same high rates as would be the case if income throughout the year ^' [Former Procedure] 1918 Law. Section 226 If a taxpaj-er making his first return for income tax keeps his accounts on the basis of a fiscal jear he shall make a separate return for the period between the beginning of the calendar year in which such fiscal year ends and the end of such fiscal year " [Former Procedure] 1918 Law. Section 226 In all of the above cases the net income shall be computed on the basis of such period for which separate return is made, and the tax sliall he paid thereon at the rate for the calendar year in which such period is inckided ; and the credits provided in subdivisions (c) and (d) of section 216 shall be reduced respectively to amounts which bear the same ratio to the full credits provided in such subdivisions as the number of montlis in such period bears to twelve months. The credits wliich nuist be prorated [section 216 (c) and (d)] are the $1,000 or $.',000 exemiilions and the $200 credits for dependents. RiaURNS— WHEN AND ilUVV TO MAKE THEM 71 were received at the same rate as during the fractional i)criod. An ilhistration of the increased tax payable under the new method of computation is given in Chapter VII. It is not necessary to apply the provisions to corporations in determining the excess profits tax, because the same result is reached by providing for a pro rata reduction of invested capital and the specific exemption of $3,000."" Notice to Commissioner required. — Regulation. If a taxpayer changes his accounting period he shall as soon as possible give to the collector for transmission to the Commissioner written notice of such change and of his reasons there- for. Tlie Commissioner will not approve a change of the basis of computing net income unless such notice is given 30 days before the close of the proposed or new taxable year or period. The due date of the separate return for such period is the fifteenth day of the third month following the close of that period. If the change in the basis of computing the net income of the taxpayer is approved by the Commissioner, the taxpayer shall thereafter make his returns and compute his net income upon the basis of the new accounting period. .... (Art. 26.) The foregoing regulation changes the date 1)YU)Y to which notice of change of fiscal year must be filed with the collector for transmission to the Commissioner.'" ='See Chapter VII. *" [Former Procedure] Since the 1916 law and the 1917 amendments thereto specifically provided that all returns must be made on a calendar year basis, unless a fiscal year was designated according to the provisions of the law, any changes made in the accounting period during 1918 or sub- sequently cannot affect any returns, calendar or fiscal, made for the year 1917. It also follows that the Commissioner is without power to accept amended returns for the year 1917 on the basis of a changed accounting period. Ruling. "A corporation having kept its accounts on a fiscal year basis, and not having made application for permission to change to a calendar year basis until July 6, 1920, will not be permitted to file its returns on the calendar vcar basis for tlie years 1918 and 1919." (C. I'. 4. page 67; A. R. R. 391.) Under Art. 26 of Reg. 45, notice bad to be given at a time wliicb was both (a) thirty days before the due date of the taxpayer's return on its existing basis, and (b) thirty days before the due date of the return for the period between the end of his existing taxable year and the end of the proposed taxable year. The Treasury held that in the case of a taxpayer who filed a return for a fiscal year ended June 30, and desired to change to a calendar year basis, notice nmst be given at least thirty days prior to March 15 of the following year. (C. B. 2, page 67; Sol. Op. 5.) 72 APPLICATION AND ADMINISTRATION Change of fiscal year to obtain greater advantage from net loss provision. — Section 204 (b) of the 192 1 law provides that if a taxpayer sustains a net loss, it may be deducted from the net income of the next succeeding two years ending after December 31, 1920.*^ Subdivision (d) of the same section provides that in the case of a fiscal year beginning in 1920 and ending in 1921, the taxpayers shall be entitled to the benefits of the net loss provision in proportion to the part of such fiscal year falling in 1921. It is quite conceivable that a future shifting of fiscal year dates may result in reduced taxes. It may result in in- creased taxes. The law regarding changes in fiscal periods is clear, so no retroactive shifting is possible. With lower rates of tax and the certainty that tax laws will continue to change, the possibilities of tax-saving by fiscal-year shifting are not worth much thought. Return must not cover period exceeding twelve months. — Throughout the law reference is made to a taxable year or to a calendar year and to parts of a taxable year, and it is stated that a fiscal year means an accounting period of twelve months.*- In no case is there a specific prohibition in the law against a return covering a period of more than twelve months; but the direction to file for a year or less would be held to be a prohibition. A regulation specifically prohibits the use of a period of more than twelve months. Regulation. No return can be made for a period of more than twelve months (Art. 431.) Blank forms for returns. — Returns must be made in the form prescribed by the Commissioner, with the approval of the Secretary of the Treasury. Blank forms are to be had from collectors. They are mailed without special request to the " [Former Procedure] Section 204 (b) of tlie 1918 law enacted a somewhat similar net loss provision. See Income Tax Froci'dure, 1921, page 783, et seq. ■*■"■ Section 200. RETURNS— WHEN AND HOW TO MAKE THEM 7Z taxpayers on the records, but failure to receive a form does not excuse the taxpayer from reporting in due season. If the form is not received in ample time to prepare and file it on or before the due date, usually March 15, application for a copy should be made to the office of the local collector of in- ternal revenue or to any bank or post-office. Taxpayers should retain exact copies of returns as filed. The forms to be used in 1922 for individual returns of $5,000 and over include a duplicate sheet as an integral part of the return. This duplicate will obviate the necessity of securing an extra copy of the form. In the case of forms which do not include dupli- cate sheets, taxpayers should secure extra copies of the blanks and retain exact duplicates of all returns filed. When not obtainable from collectors application for them should be made direct to the Commissioner in Washing^ton. 'fc)" Regulation. Copies of the prescribed return forms will so far as possible be furnished taxpayers by collectors. Failure on the part of any taxpayer to receive a blank form will not, however, excuse him from making a return In lack of a prescribed form a statement made by a taxpayer disclosing- his gross income and the de- ductions therefrom may be accepted as a tentative return, and if filed within the prescribed time a return so made will relieve the taxpayer from liability to penalties, provided that without unnecessary delay such a tentative return is replaced by a return made on the proper form (Art. 407.) Forms for 1922. — Form 1040 will be used in 1922 by individuals whose net income exceeds $5,000; for the separate returns of husband and wife when the combined net incomes exceed $5,000; for returns covering less than a year when the net income placed on an annual basis exceeds $5,000; when the individual's net income exceeds $4,000 and the entire family exemption is taken in a separate return filed by husband or wife. Form 1040A, with the exceptions noted above, will be used in cases where the net income of individual taxpayers is less than $5,000. Copies of forms 1040 A and 1040 appear in Appendix B. 74 APPLICATION AND ADMINISTRATION Form 1 04 1 will be used for filing returns of fiduciaries,*^ form 1065 for partnerships and personal service corporations, and form 1120 for corporations. It has been suggested to the Treasury that it would be a great improvement if returns such as those required from corj)orations were prepared on forms not over 83^ x 1 1 inches in size, using as many sheets as necessary. *' See Chapter XXXVII for the use of other forms by fiduciaries. CHAPTER IV RICTURNS OF INDIVIDUALS AND CORPOl^N IIONS The preceding chapter explained the law and regulations as to who must make returns, the time for filing returns, and other such requirements. The specific procedure to be fol- lowed Ijy individuals and corporations now follows/ Annual Returns by Individuals Who shall make returns. — Law. Section 22T). (a) That the following individuals shsll each make under oath a return stating specifically the items of his gross income and the deductions and credits allowed under this title. — - (i) Every individual having a net income for the taxable year of $1,000 or over, if single, or if married and not living with husband or wife; (2) Every individual having a net income for the taxable year of $2,000 or over, if married and living with husband or wife; and (3) Every individual having a gross income for the taxable year of $5,000 or over, regardless of the amount of his net income The 192 1 law for the first time requires a return to be filed whenever the gross income of an individual is «$5,ooo or over. A taxpayer with a gross income of $7,000, and allowable deductions of $5,100 (leaving net income of $1,900) would, under the 1918 law, if he were married, make no return, since his net income is under $2,000. Under the 192 1 law, however, it is necessary to file a complete return even though no tax is payable. Regulation Whether or not an individual is the head of a family'^ or has dependents is innnaterial in determining his liability 'Returns of jjartnershijis and r)ers(inal service corporations arc fully dis- cussed in Chai)ter XXIV. ' See page 52. ^ For delinition of "head of a family,'' see Chapter XII. 75 76 APPLICATION AND ADMINISTRATION to render a return. If an individual is a married person living with husband or wife, no return need be made unless their aggregate gross income is at least v$5,ooo or their aggregate net income is at least $2,000 ; but a separate return must be made by each of them, regardless of the amount of the individual income of each, where their aggregate gross income is $5,000 or over, or their aggregate net income is $2,000 or over, unless they join in a single joint return. Where the income of each is included in a single joint return, the tax is com- puted on the aggregate income and all deductions and credits to which either is entitled shall be taken from such aggregate income. The husband shall include in his return the income derived from services rendered by the wife or from the sale of products of her labor if she does not file a separate return or join with him in a return setting forth her income separately (Art. 401.) This article has been amended to take cognizance of the fact that a gross income of $5,000 is a determining factor in filing returns. It should be noted that the terms "net income" and "gross income" are used, which means that dividends, exemptions for dependents, and other ''credits" may not be deducted from the amount which determines whether or not a return is to be made.* Thus there are undoubtedly many individuals who are required to make returns who, after they have applied all their '"credits,"^ will have no tax to pay. Taxpayers whose entire net income is derived from interest on tax-exempt securities enumerated in section 213 (b-4) are relieved, under the 192 1 law, from the necessity of making any return. They do not come under the provision of section 223 (a-3) requiring a return where the gross income is $5,000 or over, because such tax-exempt interest is expressly excluded from gross income. In fact, all taxpayers are relieved from reporting income from tax-exempt securities." 'See Chapter XII. '' Section 216. ° In the Senate bill the proviso in section 213 of the 1918 law calling for the return of such income was eliminated, but an amendment to section 258 was inserted, reading in part : "In connection with ever}' return is to be submitted a statement showing holdings of all tax free securities, including all Government bonds, notes, etc., and the income received therefrom. Penalty for failure to comply. RETURNS— INDIVIDUALS 'jj It is apparent, also, that the only individual who can take advantage of the permission to refrain from reporting when his net income exceeds $i,ooo but is less than $2,000 (and whose gross income together with that of his wife is less than $5,000) is one who is "married and living with husband or wife." Heads of families who are unmarried'^ must report when they have net incomes in excess of $1,000 even though, because of dependents, they may have "credits" enough to cancel all their income above that amount. Return may be filed by agents — when. — Law. Section 223 If the taxpayer is unable to make his own return, the return shall be made by a duly authorized agent or by the guardian or other person charged with the care of the person or property of such taxpayer. In the case of a personal return, "the affidavit must be executed by the person whose income is reported unless he is a minor or incompetent or unless he is ill, absent from the country or otherwise incapacitated, in which case the legal representative or agent may execute the affidavit."^ Regulation. There may be a fiduciary relationship between an agent and a principal, but the word "agent" does not denote a fidu- ciary. A fiduciary relationship can not be created by a power of attorney. An agent having entire charge of property, with authority to effect and execute leases with tenants entirely on his own respon- sibility and without consulting his principal, merely turning over the net profits from the property periodically to his principal by virtue of authority conferred upon him by a power of attorney, is not a fiduciary within the meaning of the statute. In cases where no legal trust has been created in the estate controlled by the agent and attor- ney the liability to make a return rests with the principal. (Art. 1522.) Fiduciaries use form 1041. An agent uses the form in addition to all other penalties provided by law, is 5% of amount of tax (if any)." The requirement was, however, eliminated in the 1921 law as finally enacted. ~' See Chapter XII. *Form 1040A (1922), instructions. 78 MTLICATION AND ADMINISTRATION (usually form .1040) which his principal would file if able to do so in person. Rfx.ulation The return may be made by an agent when bv reason of ilhiess, absence, or nonresidence the person Hable for the return is unable to make it, the agent assuming the responsibihty for making the return and incurring liability to the specific penalties provided for erroneous, false, or fraudulent returns (Art. 402.) Return must be under oath. — The law requires that "every person liable to any tax imposed by this Act, or for the collec- tion thereof, shall .... render, under oath, such statements and returns .... as the Commissioner, with the approval of the Secretary, may from time to time prescribe."" The following regulation gives instructions for executing an affidavit: Regulation. All income tax returns must be verified under oath or aftirmation before an officer duly authorized to administer oaths either by the laws of the United States or by the laws of the State or Territory where such officer resides. Persons in the naval or military service of the United States may verify their returns before any official authorized to administer oaths for the purposes of those services. Income tax returns executed abroad may be attested free of charge before United States consular officers. Where a foreign notary or other official having no seal shall act as attesting officer, the authority of such attesting officer should be certified to by some judi- cial official or other proper officer having knowledge of the appoint- ment and official character of the attesting officer. (Art. 406.) The Treasury has held that oaths should be administered by officers having general rather than specific authority. Post- masters, it was held, cannot therefore j)ropcrly adnu'nister oaths for income tax purposes."' Separate returns of husband and v/ife — when desirable. — Law. Section 223 (b) If a husband and wife living together have an aggregate net income for the taxable year of $2,000 or over, or an aggregate gross income for such year of $5,000 or over — (i) Each shall make such a return, or (2) The income of each shall be included in a single joint return, in which case the tax shall be computed on the aggregate in- come " Section 1300. For verification of corporation returns, sre Chnptcr \'l\. '"C. B. 3, page 22S: O. I). 701. RJiTURNS— INDIVIDUALS 79 Under the foregoing provision of the 192 1 law, the re- quirement that a return must be filed where the gross income is $5,000 or over, is made to apply to the aggregate gross income of husband and wife, when they are living together. If husband and wife are not living together, and if the net income of either is $1,000 or more, separate returns must be made. If husband and wife, living together, elect to make a single joint return, the tax then "shall be computed on the aggregate income." This provision of the 192 1 law is new. The privi- lege of applying one spouse's loss or deductions against the other's income, however, may be availed of in the making of a single joint return. If husband and wife heretofore have filed separate returns, nevertheless in 192 1 or any future year they may file a joint return. Rulings. A husband and wife may elect to file a joint return one year and separate retiuMis the next, regardless of whether such election results in a benefit to them or a benefit to the Government. (B. 27- 21-1715; O. D. 968.) Where husband and wife clearly indicate on a single return form the net income of each and compute the tax on the basis of such sep- arate income, the return so filed does not constitute a joint return, but the separate return of each individual. Where, however, a single return form is used clearly indicating the separate net income of hus- band and wife but the tax is computed upon the basis of combined income, such return is a joint return. (C. B. 4, page 255; O. D, 960.) In practically every case where a husband and a wife have a substantial income, separate returns should be filed in order that the surtax may be applied separately. It is not necessary to file separate returns to secure the benefit of the calculation if the taxpayer is careful to segregate the income and deduc- tions of each. Usually it is better to file separate returns." In case husband and wife each received an independent " [Former Procedure] The Treasury has not always assessed the sur- tax separately, InU has in some cases levied and collected an excessive tax which would not have been imposed if separate returns had been made. 8o APPLICATION AND ADMINISTRATION net income equal to or in excess of $i,ooo, separate returns may be made, but a joint return will ordinarily serve unless the combined net income exceeds $5,000. Below that figure the taxes would, with two exceptions, be the same even though the incomes were merged, i.e., 4 per cent of the amount by which the total net income exceeded the "credits," whether individual returns or a joint return were filed. The exceptions, when a combined return is desirable even though the incomes are substantial, arise (a) in case the husband or wife has allowable charitable contributions in ex- cess of the 15 per cent limitation, full credit for which would be lost if separate returns were made ; (b) in case one spouse has a net loss which may be applied against the income of the other. When the net income for 1921 shown in a single return exceeds $5,000, the surtaxes begin to apply. By rendering separate returns the application of the surtaxes is forestalled to the extent of an additional $5,000.^" In addition to the surtaxes which begin to apply when a net income reaches $5,000, there is also the 8 per cent normal rate which applies in place of the 4 per cent rate when the ex- cess of net income over credits (personal exemptions, divi- dends, etc., see Chapter XII) is greater than $4,000. In the case of a married man with no dependents (citizen or resident of the United States) having a net income of $40,000 for 1921 (none from dividends) the tax would be arrived at thus : He receives an exemption of $2,000, pays a normal tax of 4 per cent on the next $4,000, and 8 per cent on $34,000. Surtax begins at $5,000^" and is i per cent on the first $1,000 in excess of that amount, and i per cent additional on each $2,000 above $6,000, until it reaches 18 per cent on the last $2,000 of the $40,000.^* The normal tax is $2,880 and the surtax $3,410, a total of $6,290. ''For 1922, surtaxes begin at $6,000. See Chapter VII. " Ibid. " For 1922 the surtax rates start at i per cent on the first $2,000 in excess of $6,000, and are graduated upwards so that on the last $2,000 of the $40,000 the rate is 17 per cent. RETURNS— INDIVIDUALS 8l If husband and wife each have an income of $20,000, each will presumably take $1,000 exemption. The normal tax is then 4 per cent on the next $4,000, and 8 per cent on $15,000. Surtax begins as before at $5,000, and runs to 8 per cent on the $2,000 between $18,000 and $20,000. The tax for each is: normal $1,360, surtax $710; total $2,070. The combined tax is $4,140, a saving of $2,150 secured by making separate returns. When w^ife should take no part of personal ex- emption. — The following illustrates when a wife should take no personal exemption. Husband's income $20,000; wife's income $4,000; 3 children Method A — wife takes exemption : Tax Wife's income $4,000.00 Less: Exemption 2,000.00^" Taxable at 4 per cent $2,000.00 $80.00 Husband's income $20,000.00 Less: Exemption (three children) .. . 1.200.00 $18,800.00 Taxable at 4 per cent 4,000.00 160.00 Taxable at 8 per cent $14,800.00 1,184.00 Combined normal tax $1,424.00 Method B — husband takes exemption : Wife's income — ^'taxable at 4 per cent.... $4,000.00 $160.00 Husband's income $20,000.00 Less: Exemption 3,200.00 $16,800.00 Taxable at 4 per cent 4,000.00 160.00 Taxable at 8 per cent .$12,800.00 1.024.00 Combined normal tax 1,344.00 Saving in normal tax = 4 per cent on exemption of $2,000 =: $ 80.00 "The personal e.xcmiUion is only $2,000, since the tuinregatc net inctmie of husband and wife is .$24,000. See section 216 (c). Chapter XII. 82 APPLICATION AND ADMINISTRATION If a wife has an income of $4,000 or less, and the husband has income which, after deducting the full personal exemption, is large enough to subject some of his income to the 8 per cent normal tax, the application of the entire personal exemp- tion to the husband's income results in a saving equal to 4 per cent of the exemption. Joint returns of husband and wife — when desirable.— it is well to remember that a joint return or separate returns may be rendered when husband and wife are living together, and advantage may thus be taken each year of the most advan- tageous basis of filing returns, as hereinbefore outlined. Ruling. Receipt is acknowledged of your letter of January 17th, 1921, in which you state that during the year 1920 your income was approximately $54,000.00. During the same period your wife suffered a net loss of $62,000.00. You request to be advised whether under the circumstances you and your wife may file a joint return for the purpose of applying your wife's net losses against your income. You are advised that there is no provision of the law by which a husband and wife can be denied the privilege of filing a joint return. Your wife's net losses may therefore be deducted from your income in determining income subject to both the normal tax and the surtax where you and your wife elect to file a joint return. (Letter signed by Commissioner Wm. M. Williams, and dated February 3, 1921.) Community property. — The Attorney General, in opinions dated September 10, 1920,^*^ and February 26, 1921,^^ holds that community income as defined by the laws of Texas, Wash- ington, Arizona, Idaho, New^ Mexico, Louisiana, and Nevada (but not California) may be equally divided between husband and \vife. Separate returns filed by husband and wife in many cases will result in a considerable saving in tax. A full discussion of community property wall be found in Chapter XIII which should guide the preparation of returns for 1 92 1 and subsequent years. As to the returns for years prior to 1921, amended returns '" C. B. 3, page 221 ; T. D. 3071 ; 32 Op. Att. Gen. 298. ■'C. B. 4, page 238; T. D. 3138; 32 Op. Att. Gen. 443. RETURNS— INDIVIDUALS 83 and claims fur refund may be Hied within the five-year period laid down by the lyji law. Ruling. Amended separate returns may be filed for each of the taxing years in which the law of Texas contains a provision giving husband and wife equal rights to community property, subject to five- year limitation in section 252, Revenue Act of 191S. Claim for credit of net amount of taxes overpaid for any of the taxing years may be filed for the amount of assessment outstanding and claim for refund filed for balance. Claim for abatement instead of claim for credit, however, should be filed for excess of tax assessed for 1919 over tax due for 1919 under amended separate returns. Claim for refund may be filed for entire net overpayment if no assessment is outstanding. Adjustment of taxes between husband and wife due on amended separate returns will be made as a matter of accounting and no claim for credit should be filed. Any claim for abatement, refund, or credit must be accompanied by an agreement signed by husband and wife consenting to adjust- ments therein demanded. In all cases in which it appears that returns are filed as a result of the ruling contained in Treasury Decision 3071,'^ and the income shown in the returns now filed was disclosed in a prior return or re- turns, penalty on account of delinquency will not be asserted and in- terest on account of failure to pay the tax shown by the returns of the date payment was required by law, will not be assessed. Where a claim for credit is filed under this ruling, bond will not be required. Claims for credit may be filed for unpaid additional taxes assessed under office ruling 43-20-1270.^'' .'should the above outlined procedure not cover anv specific case which may arise, the facts therein should be presented to this office for a specific ruling. (C. B. 3, page 31c O. D. 757.) The above rnling under the 1918 law applies specificallv to Texas, but it can equally well apply to the other states hav- ing community property laws (listed above). The claims will now be made under section 252 of the 192 1 law-. With the amended returns a claim for refund, credit, or abatement must be filed in order to adjust the excess tax paid by one spouse. Although tlie ruling is not commendable for its clarit}', a sul)sc(juent decision"" cnnfirnis the inference that See Chapter XIII. C. B. 3, page 30Q. C. B. 4, paye .135 ; O. D. ^54- §4 At^PLICATION AND ADMINISTRATION underpayment by one spouse may be offset against overpay- ment by the other. Claim is to be filed for the excess. Change of domicile does not affect the right to render amended returns. Ruling. A husband and wife, who were domiciled in Texas, January i, 1918, and abandoned that domicile in August, 1919, the husband having- included in his 1918 and 1919 income tax returns income received from all sources including personal earnings and no returns having been filed by the wife, may file amended separate returns for 191 8, each reporting as gross income one-half the income received during that year which constituted community income as defined in T. D. 3071. They may also file amended separate returns for 1919, each reporting as gross income one-half the income, received prior to the abandonment of the marital domicile in Texas, which constituted community income as so defined. The date of the abandonment of the Texas domicile is determined by the application to the facts in the case of general principles of law. (C. B. 4, page 235; O. D. 810.) Change of domicile does not cause the forfeiture of the right to file separate returns of income from community prop- erty acquired while domiciled in a state in which community property laws are in effect. Ruling. Where husband and wife acquire community property while domiciled in the State of Idaho, and then take up domicile in California, they may continue to render separate returns of the in- come from such property. (B. Digest 39-21-1845; S. O. 121.) Returns by minors. — Minors in receipt of taxable income are required to make returns, or returns must be made for them. Regulation. An individual under the statutory age of majority is required to render a return of income if he has a net income of his own of $1,000 or over, or a gross income of $5,000 or over, for the taxable year.-^ If he is married, see article 401.-- If a minor has been emancipated by his parent his earnings are his own income, and such earnings, regardless of amount, are not required to be included in the return of the parent. If the aggregate of the net income of a minor from any property whicli he possesses, and from any funds- '' [Former Procedure] Under the 1916 and 1917 laws, the returns of minors were filed by their guardians (Reg. 33, 1918, Art. 27). The words "of lawful age" are omitted from section 223 of the 1918 law, requiring returns of "every individual," etc. "'See page 76. RETURNS— INDIVIDUALS 85 lield in trust for him by a trustee or guardian, and from his earnings in case he has been emancipated, is at least $1,000, or his gross in- come is at least $5,000, a return as in the case of any other individual must be made by him or by his guardian, or some other person charged with the care of his person or property for him.-^ In the absence of proof to the contrary, a parent will be assumed to have the legal right to the earnings of the minor and must include them in his return. (Art. 403.) The latter part of the article which holds that a parent will be assumed to have the legal right to the earnings of his minor child is reasonable, otherwise minor children with taxable incomes might erroneously assume that they were not indi- vidually responsible for making returns and the parent in turn might assume that, since the minor had a taxable income, the latter was responsible for the making of a return. It has been stated that the Treasury has advised taxpayers that the mere failure of a parent to assert his right to' appro- priate the earnings of his minor child does not constitute emancipation within the meaning of the income tax law ; also that where a parent relinquishes his right to appropriate, such earnings are constructive income to the parent and are con- sidered as gifts to the minor, and consequently are not deduc- tible in computing the parent's net income subject to income tax. In view of the reluctance of the courts to impute taxable income to a taxpayer when none has actually been received, this far-fetched doctrine of constructive receipt is hardly likely to be adopted. The question then arises — what constitutes emancipation? The courts have hekP' that : Emancipation of a minor occurs by the voluntary act of the parent in surrendering the rights or renouncing the duties of his position, or in some way conducting himself in relation thereto in a manner inconsistent with any further performance of them. The emancipation may be expressed or implied, or in writing or oral. The test to be applied is that of the preservation or destruction of the parental and filial relations. The child's arrival at the age of majority ^ See Article 422. ^29 Cyc. 1673, citing cases. 86 ArPLICATION AND ADMINISTRATION is priiuii l.'icio, but nut necessarily, an emancipation. The mar- riage of the child is an emancipation from the control and authority of the parent, even though the parent did not consent to the marriage. .... The father's desertion of a minor child will operate as an emancipation ; but the child's desertion of the father's home does not constitute emancipation so long as the father has not relinquished his right of control or consented that the child should act for himself independently of the father. The fact that the child is allowed to live away from the parent does not amount to an emancipation, unless it is the intention of the parent to release all parental authority and control. On the other hand the fact that the son lives in the family of the father docs not establish that he is not emancipated The payment of a weekly allowance by the parent to the child does not constitute emancipation. Where a father who is able to support his minor son forces him to leave home and labor abroad for a livelihood, the law implies an emancipation. So also an infant is emancipated where he supports himself and pays his board at home, or where the parent allows him to carry on a business for himself and exer- cises no control over him or his earnings. Where the child con- tracts for his services and collects and uses his own earnings, eman- cipation is to be inferred; but a complete emancipation does not nec- essarily result from the fact that the father allows the child to re- ceive and spend his own wages, or even to contract for his services. If the father gives or sells the child his time the law implies emancipa- tion. It thus appears that the Treasury has adopted a rather narrow interpretation of the law and one that will be modified later in favor of the taxpayer. The requirement [section (a-3)] that returns must be made if gross income is $5,000 or over, applies also to minors. Returns by soldiers and sailors. — All persons in the mili- tary or naval service of the United States who are unable to file returns within the statutory time limit may obtain an ex- tension of time, or returns may be made for them by agents. They may file their returns in "the district in which they have a legal residence, or with the collector of internal revenue at Baltimore, jMaryland."-^ Regulation persons in the military or naval service of the United States, may file their returns of income with the collector of Baltimore. (Art. 447; Reg. 45, Art. 448. j For verification of such returns, see page 78. RETURNS— INiDIVIDUALS 87 Returns by fiduciaries. — The duties of fiduciaries (includ- ing their liabihty to make returns, and the procedure therefor) are fully explained in Chapter XXXVII. The law"*^ classes fiduciaries as individuals in so far as returns are concerned. Income from partnerships included in individual returns of partners.— The individual returns of partners for 192 1 should include the entire distributive shares credited to such partners ''for any accounting period of the partnership ending within the fiscal or calendar year upon the basis of which the partners' net income is computed.''"' Many partners have all their personal accounts, including income from investments, etc., kept in the partnership books, and so far as an accounting period is concerned have never recognized the calendar year except for federal income tax re- quirements. If it is more convenient for a partner to make a return at some date other than as of December 31, he should apply for permission to make the change. When there is income from partnerships and the partner- ships' accounting periods are fiscal years during which differ- ent rates of tax are in effect, three steps must be considered in the returns of individuals : (a) Partners must report their share of the income of the partnershij) credited to them on the last day of the month which marked the close of the partnerships' fiscal years. '^ (b) The partnership income must be divided into the shares applicable to each of tb.e calendar years, included in the fiscal year."^ (c) Such partnership income is then taxed to the indi- vidual partners at the rates obtaining during the cal- endar vears to which it is allocated.'''^ '' Section 225. " Section 218 (a). "Section 218 (a). "'Section 205 (c). This docs not apply to fiscal years ending in 1921 as the 1920 and 1921 rates are the same. '" Ibid. 88 APPLICATION AND ADMINISTRATION Assume the case of a partnership with a fiscal year ending June 30, 1922, and with a taxable net income of $120,000. A partner owning one-half interest in the partnership, having income from other sources of $80,000, and reporting on a cal- endar year basis, would prepare his 1922 return as follows: Other income $ 80,000 taxable at 1922 rates Partnership income (yi) $60,000 Partnership income allocated to 1922 30,000 taxable at 1922 rates $110,000 total taxable at 1922 rates Partnership income allocated to 1921 30,000 taxable at 1921 rates Total nef income for 1922 $140,000 The author has protested against the inequity of the method of superimposition of income attributable to a prior year on the income of the current year, and has suggested that such income be superimposed on the income already reported for the previous year.^'^ Congress did not re-enact in the 1921 law the provisions of section 206 of the 1918 law. It w^ould seem clear, therefore, that they intended to give the taxpayer relief from the former inequitable method. No specific method is provided in the new law as to how such income is to be reported and taxed, but the Treasury has now, by regulation, provided for the superimposition of the income, earned during the prior year by a partnership, on the other income of the individual for the current year at the rates of the preceding year. (See article 335.) Section 206 of the 1918 law^^ provided for superimposition ^^ Income Tax Procedure, 1919, pages 122-124; Income Tax Procedure, 1920, pages 152-157- "' [Former Procedure] Section 206 of the 1918 law reads : "That whenever parts of a taxpayer's income are subject to rates for different calendar years, the part subject to the rates for the most recent calendar year shall be placed in the lower brackets of the rate schedule provided in this title, the part subject to the rates for the next preceding calendar year shall be placed in the next higher brackets of the rate schedule applicable to that year, and so on until the entire net income has been ac- counted for. In determining the income, any deductions, exemptions or credits of a kind not plainly and properly chargeable against the income RETURNS— CORPORATIONS 89 of the income attributed to a preceding year upon the income subject to the current year's rate. For instance, the $30,000 in the above example taxable at the 1921 rates would be sub- jected to the surtax rates for 192 1, beginning at $110,000 and running up to $140,000. Tliis method resulted in an increase of tax when the income of the taxpayer was greater in one year than in the preceding year. Conversely, it resulted in a decrease of tax when the income of a taxpayer decreased as compared with a preceding year. Accordingly there was a penalty, or bonus, in changing to a fiscal year basis, depend- ing upon the income received in the current year as compared with the preceding year. This method has been continued in the new regulations. Incorporation of a partnership or of an individual — return as a corporation. — The 192 1 law provides^^^ that under certain conditions the income of a business organized as a corporation within four months after the passage of the act (the act was passed November 23, 1921) may, at the option of the individ- ual or partnership, be treated as if such corporation had been in existence on and after January i, 192 1, and make return accordingly. For full discussion of procedure, see Chapter XXIV. Annual Returns by Corporations For 1 92 1, corporations are required to file income and excess profits tax returns. For 1922 and subsecjuent years, income tax returns only are required. Corporations which are specifically exempt under the law^* need make no annual return; but, it will be recalled, must in certain cases establish the fact of their exemption. taxable at rates for a preceding year shall first be applied against the income subject to rates for the most recent calendar year; but any balance thereof shall be applied against tlie income subject to the rates of the next pre- ceding year or years until fully allowed." ^■' Section 229. "See page 34- 90 APPLICATION AND ADMINISTRATION All other CDi'poratiuns must file returns, regardless of the amount of their net income. But when corporations have taxable income of $3,000 or less, the excess profits data need not be furnished. Law. Section 239. (a) That every corporation subject to taxa- tion under this title and every personal service corporation shall make a return, stating specifically the items of its gross income and the de- ductions and credits allowed by this title Corporations are required to file returns for their account- ing periods, the same as arc individuals."^ If corporations have been closing their books on a fiscal year basis and report- ing on a calendar year basis, they must change their method and report for fiscal years. Return sworn to by two officials.— - Law. Section 239. (a) .... The return shall be sworn to by the president, vice president, or other principal officer and by the treasurer or assistant treasurer When onl}- one officer is available, the officer signing the return may sign for the other in the latter's official capacity.^*"' "Corporation" defined, — The law"' states that the term "corporation" shall include "associations, joint-stock com- panies and insurance companies." Under the latest rulings limited partnerships are or are not corporations, depending upon their type."® Massachusetts trusts have been held not to be associations."^ Domestic corporations, for the purpose of the revenue act, are those organized in the United States, which include only the states, the District of Columbia, and the territories of A.laska and Hawaii. Those created outside these limits are foreign corporations. ^° See page 64. '' C. B. 4, page 307. '■ Section i. '' See Chapter XXIV. '' See page 93. RETURNS— CORPORATIONS Ot The Treasury has held, however, that a corporation re- ceiving a charter from tlie United States Court for Lhina, and holding itself out to be a corporation under the laws of the United States, will, for tax purposes, be considered a domestic corporation.*" Joint-stock companies and associations. — Regulation. Associations and joint-stock companies include as- sociations, common-law trusts, and organizations l)y whatever name known, which act or do business in an organized capacity, whether created under and pursuant to State laws, agreements, declarations of trust, or otherwise, the net income of which, if any, is distril)uted or distributable among the members or shareholders on the basis of the capital stock which each holds or, where there is no capital stock, on the basis of the proportionate share or capital which each has or has invested in the business or property of the organization. A cor- poration which has ceased to exist in contemplation of law but con- tinues its business in corporate form is an association or corporation within the meaning of section 2, but if it continues its business in the form of a trust, it becomes subject to the provisions of section 219. (Art. 1502.) The last sentence of this article is new. Syndicates and joint adventures. — The ordinary syn- dicates and joint adventures are held not to be associations.''^ But a syndicate where "a shareholder's certificate entitles him to share in the distribution of profits during the life of the enterprise, to share in the distribution of assets upon dissolution, and to vote on questions affecting the man- agement and control of the business," was held to be an asso- ciation. *- Alining "partnerships" in Colorado and Idaho have been held to be associations because the shares are transferal)le and Ijccause such an organization "in all its essential elements is precisel}- like a cor[)oration."^'' '"C. B. 3, page 19; O. D. 661. " Reg. 45, Art. 1507. *' C. B. 4, page y; O. I). 8y6. " B. 45-JI-19UJ; A. R. R. 652. 92 APPLICATION AND ADMINISTRATION The courts*^ have diftereiitiated a trust from an association, holding that : An organization, in form a trust, created by an agreement of the stockholders of several street railway corporations desiring to effect a unitary control of the properties of such corporations, is an associ- ation within Section II, Paragraph G (a), of the Act, where the agreement uses language that reads much like the state corporation law, and superimposes that organization upon the several corporations by placing the legal title to the capital stock of those corporations in the trustees named, who are to do certain specified things only, and by providing for a committee which controls even the power of the trustees to vote the capital stock of the corporations, and which is elected and controlled by what are called participating shareholders, who hold certificates of common and preferred participating shares issued by the trustees in lieu of the capital stocks of the corporations. An association may be organized independently of any statute, and when so organized is nevertheless subject to income tax as such. This case was decided under the 191 3 law, but the same principle will apply under all later statutes. Association distinguished from partnership. — Regulation. An organization the membership interests in which are transferable without the consent of all the members, however the transfer may be otherwise restricted, and the business of which is conducted by trustees or directors and officers without the active participation of all the members as such, is an association and not a partnership. A partnership bank conducted like a corporation and so organized that the interests of its members may be transferred with- out the consent of the other members is a joint-stock company or association within the meaning of the statute. A partnership bank the interests of whose members can not be so transferred is a partner- ship. (Art. 1503.) A bank which had issued certificates of ownership was held not to be an association but a partnership. Certificates could not be transferred without the consent of the other members, and each member was liable for all debts. ^^ A private banking institution, unincorporated, where the " Chicago Title & Trust Company as Trustee v. Smietanka, Collector, U. S. District Court, Northern District of Illinois, Eastern Division, March 14, 1921 (not reported, see T. D. 3193, July i, 1921). "B. 44-21-1895; O. D. 1083. RETURNS— CORPORATIONS 93 interests were transferable without the consent of the other members, was held to be an association. "^^ Massachusetts trusts. — Massachusetts trusts have grown up in part because, until about ten years ago, it was not possible to organize a corporation under the Massachusetts law to own and operate real estate. Out of the common prac- tice of putting real estate in the hands of trustees for legal ownership and management, with certificates issued to the beneficiaries, grew the practice of carrying on other lines of business with the same trust organization in cases where it was considered that a trust was preferable to a corporation. Hence, in practice, there are all kinds of Massachusetts trusts. In some the beneficiaries have little or no control over the management of the trust; others have practically all the char- acteristics of corporations (except the actual corporate exist- ence and the limited liability of a stockholder in a corporation), and are governed by elaborate by-laws providmg for annual meetings of certificate holders, and for the election of trustees for relatively short periods of time, thus vesting a large meas- ure of control in certificate holders. From a tax standpoint the question is : Is a Massachu- setts trust an ordinary trust or an association? If the latter, it is taxable as a corporation. If the former, the income, if distrilxitable, is taxable to the beneficiaries. In the case of Crocker v. MaUcy,^'^ the court pointed out that, by the terms of the trust, the beneficiaries were "trust beneficiaries only, without partnership, association or other relation whatever inter sese." It also pointed out that the trustees had discretion to distribute income or to add it to capital, although in fact they did make complete distribution, and that the beneficiaries had no control over the management of the trust, except that they must assent to any increase of the trustees' compensation, to the filling of vacancies among "I-i-i. I. T. 1150. "249 y. S. 223; 62, L. Ed. 573; 39 Sup. Ct. 270; 2 A. L. R. looi. 94 APPLICATION AND ADMINISTRATION the trustees and to the modifieation of the terms of the trust. .In this case also, the purpose of the trust was not to run a l)usiness, l)Ut to hold certain shares of stock and property for a limited period of years, preparatory to liquidation of the trust property. Upon these facts the court found that the trust did not have the attributes of an association, and that the provisions of the Income Tax Act of October 3, 1913, section II, G (a), did not require that such a trust be treated as a corporation for the purpose of taxation. The opinion in the case does not deal directl}- with the question whether the trust, as a trust, or the loeneficiaries are accountable for a tax on the dividends received by the trust, because under the with- holding provisions of the 19 13 act, the trustees were liable to make a payment of tax in any event, whether they were taxable themselves or merely paid on behalf of the beneficiaries. The test laid down by the Treasury is whether the bene- ficiaries have a voice in the business. Ruling. Where beneficiaries holding certificates evidencing their interest under a so-called 'Massachusetts trust' agreement annually elect persons delegated to conduct the affairs of the trusts, thus re- taining a voice in the business, the trust is an association and is sub- ject to the normal tax upon its income under the Acts of 1913, 1916, and 1918; the excess profits tax under the Acts of 1917 and 1918; the capital stock tax under the Acts of 1916 and 1918; and the cer- tificates issued by the trust to the beneficiaries are subject to the stamp tax under the Acts of 1917 and 1918. Where the trustees originally appointed were to hold office during the entire period of the trust, the right of the shareholders being limited to filling vacancies, the beneficiaries not retaining any sub- stantial control over the affairs of the trust, such a trust is not an association or taxable as such under section 230 of the act of 19 18, but under section 219 relating to trusts. They are not subject to the excess profits tax nor the capital stock tax, nor are the certificates issued by the trustees subject to stamp tax. (C. B. i, page 5 ; S. 1068.) The question, whether beneficiaries in such trusts must return their distributive shares of income of the trust, or merely the income which is distributed to them, answers itself in accordance with the general rules applicable to corporations and trusts. Clearh*, if the trust is of such a nature that it RETURNS— COnrORATIONS 95 niiisl l)c taxed as a corporation, its distributions are dividends and its shareholders have no taxable interest in its undistrib- uted earnings. On the other hand, if the trust upon its pecu- liar facts is classifiable for tax purposes as a trust, and not as a corporation, the question whether the beneficiaries must re- turn their distributive shares of income, or only the income distributed to them, depends upon their rights under the trust to have income distributed. In the Crocker case the trustees had discretion to distribute income or to add it to capital. According to the Treasury,*^ in such a case all the income would be taxed to the trustees. It would seem, however, that the language in section 219 (a-3) and (c), which makes in- come taxa1)le to the trustees if "held fur future distrilnition under the terms of the will or trust," looks to the act of the trustee under his authority given by the trust instrument as determining whether or not the income, under tlie language of the statute, is ''held for future distribution." Returns of incomplete and inactive corporations. — In the language of section 239, '"every corporation subject to taxation under this title"*^ must make a return."" Consequently all corporations, no matter how small the income or whether or not they have any income at all, provided only that as corpora- tions they are subject to the tax, must file a return. Such corporations, if in existence during any part of the year, are liable and must report from the first of the year to the date uf dissolution or liquidation, or from the date of incorpora- tion to the end of the taxable year. The general rule is that, "so long as it has the right to function as a corporation under the laws of the State in which it was incorporated, regardless of whether or not it received "C. B. I, page 176; S. 1088. ■"" "And every personal service corporation" l)ut sucli corporations are exempt under this title (section 239). ""Section 13 (h) of the 1017 law reads, "every corporation not spe- cifically enumerated as exempt shall make return of annua! net income whether or not it may have for the parlicnlar year any net incuuie." 96 APPLICATION AND ADMINISTRATION any income during the period for which the return is rendered," a return must be made.'^^ It has been held that a return must be filed although the organization as a corporation has not been completed ;^^ where a single stockholder acquires all the stock and continues the business, the corporation is not thereby dissolved;" where after expiration of the charter by limitation, its business is continued in the corporate form.^* A stockholder purchased the business of a corporation, operated the same as an indi- vidual, filed a "change of attitude" with the Secretary of State in Michigan. A return was required because it was held that the corporation was not dissolved but its powers merely sus- pended.^^ As was pointed out by the Solicitor in the first ruling cited, the question whether a corporation has been properly organ- ized or not is a question which cannot be raised collaterally. Regulation A corporation having an existence during any portion of a taxable year is required to make a return. A corpor- ation which has received a charter, but has never perfected its organ- ization, and which has transacted no business and had no income from any source, may upon presentation of the facts to the collector be relieved from the necessity of making a return so long as it re- mains in an unorganized condition. In the absence of a proper show- ing to the collector such a corporation will be required to make a return. A corporation which was dissolved in 1921 prior to the enactment of the present statute is not relieved from the necessity of rendering" returns thereunder for such portion of 1921 as elapsed before its dissolution (Art. 621.) Ruling. A charter was granted A and B in 1915 to carry on business as a corporation. The charter was granted under section 2823 of the Civil Code of Georgia, which provides in part that "* * * No charter shall have any force or effect for a longer period than two years unless the corporation, within that time, shall in good faith commence to exercise the powers granted by the act of incorporation * * *. " Prior to the application for a charter A and B operated the business as a partnership, and since the granting of the charter " C. B. 4, page 307 ; O. D. 882. "C. B. I, page 233; S. 972. But see also Art. 621. ''C. B. 4, page 302; S. O. 91 • " C. B. 4, page 305 ; S. O. 93. "C. B. 4, page 308; O. D. 919. RETURNS— CORrORATIONS 97 they iiavc continued its operation as a partnership. Corporation re- turns were filed for 1916, 1917, and 1918. No articles of incorporation or by-laws exist ; no meeting of the stockholders was ever held ; no stock was issued nor any officers elected; and the company has never held itself out as a corporation in any of its dealings and has never brought suit nor been sued as a corporation. The company has always been taxed for State, county, and school purposes as a copartnership. Held, that the organi;cation of A and B never existed either as a de jure or a de facto corporation. (B. 43-21-1887; O. D. 1078.) When a change is made from the corporate form to single proprietorship or partnership, corporations are not always formally dissolved. Care should be taken in such cases to observe all legal requirements, or the Treasury may require corporation returns to be made, even though entries have been made on the books transferring the assets. This com- ment is particularly applicable to those closely held corpora- tions in which there is laxity in the holding of stockholders' meetings and proper authorization of the acts of the officers. In general, if the business is continued under the corporate form, the Treasury takes the position that such an organiza- tion, if not a corporation de jure or de facto, is an association.^" The Treasury may not require a return if a proper state- ment of the facts is made. Ruling. The M Company was incorporated in July, 1919, but did not commence business until September i, 1919, on which date the corporation opened its books and established a fiscal year ending August 31. In March, 1920, it filed a return for the fractional part of the year from September i, 1919, to December 31, 1919, but failed to render a return for the fractional period from July, 1919, to August 31, 1919, during which time it remained in an unorganized condition and had no income. Article 621, Regulations 45, provides that a corporation which has received a charter but has not perfected its organization and received no income, may, upon presentation of the facts to the col- lector, be relieved of the necessity of making a return for the fractional period during which it remained in an unorganized condition and had no income. ' C. P.. 4, page 305 ; Sol. Op. 93. Qg APPLICATION AND ADMINISTRATION Held, that a failure to make such presentation of facts on or before November 15, 1919, the last due date of the return for the period July, 1919, to August 31, 1919, will be construed as a waiver of the privilege on the part of the taxpayer; a return covering the fractional period July, 1919, to August 31, 1919, accompanied with an affidavit stating the reason for the delay in filing, will accordingly be required, although there was nn income for the period. ( B. 48- 21-1951 ; O. D. 1120.) Ruling. The M Company was formed by incorporating the busi- ness of a copartnership. It was intended that the business of the partnership would be transferred to the new corporation as of May — , 1920, the beginning of the partnership's fiscal year, but the neces- sary legal preliminaries were not begun in time and the charter of the corporation was not issued until October — , 1920. However, the employees were sold the common stock at par with the understanding that they would thereby share proportionately in the profits from May — , and in transferring the business the corporation assumed the operation thereof from May — and entered the same on its books. Inquiry is made as to whether or not it is proper for the cor- poration to make return for the 12 months ending April — , 1921, and report as its net income the net income of the business for this period. It is held that October — , 1920, is the date to be taken as the be- ginning of the period to be covered by the return of the M Company and, therefore, the corporation can not make return for the 12 months ending April — , 1921. The corporation was not in existence nor did it receive income prior to October — , 1920. (B. 35-21-1796; O. D. 1016.) The foregoing ruling is not consistent with the position taken l)y the Treasury in those cases where it was held that a return nnist l)e made as a corporation even though the cor- ])orate organization has not been coni])]eted. In another case the Treasury held that tlie taxable jjcriod of the C(ir])iiratii)n l)egan as of the date of the issuance of the certilicate l)y the Secretary of State. •'^^' Rtti.inc. In accordance with the terms of a contract between the O Corporation and the M Corporation, the assets and liabilities uf the O Corporation were transferred to the M Corporation on December 31, 1919, and the M Corporation vvas to have the income received by the O Corporatian between October 4, T919. and December 31. 1919, the end of its taxable year. Held, that each corporation is required to render a return for its E. 4S-21-1952; O. D. 1 121. RETURNS— CORPORATIONS 99 full taxable year and that the O Coi"i)oratioii must iuckule in its return the entire income received in 1919, including any gain realized from the sale of its assets to the M Corporation. (B, 36-21-1808; O. D. 1025.) It is proper that returns should cover the full period during which both corporations were in existence; but the ruling should have stated that the O corporation could claim as an allowable deduction the income turned over after October 4 to the M corporation. The net income after October 4 was taxable income only to the corporation wliich retained it. Return by new corporation. — The provision in the 1918 law^^ with reference to the making of a first return in case of a fiscal year, w^as never clear and has been repealed. In making a first return a corporation simply makes return on the basis of its fiscal year. No notice to the Commissioner of the date of the close of the fiscal year is required from a new corporation. Holding companies with income only from dividends must make returns. — Section 239, quoted on page 90. appears t(j include holding companies receiving no income other than dividends from subsidiaries. Dividends received by a cor- poration must be reported as gross income [section 233 (a) and section 213] even though they are deducted in order to ascertain net income. If any doubt arises concerning tlie liability of holding companies to submit returns, the Commis- ■" [Former Procedure] Section 226 of the igi8 law provides: "If a taxpayer making his first return for income tax keeps his accounts on the basis of a fiscal year he shall make a separate return for the period between the beginning of the calendar year in which such fiscal year ends and the end of such fiscal year." In answer to an inquiry as to the method of reporting used by a cor- poration which organized on October i, 1Q18, and wished to establish September 30, 1919, as its first fiscal period, Commissioner Roper on March 12, 1919, advised as follows : "If your books are kept on basis of a fiscal year ending September thirtieth you should file your first corporate income tax return upon basis of such fiscal year ending in nineteen nineteen on or before December fifteenth, nineteen nineteen. No notice of date of close of fiscal year required." This interpretation obviated any necessity for reporting a fractional part of the year when a new corporation did not wish to do so. lOO APPLICATION AND ADMINISTRATION sioner will undoubtedly require such returns through an exer- cise of his power under section 1307 to demand returns when- ever in his judgment he considers them "necessary."^^ Return of foreign corporation filed by agent. — Law. Section 239. (a) .... If any foreign corporation has no office or place of business in the United States but has an agent in the United States, the return shall be made by the agent Regulation. Every foreign corporation'^*' and corporations satis- fying the conditions set forth under section 262, having income from sources within the United States, must make a return of income on Form 1 120. If such a corporation has no office or place of business here, but has a resident agent, he shall make the return. It is not nec- essar}', however, for it to be required to make a return that the for- eign corporation shall be engaged in business in this country or that it have any office, branch, or agency in the United States. (Art. 625.) The first sentence of this article has been changed to give effect to corporations entitled to the benefits of section 262 of the law. Returns of insurance companies. — The new law®^ provides for taxation of life insurance companies on the basis of in- vestment income only. No excess profits tax return or capital stock tax return is to be made for 1921, as is the case with ordinary corporations. Beginning with 1922, insurance com- panies®" (other than life or mutual insurance companies) make special returns in lieu of the ordinary income and capital stock tax returns. For detailed discussion, see Chapter XXXVIII. Returns of mergers, reorganizations and corporations with changed names. — Regulation, (a) Where corporations are affiliated at the be- ginning of a taxable year but due to a change in stock ownership or control during the year the affiliated status is terminated, or (&) where corporations are not affiliated at the beginning of the taxable ^'See Chapter III._ _ °" For special provisions appl3'ing to foreign life insurance companies, see Chapter XXXVIII. " Section 243. " Section 246. RETURNS— CORPORATIONS lOl year but through change of stock ownership or control durhig the year become affiliated, a full disclosure of the circumstances of such changes of stock ownership shall be submitted to the Commissioner. Ordinarily in such cases the parent or principal company, under the conditions described in (a) above, should exclude from its return the income and invested capital of such subsidiary or subordinate com- pany from the date of the change of stock ownership, and under the conditions described in (&) above, should include in its return the in- come and invested capital of such subsidiary or subordinate company from the date of the change of stock ownership. In either case the subsidiary or subordinate corporation whose status is changed dur- ing the taxable year should make a separate return for that part of the taxable year during which it was outside of the affiliated group. Where, in accordance with the procedure set forth above, a return is made by a corporation for a period less than a year, the tax shall be computed in accordance with sections 226 and 239 and the articles thereunder. In any case in which the change of consolidated status is for a period so short as to be negligible, a consolidated return or separate returns for the entire period, as the case may be, may be filed; in such cases, however, there should accompany the return a complete statement setting forth the changes in the affiliated status occurring during the taxable year. (Art. 634.) The new article takes into account the option available to affiliated corporations after January i, 1922, to file separate or consolidated returns. It also clarifies the procedure to be followed. It may be necessary to file three or more returns for a single year in case of merger — one for each corporation before the merger, covering the portion of the year during which the corporations existed as separate entities, and one for the merged corporation after consolidation. When the change consists of the absorption of one company by another and the effect has been merely the enlargement of the absorbing cor- poration, separate returns for the companies before and after the merger are not required. Generally speaking, it is not advantageous to file separate returns when consolidated returns may be filed. In what are known as "seasonal" businesses, care should be taken to avoid making a change at a time of year when there may be a net loss for the period elapsed since the ID2 APPLICATION AND ADMINISTRATION beginning of the liscal year. Althongh, under the 1921 law,"^ a net loss may be carried forward and "deducted from the net income of the taxpayer for the succeeding year," such net loss could not be taken advantage of by a siicct'ssor cor- poration. Returns by receivers, trustees in bankruptcy or assignees. — Law. Section 239. (a) .... In cases where receivers, trustees in bankruptcy, or assignees are operating the property or business of corporations, such receivers, trustees, or assignees shall make returns for such corporations in the same m.anner and form as corporations are required to make returns. Any tax due on the basis of such re- turns made by receivers, trustees, or assignees shall be collected in the same manner as if collected from the corporations of whose busi- ness or property they have custody and control. Regulations. A receiver who stands in the stead of an individual or corporation must render a return of income and pay the tax for his trust, but a receiver of only part of the property of an individual or corporation need not In general, statutory receivers and common law receivers of all the property or business of an individual or corporation must make returns (Art. 424.) When a corporation is dissolved, its affairs are usually wound up by a receiver or trustees in dissolution. The corporate existence is continued for the purpose of liquidating the assets and paying the debts, and such receiver or trustees stand in the stead of the corpora- tion for such purposes. Any sales of property by them are to be treated as if made by the corporation for the purpose of ascertaining the gain or loss. No gain or loss is realized by a corporation from the mere distribution of its assets in kind upon dissolution, however they may have appreciated or depreciated in valtie since their acquisi- tion (Art. 548: Reg. 45. Art. 547.) Receivers, trustees in dissolution, trustees in bankruptcy, and as- signees, operating the property or business of corporations, must make returns of income for such corporations on form 1120, covering each year or part of a year during which they are in control. Notwith- standing that the powers and functions of a corporation are sus- pended and that the ])roperty and business are for the time being in the custody of the receiver, trustee, or assignee, subject to the order of the court, such receiver, trustee, or assignee stands in the place of " Section 204. RETURNS— C(JRPORATIONS 103 tlic corporate officers and is required to perform all the duties and assume all the liabilities which would devolve upon the officers of the corporation were they in control. A receiver in charge of only part of the property of a corporation, howeyer, as a receiver in mortgage foreclosure proceedings involving merely a small portion of its prop- erty, need not make a return of income (Art. 622.) Consolidated returns. — Affiliated corporations''^ arc rc- (|uircd by the new law to make consolidated returns for 1921 in the same manner as is provided by the 1918 law."' For 1922 and subsequent years, affiliated corpoi-ations may file consoli- dated returns or separate returns for each corporation, at the oi)tion of the taxpayer. However, once the option is exercised, returns nnist be made on the same basis thereafter. Careful consideration should be given, therefore, before deciding which basis to adopt. From the standpoint of income tax, it makes little differ- ence whether or not the accounts of affiliated concerns are consolidated, unless one or more of a group should be losing money. In such a case, under separate returns no credit could be taken for the loss, in the current year's return; a net loss, however, could be carried forward. ,An attempt might be made in such circumstances to shift some of the profit to a losing subsidiary, but a new provision of the 192 1 law gives the Commissioner power to consolidate the accounts of "two or more related trades or businesses . . . . owned or controlled directly or iridirectl5^ by the same inter- ests .... for the purpose of making an accurate distribu- tion or apportionment of gains, profits, income . . . ."''^ Under these largely increased powers, it may be expected that [Former Procedure] There was a similar specific requirement in the 1918 law. The 1917 law specified that the return include information regarding "the tax years and the applicable amounts in which such divi- dends were earned." This was necessary because in 1917 dividends were taxable at the rates which were in force during the years to which the dividends were applicable, under the rule that dividends were deemed to have been paid out of most reccntlv accumulated surplus (1917 law, section 26). "'bor dcbnition of alliliatecl cnri)oration. Sec h.Virss Profils lax I'yn- ccdure. 1921, page 308. "Section 240 (c). See Chaiiter XIV of Appendix A. "Section 240 (d). I04 APPLICATION AND ADMINISTRATION the Commissioner will exercise them in those cases where the income or deductions are illegally shifted. If minority inter- ests are not affected, there is nothing illegal or immoral in shifting profits or losses in order to bring about an equitable tax burden. Consolidated returns after January i, 1922. — Law. Section 240. (a) That corporations which are affiliated within the meaning of this section may, for any taxable year beginning on or after January i, 1922,^^ make separate returns or, under regula- tions prescribed by the Commissioner with the approval of the Sec- retary, make a consolidated return of net income for the purpose of this title, in which case the taxes thereunder shall be computed and de- termined upon the basis of such return. If return is made on either of such bases, all returns thereafter made shall be upon the same basis unless permission to change the basis is granted by the Commis- sioner If the tax is assessed upon the basis of a consolidated re- turn, the total tax shall be computed in the first instance as a unit. " [Former Procedure] Under the 1918 law, consolidated returns were required for both income and profits taxes (see Excess Profits Tax Procedure, 1921, Chapter XIV). No specific provision in the 1917 law required the filing of consolidated returns ; but by regulation (Reg. 41, Arts. 77 and 78) the Treasury, under the general provision of section 201, required the filing of consolidated returns for excess profits tax in the case of corporations, when there was either substantial stock ownership, or close financial relationship or control. Partnerships, which in 1917 were subject to excess profits tax, were, under the 1917 regulations, neither required nor permitted to make conscriidated return. In a specific case the Treasury refused to accept a consolidated return where a partnership was affiliated with a corporation. Considerable doubt as to the right of the Treasury to require any con- solidated returns under the 1917 law, gave rise to the inclusion in the 1921 law of section 1331, declaratory of the 1917 law, in effect validating Reg. 41, Arts. 77 and 78, referred to above. A comparison of the language of section 1331 of the 1921 law, with that of Reg. 41, Arts. 77 and 79, reveals the fact that while section 1331 follows the wording of the regulations, an important change is made in that the law specifically treats partnerships on the same basis as corporations as regards affiliation. Under this section, amended returns may be desirable and necessary in those cases in which a partnership has previously been denied affiliation either with another partnership or with a corporation. Under previous income tax laws, prior to 1918, every corporation was held to be "a separate and distinct entity" and the tax was imposed upon each separately. If the subsidiary corporations had merely a nominal existence, however, being integral parts of the parent corporation, they were held not to be separately taxable (Reg. 33, 1918, Art. 208). RETURNS— CORPORATIONS 105 The distribution of the tax among the affihatecl corporations may be made on the basis of the net income properly assign- able to each, or as may be agreed upon between them.*'^ Foreign affiliated corporations — -and corporations having income from united states possessions. a for- eign corporation cannot be included in a consolidated return, since section 240 applies only to domestic corporations. A corporation entitled to the benefits of section 262''^ (receiving the major portion of its income from sources within posses- sions of the United States) is treated as a foreign corporation, and cannot, therefore, be included in a consolidated return.'^" The subject of consolidated returns is fully dealt with in the author's Excess Profits Tax Procedure, 1921, Chap- ters XIII and XIV. New "government contract" corporations must make sep- arate returns.— Since consolidated returns for 192 1 are to be made "subject to the same conditions as provided by the Rev- enue Act of 19 18,"" the following sections of that law apply to certain corporations in 1921, but will not apply in 1922 be- cause sections 240 (a) and 1408 of the 19 18 law have not been re-enacted in the new law^ 191 8 Law. Section 240. (a) . . . . Provided, That there shall be taken out of such consolidated net income and invested capital, the net income and invested capital of any such affiliated corporation organized after August i, 1914, and not successor to a then existing business, 50 per centum or more of whose gross income consists of gains, profits, commissions, or other income, derived from a Govern- ment contract or contracts made between April 6, 1917, and November II, 1918, both dates inclusive. In such case the corporation so taken out shall be separately assessed on the basis of its own invested capital and net income and the remainder of such affiliated group shall be as- sessed on the basis of the remaining consolidated invested capital and net income Section 240 (b). See page 209. See Chapter XXXVI. ' Section 240 (d). Section 240 (e). I06 APPLICATION AND ADMINISTRATION The intention of this section evidently was to prohi])it any relief to a new subsidiary corporation organized by an existing corporation to handle war contracts. 191S Law. Section 140M The Commissioner shall (when not violative of the technical military or naval secrets of the Govern- ment) have access to all information and data relating to any such con- tract, undertaking or agreement, in the possession, control or custody of any department, bureau, board, agency, officer or commission of the United States, and may call upon any such department, bureau, board, agency, officer or commission for a full statement and description of any allowance .for amortization, obsolescence, depreciation or loss, or of any valuation, appraisal, adjustment, or final settlement, made in pursuance of any such contract, undertaking, or agreement. Copies of government contracts. — J918 Law. Section 1408. That every person who on or after April 6, 191 7, has entered into any contract, undertaking, or agreement, with the United States, or with any department, bureau, officer, commis- sion, board, or agency under the United States or acting in its be- half, or with any other person having contract relations with the United States, for the performance of any work or the supplying of any materials or property for the use of or for the account of the United States, shall, within thirty days after a request of the Commissioner therefor, file with the Commissioner a true and correct copy of every such contract, undertaking, or agreement. Whoever fails to comply with such request of the Commissioner shall be guilty of a misdemeanor and shall be punished by a fine of not more than $1,000, or by imprisonment for not m.ore than one year, or both "(io\i:RN]\IENT contracts" DEFINED. ''' Regulation. Government contracts may include (a) a con- tract with the United States, (b) a contract with an agency of tlie United States, (c) a contract with an agency of such agency, and (d) a subcontract with a contractor under any such contract; pro- vided in every case the contract or subcontract is for the benefit of the United States. The term "Government contract or contracts niade l)etween April 6. 1917 and November ii, 1918, both dates in- clusive," inchules contracts which although entered into during such period were originally not enforceable but which have been or may become enforceable by reason of subsequent validation in pursuance of law The realization by a corporation of income from a '"See section i, and CIiai)ter X\\ Also see Hxrrss I'rofils Tax I'lo :cdit)\\ lo-i. Cli;i]i1er XV'lll, and AjJiiendix A nf this vnUnne. RETURNS— L( )RFU1v:ATI0NS I07 Government contract may atfect its status under the consolidated returns provision and the amount of its war profits and excess profits tax.'-'' .... (Art. 1510.) The Treastiry has alsij held that ''a contract entered inlu subsequent to Novemljcr 11, 1918, which is supplementary t(^ an original contract . . . ." is to be treated as a government contract.'^'* Return of earnings allocated to distributions.— The 1921 law contains a new [)rovision relative to ftiniishing with the corporation return a statement of the allocation of earnings to distributions made by a corporation. Law. Section 239 (c) There shall be included in the re- turn or appended thereto a statement of such facts as will enable the Commissioner to determine the portion of the earnings or profits of the corporation (including gains, profits and income not taxed) accumu- lated during the taxable year for which the return is made, which have been distributed or ordered to be distributed, respectively, to its stock- holders or members during such year. The general rule is that dividends are deemed to be paid from the ''most recentl}- accunuilated earnings or profits,"'^ and the alxjve requirement will more readily enable the Treas- ury to make the pro]X'r allocation.'" What is desired is the amount of each dividend only, not the names of stockholders lo whom they are payable. The Treasury has been sending out to taxpayers a fcjrm of surplus and profit and loss analysis, from which the infor- mation called for in the above provision of the law is oljtain- able. " [Former Procedure] TIic following sentence was found in Art. 1510, Reg. 45: "Tlic agreements for the oiieration of transportation sys- tems while under federal control and for the just compensation of their owners made pursuant to the Act of March 21, iyi8, arc not Government contracts within the meaning of tliis article." ;•' See Chapter XV. " Section 201 (b). '" For discussion of how tlie allocation should be made, see Chap- ter XXII. I08 APPLICATION AND ADMINISTRATION Miscellaneous ''Information" Returns Corporation returns of dividends paid. — In order that the Treasury may be able to check the returns of those who re- ceive dividends the law provides that, upon request by the Commissioner, corporations must file returns of dividends paid. Law. Section 254. That every corporation subject to the tax imposed by this title and every personal service corporation shall, when required by the Commissioner, render a correct return, duly verified under oath, of its payments of dividends, stating the name and ad- dress of each stockholder, the number of shares owned by him, and the amount of dividends paid to him."" The following regulation makes it clear that the return may be required in the discretion of the Commissioner. Regulation. When directed by the Commissioner, either spe- cially or by general regulation, every domestic or resident foreign corporation and every personal service corporation shall render a return on form 1097 of its payments of dividends and distributions to stockholders for such period as may be specified, stating the name and address of each stockholder, the number and class of shares owned by him, the date and amount of each dividend paid him, and when the surplus out of wliich it was paid was accumulated. Art. 1060. (Reg. 45, Art. 1051.) CHAPTER V AMENDMENT AND EXAMINATION OF RETURNS After returns are made questions may arise with regard to their amendment, their examination by the Treasury, and their inspection by outsiders. These questions are discussed in this chapter. Amended Returns The discovery that error exists in returns previously filed may occasion a request for an amended return either from the government or from the taxpayer/ In regard to corporations the instructions from the Commissioner to collectors are as follows : Ruling. All returns should be carefully scrutinized, and, if im- properly prepared, they should be returned to the taxpayer for cor- rection, with instructions that if a new return be executed, the old one, showing" the date of the receipt thereon, should be forwarded to the collector to avoid the possibility of subjecting the taxpayer to additional tax or penalties for failure to file the return within the period required by law. A record of each return sent back to the taxpayer for correction should be made in the office of the collector, so that if the taxpayer fails to properly amend and forward same, the collector may take steps to secure the return. (Mini, letter 1160, February 9, 1915.) In the case of individuals, however, the instructions to collectors state that under these circumstances the amended return will not be required. Ruling. Hereafter, in cases where an individual, a fiduciary or a withholding agent has been found subject to a further tax as a 'It is not the general practice to require amended returns from a tax- payer. If an examination is made by a revenue agent and additional tax is to be assessed, the revenue agent prepares the equivalent of an amended return on which the adjusted tax is based, and the taxpayer is informed by the Treasury of the reasons for the additional assessment. 109 no APPLICATION AND ADMINISTRATION result of the audit of a return in this office, or of an investigation made by a revenue agent, an amended return will not be required. (Mini, letter 1232, June 22, 1915.) In such cases notice of the proposed additional tax is set forth in the form of a letter from the Commissioner. This procedure has also been extended to corporations. The foregoing instructions do not cover the procedure to be followed when taxpayers on their own initiative de- sire to file amended returns. The Treasury prefers that a taxpayer desiring to file an amended return should request permission, stating his reasons. It is obvious that when cases come up for examination those that have attached letters from the Commissioner granting such permission will receive better consideration than those without such permission, because to some extent at least the changes between original and amended returns will have been already passed upon by the Treasury. But the formal refusal by the Treasury to sanction amended returns should not be deemed to be final in meritorious cases. If the formal consent is withheld it would seem to be proper procedure for the taxpayer to prepare corrected returns^ and file them with his local collector who should not refuse to accept them for transmission to the Commissioner. The regulations specifically provide for amended returns in certain contingencies. 1m )r example, the regulation in regard to losses points out the taxpayer's privilege to file an amended return. Regulation If subsequently to its occurrence, however, a taxpayer first ascertains the amount of a loss sustained during a prior taxable year which has not been deducted from gross income, he may render an amended return for such preceding taxable year including such amount of loss in the deductions from gross income and may file a claim for refund of the excess tax paid by reason of the failure to deduct such loss in the original return (Art. in.) Ruling. A corporation may submit amended returns for previous years when through vvrong accounting practice capital charges have been made to income. An affidavit should be attached, explaining the "When amended returns for igi6 and years prior are filed the form prescribed for the year 1916 should be used. RETURNS-AMI'INDMENT, EXAMINATION m changes made by sucli amended rehirns in the amounts shown on the original return, and explaining why the original returns were not properly prepared and the object of the company in preparing amended returns. Such amended returns will be accepted only when the erroneous charge can be specifically pointed out and the facts proven. The Internal Revenue Bureau reserves the right to penalize for the making of false returns in the past. (C. B. r, page 234; O. D. 113.) Amended returns may of course be made for reasons other tlian incorrect accounting. Amended returns — community property. — Those taxpay- ers who ha\e not taken adwintage of the decision on coni- iniiiiity property'' are still entililed to file amended returns so as to give effect to the treatment of communit}- i)roperty' as separate property of husband and wife. Amended returns barred four years after payment. — Amended returns may be bled for lOiy or su])sequent years. Law. Section 13(6. [Section 3228, Rev. Stat.] All claims for the refunding or crediting of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty alleged to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, must be presented to the Commissioner of Internal Revenue within four years next after payment of such tax, penalty, or sum. This section, except as modified by section 252, shall apply retro- actively to claims for refund under the Revenue Act of 1916, the Reve- nue Act of 1917, and the Revenue Act of 1918. It should be noted that the period begins to run ''after pay- ment of such tax, penaUy, or sum." Therefore when addi- tional taxes are assessed in respect of the year 19 17 or prior, the four-year hmitation does not bc(/in to run until payment is made. Amended returns not necessary to adjust minor items. — In cases in which there are only a few items requiring adjust- ""C. B. 3, page 309; O. D. 708, * See page 82. 112 APPLICATION AND ADMINISTRATION meiit, a statement showing" the recomputation of tax is suffi- cient. If the adjustments show an additional tax, the Commis- sioner will in due course make an assessment. Where an overpayment is shown, the statement should be attached to either a claim for refund or a claim for credit. Supplemental returns must be filed by corporations with fiscal years ending in 192 1. — Where the tax due under the new law differs from that shown by the returns already filed, supplemental returns should be prepared to show the adjusted tax. The return already filed under the 1918 law will be used as the basis for assessing the tax for that portion of the fiscal year included in the calendar year 1920. The supplemental return, i.e., the return under the 192 1 law, will be the basis for the tax applicable to that portion of the fiscal year included in the calendar year 192 1. Tax adjustment when amended returns for 1913-1916 are filed. — When the filing of amended returns results in a refund from or an additional payment to the government, the matter is not finally settled if the returns are for 1916 or prior years. Until December 31, 19 16, federal income taxes paid or ac- crued were an allowable deduction. If net income during 19 1 6 or prior years was greater or less than that shown by the returns, and the tax thereon is readjusted, there will be required a corresponding adjustment of net income in the succeeding year equal to the refund received or additional payment made. If a refund is received, the tax for the fol- lowing year will be increased. If an additional payment is made, the tax for the following year will be decreased. This is usually taken care of by setting up a statement showing all adjustments of income on the corrected basis and including the corrected tax of previous years as a deduction in succeeding years. RETURNS— AMENDAIENT, EXAMINATION 113 Payment of tax shown by amended returns — payable when? — Generally speaking, additional taxes shown by an amended return are not payable until they have been assessed by the Commissioner. Aside from those cases arising under T. D. 3220,^ the procedure is that collectors forward the re- turns to the Commissioner, and after they have been audited, assessments, if any, are sent to the collector, who in due course demands payment. Examinations to Ascertain Correctness of Returns Treasury officers have full power to examine books and records and to require attendance of the necessary persons in the course of examinations to establish the accuracy of in- come tax returns. Law. Section 1308. That the Commissioner, for the purpose of ascertaining the correctness of any return or for the purpose of making a return where none has been made, is hereby authorized, by any revenue agent or inspector designated by him for that purpose, to examine any books, papers, records or memoranda bearing upon the matters required to be included in the return, and may require the at- tendance of the person rendering the return or of any officer or employee of such person, or the attendance of any other person having knowledge in the premises, and may take his testimony with reference to the mat- ter required by law to be included in such return, with power to ad- minister oaths to such person or persons. Law. Section 1310. (a) That if any person is summoned under this Act to appear, to testify, or to produce books, papers, or other data, the district court of the United States for the district in which such person resides shall have jurisdiction by appropriate process to com- pel such attendance, testimony, or production of books, papers, or other data. (b) The district courts of the United States at the instance of the United States are hereby invested with such jurisdiction to make and issue, both in actions at law and suits in equity, writs and orders of injunction, and of ne exeat republica, orders appointing receivers, and such other orders and process, and to render such judgments and decrees, granting in proper cases both legal and equitable relief together, as may be necessary or appropriate for the enforcement of the provision of this Act. The remedies hereby provided are in "See B. 37-21-1822. 114 API'LICATION AND ADMINISTRATION addition to and not exclusive of any and all other remedies of the United States in such courts or otherwise to enforce such pro- visions It sh(»u1(l 1)C noted that the plenary power of examination extends also to i)ersons, other than the tax[)a3"er, who have knowledge of his income." Tlie anthor has frecpiently been asked by taxpayers : "What shall we do when an inspector calls?" Perhaps tax- payers will have a better understanding of their own obliga- tions if acquainted with the duties of income tax inspectors, as set forth in the regulations. These are, in part, as follows : Rm rN(;. The duties nf (ifiicers of tliis class arc to ascertain and report the names of persons who in their opinion are liable to the income tax and who have failed to make return as required Viy law; to imjuire into income tax rclurns where there is any suspicion that the return made is erroneous; to examine the l^ooks and accounts of persons who have made returns, for the purpose of ascertaining and reporting;- as to whether the law has been complied with In the discharge of their official duties officers of this class, as well as all officers of the Internal Revenue Bureau, in making in- quiries and investigations are expected to exercise sound discretion, treat all persons with due courtesy, and, while acting firmly and courageously, to avoid all contention or controversy that would give just ground for complaint. (T. D. 1932, January 13, 1914.) Inspectors usually call upon individual taxpayers without notice. In the case of business concerns appointments con- venient to both are made over the telephone. Although the right of inspectors to examine the books and accounts of all taxpayers is unquestioned, the author does not know of an in- stance when an immediate examination has been insisted upon to the inconvenience of the taxpayer. There should be no trouble in arranging a convenient time. Taxpayers should furnish the inspector w'ith all informa- tion called for, and, by placing at his disposal tlie original data supporting the returns, the examination will be expedited. In 'In re Chadzvick, 5 Fed. Cas. 401; Fed. Cas. No. 2570, held that a cor- poration was net compelled to produce its books upon an inquiry into the income of its stockholders. RETURNS— AMENDMENT, EXAMINATION 115 case of doubt, too much rather than too Httle information should be tendered. Ruling. Under section 1305 [Section 1308 of the 1921 law] of the Revenue Act of 19 18, it is held that the Commissioner of Internal Revenue is authorized, hy any revenue agent or inspector designated by him for that purpose, to examine any of the books, papers, records or memoranda of a hank, bearing upon any matter required to be in- cluded in a tax return of one of its depositors or customers. The bank, however, is entitled to satisfy itself in a reasonable manner of the official character and authority of any person making request to examine books or accounts of the bank as an official of the Inter- nal Revenue Bureau. ( C. B. 3, page 371 ; O. D. 609.) The new law provides that there sliall ])e onl}' one examina- tion each year, unless the taxpayer recpiests it or the Commis- sioner notifies the taxpayer in writing that an additional in- spection is necessary.'^ Publicity of Returns and Disclosure of Information Returns are guarded very carefully. Section 257 pro- vides that they may be inspected by certain parties under cer- tain conditions. Inspection must Ije made under rules and regulations prescri])ed by the Secretar}- of the Treasury and approved by the President. The Senate attempted to amend section 257, so as to per- mit either house of Congress to inspect returns. The con- ferees very wisely eliminated this amendment. Law. Section 257. That returns upon which the tax has been determined by the Commissioner shall constitute public records; but they shall be open to inspection only upon order of the President and under rules and regulations prescribed by the Secretary and approved by the President: .... The followijig regulation has ])een recently pronnilgated with reference to inspection of returns liled under the igr^, 1916, 1917, 1918 and 1921 laws.'' Tliis regulation has been ' Section 130Q. "A similar ])r()\ isioii (if the kjoo law was declared constitntinnal. (I'lint f. Stain- 'inuy Co., :>.'\) C. S. 107; 55 I,, h'd. jXij; 31 S. Ct. 3 l-^J Ii6 APPLICATION AND ADMINISTRATION signed by I'le Secretary of the Treasury and approved by the President. It should be noted that a written appHcation must be made to inspect a return. Regulation i. These regulations deal only with in- spection of returns, as the statutes expressly require the approval of the President of regulations on this subject. Other uses to which returns may be lawfully put, without action by the President, are not covered by these regulations. 2. The word "corporation'' when used alone herein shall, unless otherwise indicated, include corporations, associations, joint-stock companies, and insurance companies. The word "return" when so used shall, unless otherwise indicated, include income and profits tax returns; and also special excise tax returns of corporations filed pursuant to Section looo, Title X, of each of the Revenue Acts of 1918 and 1921. 3. Written statements filed with the Commissioner of Internal Revenue designed to be supplemental to and to become a part of tax returns shall be subject to the same rules and regulations as to in- spection as are the tax returns themselves. 4. Except as hereinafter specifically provided, the Commissioner of Internal Revenue may, in his discretion, upon written application setting forth fully the reasons for the request, grant permission for the inspection of returns in accordance with these regulations. The application will be considered by the Commisisoner and a decision reached by him whether the applicant has met the conditions imposed by these regulations and whether the reasons advanced for permission to inspect are sufficient to permit the inspection. Such written ap- plication is not required of the officers and employees of the Treasury Department whose official duties require inspection of a return, or of the Solicitor of Internal Revenue 13. When it becomes necessary for the Department to furnish returns or copies thereof for use in legal proceedings, inspection of such returns or copies that necessarily results from such use is per- mitted. 14. Except as provided in paragraph 13 returns may be inspected only in the office of the Commissioner of Internal Revenue, Wash- ington, District of Columbia. 15. A person who, under these regulations, is permitted to inspect a return may make and take a copy thereof or a memorandum of data contained therein. 16. By Section 3167 R. S., as amended by the Revenue Act of 1918, and reenacted without change in Section 131 1 of. the Revenue Act of 1921, it is made a misdemeanor for any person to print or RETURNS— AMENDMENT, EXAMINATION 117 publish in any manner whatever not provided by law any income re- turn, or any part thereof or source of income^ profits, losses, or ex- penditures, appearing in any income return, which misdemeanor is punishable by a fine not exceeding $1,000 or by imprisonment not exceeding one year, or both, at the discretion of the Court, and if the offender be an officer or employee of the United States, by dis- missal from office or discharge from employment. 17. All former regulations bearing on the subject of inspection of returns are hereby superseded. 18. These regulations shall remain in force until expressly with- drawn or overruled. (T. D. 3277, signed by A. W. Mellon, Secretary of the Treasury, approved by the President, and dated January 24, 1922.) Method of securing copy of return. — Persons or corpora- tions desiring copies of their own returns may secure them. Representatives of taxpayers holding powers of attorney are legally entitled to inspect or secure copies of returns. Access to corporation returns is permitted stockholders and receivers as a right and to state officers under carefully restricted con- ditions.^ Copies of returns are furnished the proper officers and employees of the Treasury, and to the proper officers of a court for use in a trial of any case to which both the United States and the person rendering the return are parties.^" Other- wise returns are considered "inviolably confidential."" Regulation 2. A copy of an income return may be fur- nished by the Commissioner of Internal Revenue to the person who made the return or to his duly constituted attorney, or if the person is deceased, to his executor or administrator; or if the entity is in the hands of a receiver, trustee in bankruptcy, guardian, or similar legal custodian, to the receiver, trustee, or other similar custodian upon writ- ten application for same, accompanied by satisfactory evidence that the applicant comes within this provision. "The person who made the re- turn," as herein used, refers in the case of an individual return to the individual whose return is desired, and in the case of a return of a corporation, association, joint-stock company, insurance company, or fiduciary to the corporation, association, joint-stock company, or fiduciary, a copy 'of whose return is desired. A corporation may also designate by proper action of its board of directors the officer or individual to whom a copy of a return made by the corporation may °See pages 124-125. "Art. 1091. ^'^ Income Tax Primer, igi8, question 142. Il8 APPLICATION AND ADMINISTRATION be furnishetl, and upon sufficient evidence of such action and of the identity of the officer or individual, a copy may be furnished to such person. A copy of a partnership income return vi^ill be furnished to the partners only in case all the partners join in the request there- for, it matters not what particular partner or officer of the partner- ship made the return. If the partnership has been dissolved, the members surviving may be furnished a copy if all the members sur- viving join in the request. (Art. 1091.) Inspection of individual returns. — Rkgl'lation 5. The return of an individual shall be open to inspection as follows: (o) By the officers and employees of the Treasury Department whose official duties require such inspection and by the Solicitor of Internal Revenue; (b) by the person who made the return, or by his duly constituted attorney in fact; (c) by the administrator, executor, or trustee of the taxpayer's estate, or by the duly constituted attor- ney in fact of such administrator, executor, or trustee, where the maker of the return has died; and (d) in the discretion of the Com- missioner of Internal Revenue, by one of the heirs at law or next of kin of such deceased person upon showing that he has a material interest which will be affected by information contained in the return. 6. A joint return of a husband and wife shall be open to inspec- tion (a) by the officers and employees of the Treasury Department whose official duties re(|uire such inspection and by the Solicitor of Internal Revenue; and (b) by either spouse for whom the return was made (or his or her duly constituted attorney in fact or legal representative), upon satisfactory evidence of such relationship being furnished (Art. 1090.) It is well to remember that not even the officers of a stale imposing an income tax have been able to sectire access to individual returns. Inspection of partnership returns. — Regulation 7. The return of a partnership shall be open to inspection (a) by the officers and employees of the Treasury De- partment whose official duties require such inspection and by the Solicitor of Internal Revenue: and (b) by any individual (or his duly constituted attorney in fact or legal representative) who was a member of such partnership during any part of the time covered by the return, upon satisfactory evidence of such fact being furnished. (Art. 1090.) RETURNS-AMENDMENT, EXAMINATION 119 Inspection of returns of estates and trusts. — Regulation 8. The return of an estate shall be open to inspection (a) by the officers and employees of the Treasury Department whose official duties require such inspection, and by the Solicitor of Internal Revenue; (b) by the ad- ministrator, executor, or trustee of such estate, or by his duly con- stituted attorney in fact; and (t) by one of the heirs at law or next of kin of the deceased person whose estate is being administered upon a showing of a material interest which will be affected by information contained in the return (Art. 1090.) Beneficiaries are entitled to inspect returns of the estate. Regulation 9. The return of a trust upon which a tax has been determined shall be open to inspection (a) by the officers and em- ])loyees of the Treasury Department whose official duties require such inspection, and by the Solicitor of Internal Revenue; (b) by the trustee or trustees, or the duly constituted attorney in fact of such trustee or trustees; and (c) by any individual (or his duly constituted attorney in fact or legal representative) who was a beneficiary under such trust during any part of the time covered by the return, upon satisfactory evidence of such fact being furnished. (Art. 1090.) Rulings. An original letter with regard to his return written by a decedent to the collector may not be furnished to the attorneys for the estate. A certified or photostatic copy may, however, be given to them provided the executors submit a copy of the letters testa- mentary issued to them by the court, together with a letter signed by them authorizing the attorneys to receive a copy of the letter in question. (C. B. 3, page 313; O. D. 576.) The executor of an estate may secure copies of income tax re- turns filed by the decedent upon submission to the ("onnnissioner of a certified copy of letters testamentary cvi2)^ 1918, Art. 52.) "'262 Fed. 114. Petition for writ of certiorari denied, March 8, 1920, 252 U. S. 579 ; 64 L. Ed. 725 ; 40 S. Ct. 344. ''31 Op. Att. Gen. 459. [Former Procedure] Prior to this opinion it was held by some authorities tliat tlie Commissioner liad no power to mitigate the 25 and 50 per cent penalties. PENALTIES 149 may be compromised by the Commissioner whenever, in his judgment, such compromises are for the interest of the United States : (i) Claims for amounts 50 per cent in addition to amounts of income and excess-profit taxes assessed under authority of section 3176 of Revised Statutes, as amended by section 16 of the act of September 8, 1916, and of section 212 of the act of October 3, 1917, in cases of failure to make and file returns or lists within the time pre- scribed by law or by the collector; (2) Claims for amounts 100 per cent in addition to amounts of income and excess-profit taxes assessed under authority of said sec- tions in cases of false or fraudulent returns or lists willfully made; Collectors have no authority to waive penahies or interest."* When specific penalties will not be subject of suit. — In view of the extraordinary conditions now existing it is beheved by some that many taxpayers have subjected themselves to penalties. Under the circumstances it may be of interest to re- produce instructions to collectors regarding the imposition of the specific penalties and the attempt to recover them by suit. Ruling. Liability to specific penalty attaches upon all delinquent returns and is recoverable by suit. By Section 3214 R. S. the Com- missioner of Internal Revenue may or may not institute suit. It has been decided not to institute suit nor to assert specific penalty in cer- tain cases. The assertion of specific penalty does not depend upon the fact of whether or not the 50 per cent addition to tax has been assessed. In some cases where the 50 per cent addition to tax must be assessed because the return was filed after notice from the col- lector, the specific penalty will not be asserted. It will not be as- serted, regardless of whether the 50 per cent addition to tax has been assessed, in cases falling under any of the following designations: 1. Extension granted. Where a return is filed within the thirty- day period of extension granted by the collector or within a further period of extension granted by the Commissioner of Internal Revenue, as provided by Section 14 (c) of the act of September 8, 1916. 2. Return on time. Specific penalty will not be asserted upon an amended return provided the original return was filed within the prescribed time. 3. Mailed in time. Where an affidavit is filed satisfactorily estab- -■* 1-2-22 ; L T. 1 161. I50 APPLICATION AND ADMINISTRATION lishing that the return was placed in the mails in ample tiine to reach the collector's office in ordinary course of mails before the close of business on the final day for filing. 4. Tentative return. Where an informal return was filed within the time prescribed. The return of a parent company including therein the income of a subsidiary company will be accepted as a ten- tative return of the subsidiary company, if the fact is stated that the tentative return includes the income of the subsidiary. 5. Filed in wrong district. Where the return was filed in some other collection district within the prescribed time. 6. Net income under $3,000. Where it develops that the net in- come of an individual for 1913, 1914, 1915 or 1916 was less than $3,000, or under the act of October 3, 1917, for 1917, etc., less than $1,000 or $2,000. 7. Erroneous information. Where the delinquency is alleged to be due to erroneous or misleading information given by officials or employees of the Internal Revenue Service and there is no evidence in conflict therewith. 8. Organization incomplete. Where it is established that the or- ganization of a corporation, joint-stock company or association, or insurance company was not completed until after the expiration of the period for which the return should have been filed. 9. Death. Where by reason of the death of an individual his re- turn for the year or portion of the year prior to his death is not filed within the time prescribed. The death of a delinquent abates liability to specific penalty. An administrator or executor is charged with the duty of rendering a return for the decedent, and if he is appointed in ample time to make the return prior to March i and fails to do so, he should be charged as delinquent and the specific penalty should be asserted against him. The administrator or executor will not be re- lieved from specific penalty unless the return is made within a rea- sonable time after his appointment. 10. Severe illness or unavoidable absence. Where it is clearly established that the delinquency in the filing of a return of an indi- vidual or of a corporation within the time prescribed was due to severe illness of the individual or of an officer of a corporation whose duty it was to prepare or sign the return, or to unavoidable absence from place of business or place of abode. 11. Absence from the United States. Where it appears that the filing of a return within the time prescribed was rendered impossible by reason of absence from the United States. Delinquency heyond the period of extension which may be granted by the Commissioner of Internal Revenue will not be excused under this heading. 12. Military or naval service of United States. Where the de- linquency of an individual was occasioned by service in the military or naval forces of the United States. PENALTIES 151 13. Not organized for profit. CouiprcheiKls minicroiis small cor- porations not organized primarily for profit, such as local telephone companies, co-operative purchasing societies, etc., concerning whose liability under the law to make a return there may have been a rea- sonable doubt. 14. Inactive corporations. Those which transacted no business and had no income during the return year. 15. Fiscal year. Corporations which have established a fiscal year in the manner prescribed by law which file a return on or before the first day of the third month following the close of the fiscal year. 16. Assigned. Where corporations have made an assignment on account of insolvency and do not intend again to engage in business. 17. Insolvent. Where the assets of a corporation are insufficient for the payment of its debts and the corporation has ceased to do business. 18. Charter forfeited. Where, prior to the date when the return was due, the charter of a corporation is forfeited on account of non- compliance with state laws. It must be clear, however, that business in the name of the corporation was suspended at the time of such for- feiture. If business was continued under the same name, the con- cern will be held to be an association and the same liabilities will attach as if the charter had not been forfeited. 19. Defunct. Where corporations are out of business, have no assets, maintain no organization, and the purpose for which organized has been abandoned. 20. Dissolved. Where all the assets of a corporation have been distributed. 21. Sale. Where corporations have disposed of all their assets and property by sale to other corporations, firms, or individuals and business is no longer carried on under their charters. 22. Consolidated, merged or succeeded. Where corporations have terminated their existence as represented by these terms and it appears that no assets or property remain in the name of the retiring corporation. 23. No assets. Includes all corporations having no assets from which to submit an offer in compromise. In cases not included in any of the above classes, the specific penalty will be asserted, and if the delinquency was not due to an in- tention to delay the administration of the law the minimum amount which will be accepted in compromise is as follows: $5 in the case of an individual or withholding agent. $10 in the case of a corporation, joint-stock company or asso- ciation, or insurance company. These amounts will be considered insuflicient and will not be accepted in any case where it appears that a taxpayer was intention- 152 APPLICATION AND ADMINISTRATION ally violating the provisions of law, and purposely delaying the filing of the returns. In all cases where revenue agents or other examin- ing officers discover that any individual has an appreciable taxable in- come and the examining officer is of the opinion that the individual knew or should have known that he was required to make a return, he should make a recommendation as to the minimum amount which should be accepted as an ofYer in compromise, and where the intent to evade tax is plain he should recommend prosecution. Special atten- tion should be called to cases of individuals having a taxable income who have failed to file returns for a number of years. In all cases of delinquency discovered by revenue agents and other examining officers, if the delinquency falls within a period for which the penalty can be asserted, such officers should secure from the de- linquent a sworn statement setting forth the reason for delinquency. This statement should be attached to the return forwarded to the collector. The examining officer should state in his report the alleged reason for delinquency and if he is of the opinion that the minimum amount should not be accepted as an offer in compromise of liability to specific penalty, he should make a recommendation as to the mini- mum amount which should be accepted. Consideration will be given such recommendation by this office in accepting an offer in compro- mise. In forwarding offers in compromise on form 656 collectors should call attention to revenue agents' reports, if any, in which the non-acceptance of the minimum amount as an offer in compromise is recommended. The statement or affidavit attached to the return set- ting forth the reason for delinquency is not in lieu of the affidavit required to be attached to form 656. (Mim. Letter to Collectors No. 1675, November 3, iQi/."* Suits for penalties barred after 5 years. — Section 1047, Revised Statutes, in part, is as follows: Law. Section 1047 [Rev. Stat.]. No suit or prosecution for any penalty or forfeiture, pecuniary or otherwise, accruing under the laws of the United States, shall be maintained, except in cases where it is otherwise specially provided, unless the same is commenced within five years from the time when the penalty or forfeiture accrued Limitation on prosecution for criminal violations. — Law. Section 1321. (a) That the Act entitled "An Act to limit the time within which prosecutions may be instituted against persons charged with violating internal-revenue laws," approved July 5, 1884, is amended to read as follows: "That no person shall be prosecuted, tried, or punished for any of the various offenses arising under the internal-revenue laws of the United States unless the indictment is found or the information insti- PENALTIES 153 tuted within three years next after the commission of the offense: Provided, That the time during which the person committing the of- fense is absent from the district wherein the same is committed shall not be taken as any part of the time limited by law for the com- mencement of such proceedings: Provided further, That the provisions of this Act shall not apply to offenses committed prior to its passage: Provided further. That where a complaint shall be instituted before a commissioner of the United States within the period above limited, the time shall be extended until the discharge of the grand jury at its next session within the district: -liid provided further. That this Act shall not apply to offenses committed by officers of the United States." (b) Any prosecution or proceeding under an indictment found or information instituted prior to the passage of this Act shall not be affected in any manner by this amendment, but such prosecution or proceeding shall be subject to the limitations imposed by law prior to the passage of this Act. Law. Section 1046. [Rev. Stat.] No person shall be prosecuted, tried, or punished for any crime arising under the revenue laws, .... unless the indictment is found or the information is instituted within five years next after the committing of such crime. No person shall be prosecuted, tried or punished for any of the various offenses arising under the internal revenue laws of the United States unless the indictment is found or the information instituted within three years next after the commission of the offense, in all cases where the penalty prescribed may be imprisonment in the peni- tentiary, and within two years in all other cases: Provided. That the time during which the person committing the offense is absent from the district wherein the same is committed shall not be taken as any part of the time limited by law for the commencement of such pro- ceedings: Compromise of penalty a bar to prosecution. — In a recent case-' in which internal revenue officers, after defend- ant had admitted that he had not filed an income tax return as required by section 1004, accepted not only the tax but the penalty, informing defendant that such payment would end the matter and there would be no indictment, it was held that such acceptance and statement was a "compromise" within section 3229, Revised Statutes, and was a bar to prose- cution. Rau V. U. S., 260 Fed. 131 ; 171 C. C. A. 167. CHAPTER VII RATES AND COMPUTATION OF TAX The changes in rates and in the computation of tax under the 1 92 1 law may be summarized as follows: 1. There is a decrease in the individual surtax rates for 1922. 2. There is an increase in the corporation income tax rate to 12^ per cent for 1922. 3. Capital net gains are taxed at a flat rate of 12J/2 per cent (including normal tax), from January i, 1922. 4. Computations in case of fiscal years of individuals, partnerships, personal service corporations, and regular corporations are changed. 5. When return is made for less than one year, income is calculated on annual basis. 6. When individuals are not entitled to increased ex- emption, or specific credit of $2,000 is denied a corporation, special computations are necessary. Rates The 1 92 1 law introduces an additional problem for the taxpayer because of a change in rates, a change of basis of taxation (as in the case of personal service corporations after December 31, 1921), and because of the adjustments that must be made in the case of fiscal year taxpayers whenever the tax rates and basis of taxation (such as elimination of excess profits tax after 192 1) are changed. Under the 1921 law the rates of tax imposed by the 19 18 law remain unchanged for 192 1, but are changed commenc- ing January i, 1922. 154 RATES AND COMPUTATION OF TAX 155 Rates applicable to individuals. — The total rate applying to the income of individuals consists of two parts, the normal tax and the surtax. For the calendar year 192 1 and subse- quent years, the normal tax is a fiat rate of 8 per cent (re- duced to 4 per cent upon the first $4,000 subject to normal tax).^ The surtaxes begin to apply when the net income ex- ceeds $5,000 for 192 1 and $6,000 for 1922 and are rapidly progressive. The rates are applied to "net income" which is ascertained by subtracting (specified deductions from "gross (income,"' the latter being defined in the law to include the distributive shares of the profits of partnerships and personal service cor- porations. Beginning with January i, 1922, personal ser- vice corporations are taxed as ordinary corporations, and the undistributed profits thereof are not taxed to the in- dividual stockholders." The terms "gross income" and "net income" are fully explained in Chapter XIII. For the purposes of the normal tax only, further deductions are permitted under the title of "credits."^ These credits consist of dividends, interest on cer- tain securities, and the personal exemptions of $1,000, $2,000, or $2,500, together with $400 for each dependent. Normal tax. — Law. Section 210. That, .... there shall be levied, collected, and paid for each taxable year upon the net income of every individual a normal tax of 8 per centum^ of the amount of the net income in ex- _' Citizens or residents of the United States entitled to the benefits of section 262 are subject to normal tax at the rate of 4 per cent on the first $4,000 of total net income from sources within the United States, in excess of credits and 8 per cent on the balance. See Chapter XXXVI. 'Section 218 (d). ' See XXV. '[Former Procedure] The normal rate under the 1913 law was i per cent (section II, A, sub. i). This applied for the years 1913, 1914 and 1915. The 1916 law made the normal rate 2 per cent [section i (a)]. This rate was in force for one year (1916) before it was supplemented by an additional normal tax of 2 per cent (1917 law, section i). Conse- quently in 191 7 the normal tax amounted to 4 per cent in all, the entire 4 per cent, however, not applying to the smaller incomes. The normal 156 APPLICATION AND ADMINISTRATION cess of the credits provided in section 216 ■/• Provided, That in the case of a citizen or resident of the United States the rate upon the first $4,000 of such excess amount shall be 4 per centum. Surtax. — For 192 1 all individual net incomes in ex- cess of $5,000 are subject to surtaxes.''' For 1922 and sub- sequent years the surtaxes start at $6,000.' The personal exemptions and other credits such as divi- dends do not relieve the taxpayer of surtaxes.^ The surtax rates for 1921 are the same as in the 1918 law, increasing i per cent with each $2,000 of income, until the rate of 48 per cent is applied to the increment between $98,000 and $100,000. Thereafter the steps are more widely separated, until a maximum is reached of "65 per centum of the amount by which the net income exceeds $1,000,000.'' The surtax rates for 1922, starting with i one per cent on the $4,000 between $6,000 and $10,000, increase by i or 2 per cent steps, and reach 47 per cent of income between $98,000 and $100,000. The maximum rate is 50 per cent of all over $200,000. Thus on incomes up to $100,000 the sur- tax is slightly less and on incomes over $100,000 the rates are considerably reduced, as compared with 192 1. The House bill provided for same surtax rates as under 19 18 law to $66,000 with a flat rate of 32 per cent on all over that amount. As ])assed by the Senate the bill provided for a maxinuim rate of 50 per cent on all over $200,000. The rates which ajjply to each successive increment of in- come, the tax which results from the application of the rates rate for tlie calendar year 1918 was 12 per cent upon net incomes exceed- ing $4,000 and 6 per cent on the first $4,000 or any part thereof. In the case of the individual's fiscal year, beginning in 1918. the rates of 1918 were applicable to a portion of the year's income. See Income Tax Procedure, 1920, page III. ' See Chapter XII. • Section 211 (a-i). ' Section 211 (a-2). "^See Chapter XII. RATES AND COMPUTATION OF TAX 157 to the increments, and the cumulation of these taxes, are set forth in the following table :^ In 1916 the surtax rates were changed to the scale shown in column A in the table given below [1916 law, section i (b)]. These rates applied in 1916, and in 1917 the scale of rates shown in column B was added to the 1916 rates and the resulting combined rates shown in column C were imposed for that year. Net income subject to tax A 1016 law (percentage) B 1917 law (percentage) C Total surtax applied in 1917 (percentage) S 5.000 to $ 7,500 7.500 " 10,000 'i% 3 4 5 6 7 8 9 10 10 11 12 13 i'7« 3 4 5 7 10 14 IS 22 25 30 34 37 40 45 50 50 50 1% 2 10.000 " 12..500 12,500 " 15,000 3 4 15.000 " 20.000 5 20,000 " 40.000 8 40,000 " 60.000 12 60 000 " 80,000 17 80.000 " 100.000 22 100 000 " 150 000 . 27 150.000 " 200.000 31 200.000 " 250.000 37 250.000 " 300.000 42 300.000 " 500,000 46 500,000 " 750,000 50 750 000 " 1,000,000 55 1,000,000 " 1,500,000 1,500,000 " 2,000.000 61 62 On excess of 2.000.000 63 In 1918, 1919, and 1920 the surtax rates were the same as those given Oil page 158 for 1921. • [Former Procedure] Under the 1913 law (section II, A, the surtax rates on net income of individuals were as follows : Net income subject to tax. J 20,000 to 50,000 " 75,000 " 100,000 " 250,000 ^ 50,000 75,000 100,000 250,000 500,000 500,000 and over These rates were in force in 1913, 1914 and 1915- sub. 2) 1% 2 3 4 5 6 158 APPLICATION AND ADMINISTRATION SURTAX RATES AND AMOUNTS OF SURTAXES PAYABLE UNDER 1921 LAW come 1921 1922 and subsequent years Net In Total Total Per cent Surtax cumulative Per cent Surtax cumulative surtax* surtax* % 5,000 to $ 6.000 1% SIO 810 6,000 " 8.000 2 40 50 "'i% 26' 26' 8,000 « 10,000 3 60 110 1 20 40 10,000 " 12.000 4 80 190 2 40 80 12.000 " 14.000 5 100 290 3 60 140 14,000 " 16.000 6 120 410 4 80 220 16.000 " 18,000 7 140 550 5 ■ 100 320 18,000 •' 20,000 8 160 710 6 120 440 20.000 " 22,000 9 ISO 890 8 160 600 22,000 " 24,000 10 200 1.090 9 180 780 24,000 " 26,000 11 220 1,310 10 200 B80 26,000 " 28,000 12 240 1,.5.50 11 220 1.200 28,000 " 30,000 13 260 1,810 12 240 1.440 • 30,000 " 32,000 14 280 2,090 13 260 1.700 32,000 " 34,000 15 300 2,390 15 300 2.000 34,000 " ,S6.000 16 320 2.710 15 300 2,300 36,000 ' 38.000 17 340 3.050 16 320 2,620 38,000 " 40.000 18 360 3.410 17 340 2,960 40.000 " 42.000 19 380 3,790 18 360 3.320 42.000 " 44.000 20 400 4.190 19 380 3.700 44.000 " 46.000 21 420 4,610 20 400 4.100 46.000 " 48.000 22 440 5,050 21 420 4.520 48.000 " 50,000 23 460 5,510 22 440 4.960 50.000 " 52,000 24 480 5,990 23 460 5.420 52.000 " 54.000 25 500 6.490 24 480 5.900 54.000 « 56.000 26 520 7,010 25 500 6.400 58,000 ' 58.000 27 540 7,550 26 520 6,920 58,000 " 60.000 28 560 8,110 27 540 7.460 60,000 " 62.000 29 580 8,690 28 560 8.020 62,000 " 64.000 30 600 9,290 29 580 8.600 64,000 " 66,000 31 620 9,910 30 600 9.200 66,000 " 68.000 32 640 10,5.50 31 620 9.820 68.000 " 70.000 33 660 11.210 32 640 10.460 70.000 " 72.000 34 680 11,890 33 660 11.120 72,000 " 74.000 35 700 12,590 34 680 11.800 74,000 " 76.000 36 720 13,310 35 700 12.500 76,000 " 78,000 37 740 14,050 36 720 13.220 78,000 " 80.000 38 760 14,810 37 740 13.960 80,000 " 82.000 39 780 15,590 38 760 14.720 82,000 " 84.000 40 800 16,390 39 780 15.500 84,000 " 86.000 41 820 17,210 40 800 16.300 86,000 " 88.000 42 840 18,050 41 820 17.120 88,000 " 90.000 43 860 18,910 42 840 17,960 90,000 " 92.000 44 880 19,790 43 860 18,820 92,000 " 94.000 45 900 20,690 44 880 19,700 94,000 " 96.000 46 920 21,610 45 900 20,600 96,000 " 98.000 47 940 22,550 46 920 21,520 98,000 " 100.000 48 960 23,510 47 940 22,460 100,000 " 1.50.000 52 26,000 49,510 48 24,000 46,460 150.000 " 200.000 56 28.000 77.510 49 24.500 70,960 200.000 " 300.000 60 60.000 137.510 50 50,000 120,960 300,000 " 500.000 63 126.000 263,510 50 100,000 220,960 500.000 " 1.000.000 64 320.000 583.510 50 250.000 470,960 1,000,000 up 65 50 *To ascertain the total tax payable, the normal tax of 8 per cent (reduced to 4 per cent on the first $4,000) must be applied to the total net income minus the credits, and the result added to the figures given in this table. RATES AND COMPUTATION OF TAX 159 The official directions for interpreting the foregoing table read as follows : Regulation The surtax for any amount of net income not shown in the above tables is computed by adding to the total sur- tax for the largest amount shown, which is less than the income, the surtax upon the excess over that amount at the rate indicated in the table. For example, if the amount of net income is $63,128, the sur- tax for calendar year 192 1 is the sum of $8,690 (the surtax upon $62,000 as shown by Table I) plus 30 per cent of $1,128, or $338.40, making a total surtax of $9,028.40 (Art. 12.) The total surtax of $9,028.40 shown in the foregoing is based on 1921 rates. At 1922 rates the surtax would be $8,347.12 (the surtax as shown by the table, $8,020, plus 29 per cent of $1,128, or $327.12, making a total surtax of $8,347.12). Surtax on sale of mineral deposits. — Law. Section 21 1 (b) In the case of a bona fide sale of mines, oil or gas wells, or any interest therein, where the principal value of the property has been demonstrated by prospecting or ex- ploration and discovery work done by the taxpayer, the portion of the tax imposed by this section attributable to such sale shall not exceed, for the calendar year 1921, 20 per centum, and for each calendar year thereafter 16 per centum, of the selling price of such property or in- terest. The new law re-enacts the provision of the 1918 law limit- ing the surtax to 20 per cent of the selling price, for 1921, in case of the sale of mineral properties, but for 1922 and subsequent years the limit is placed at 16 per cent. Regulation. Where the taxpayer by prospecting and locating claims, or by exploring and discovering undeveloped claims, has demonstrated the principal value of mines, oil or gas wells, which prior to his efforts had a relatively minor value, the portion of the surtax attributable to a sale of such property or of the taxpayer's in- terest therein shall not exceed for the calendar year 1921, 20 per cent, and for subsequent calendar years 16 per cent of the selling price. Exploration work alone without discovery is not sufficient to bring a case within this provision. Shares of stock in a corporation owning mines, oil or gas wells, do not constitute an interest in such property. To determine the application of this provision to a particu- l6o APPLICATION AND ADMINISTRATION lar case the taxpayer should first compute the surtax in the ordinary way upon his net income, including his net income from any such sale. The proportion of the surtax indicated by the ratio which the taxpayer's net income from the sale of the property, or his interest therein computed as prescribed in article 715,^° bears to his total net income is the portion of the surtax attributable to such sale, and if it exceeds for the calendar year 1921, 20 per cent and for subsequent calendar years 16 per cent of the selling price of the property or in- terest, such portion of the surtax shall be reduced to that amount. ^^ (Art. 13.) If the taxpayer has held the property for more than two years, he may, however, elect to be taxed at a maximum rate of I2j4 per cent under the capital gains provision. ^^ Ruling. Where individuals transfer property to a corporation which later demonstrates the principal value of such property as oil- producing property "by prospecting or exploration and discovery work" and then dissolves, transferring the property to the individuals, who remain stockholders without change in interests, and such stock- holders sell the property, the portion of the surtax attributable to such sale is not limited to 20 per cent of the selling price of such property or interests under the provisions of section 211 (b). (C. B. I, page 57; T. B. R. 8.) It is well to bear in mind that in computing the profit on the sale of oil wells the "discovery value" is not a factor. The "discovery" itself operates to give the seller the benefit of the 20 per cent tax. The "discovery value" is used only in com- puting the depletion allowance. Some confusion has arisen on this point in rulings handed down by the Committee on Ap- peals and Review and by the Advisory Tax Board, but the question was definitely settled in Solicitor's Opinion 26, C. B. 4, page 44. Rates applicable to corporations. — The new law imposes on corporations, for 1921, the same rate of income tax, viz., 10 per cent, as was imposed for 1919 and 1920 under the 1918 law, and the same rates of excess profits tax. For 1922 i " See Appendix A, Chapter V. " Ibid. ^' Section 206, see Chapter XVII. RATES AND COMPUTATION OF TAX i6i and subsequent years the income tax rate is 12}4 per cent. The excess profits tax is not imposed on net income which accrues after January i, 1922/^ Corporations in general. — Law. Section 230. That, .... there shall be levied, collected, and paid for each taxable year upon the net income of every corpora- ion a tax at the following rates: (a) For the calendar year 1921,^^ 10 per centum of the amount of the net income in excess of the credits provided in section 236; and (b) For each calendar year thereafter, 12^ per centum of such excess amount.^^ Although the limitation of tax on capital gains does not apply to corporations, no hardship is suffered by a corporation because the minimum tax under those provisions^" in any event must amount to 12^/^ per cent, which is the rate imposed upon corporations. Computation of the Tax The application of the rates, the arrangement upon the return blanks of the various items going to make up the tax base, the subtraction of the various credits and deductions, and the calculation of the tax payable are problems which have been greatly complicated by the extension of the privilege of reporting upon the basis of fiscal years to individuals tax- able at progressive rates." " See Appendix A. " [Former Procedure] The 1913 rate on corporate incomes was iden- tical with the normal rate on individual incomes, i per cent [section II, G (a)]. Again in the 1916 law it was made the same, 2 per cent (section 10). In 1917, however, when an additional normal tax of 2 per cent was made to apply to individuals, the additional corporation rate was made 4 per cent (section 4), the total rate applying to corporations in 191 7 being 6 per cent as compared with a total normal tax of 4 per cent on individuals. Corporations were permitted to take credit, in the case of dividends received, for only 4 per cent in place of 6 per cent, the 2 per cent difference operating as a penalty upon the corporate form. The rate for 1918 was fixed at 12 per cent, and for 1919 and 1920 at 10 per cent. For rates on transportation companies under government control, sec Income Tax Procedure, 1921, page 154. '^ See page 166. "See Chapter XVII. " See page 164. l62 APPLICATION AND ADMINISTRATION The 192 1 law specilies the procedure to be followed in certain cases which the regulations issued by the Treasury have greatly amplified. Reconcilement of returns and books of account. — In vari- ous parts of this book the author has called attention to the desirability of maintaining uniformity between the tax returns and the books of account. When tax rates were low it made little difference to the taxpayer whether or not the returns could readily be reconciled with his books. Preparation of the returns with the numerous adjustments required has been such an annoying matter and the time allowed for preparing returns has been so limited, that the matter was dismissed with a sigh of relief as soon as the returns were filed. The honest taxpayer is quite as likely to make mistakes against himself as against the government. With high rates in effect it is most important that returns be accurate, in the interest of both taxpayers and government. It is impossible to know that a return is accurate unless it is reconciled with the books of account. It must be known that every item omitted from or added to the books and every item omitted from or added to the returns is justified, and in subsequent periods it must be readily apparent why the omissions and additions occurred. In addition to a hasty examination which is made soon after filing, the Treasury's policy is to examine in a detailed and exhaustive manner every return which involves or should involve a substantial amount of tax. Taxpayers wnll avoid many hours of annoyance if a careful memorandum is kept of all differences between books and returns. A complete form for recording the reconciliation between books of ac- count and income and excess profits tax returns is given in Excess Profits Tax Procedure, 192 1. Capital net gains taxed at 12^/2 per cent. — A new provision is found in the 192 1 law,^^ under which gains from the sale " Section 206. RATES AND COMPUTATION OF TAX 163 or exchange of capital assets are taxed at I2j/^ per cent instead of at the higher rates when the tax on net income is computed at the regular normal and surtax rates. For a full discussion of capital gains, capital deductions, and for illustrations of the necessary computations, see Chapter XVII. Fiscal years ending in 1921. — Law. Section 205. (a) That if a taxpayer makes return for a fiscal year beginning in 1920 and ending in 1921, his tax under this title for the taxable year 1921 shall be the sum of: (i) the same proportion of a tax for the entire period computed under Title II of the Revenue Act of 1918 at the rates for the calendar year 1920 which the portion of such period falling within the calendar year 1920 is of the entire period, and (2) the same proportion of a tax for the entire period com- puted under this title at the rates for the calendar year 1921 which the portion of such period falling within the calendar year 1921 is of the entire period. Any amount paid before or after the passage of this Act on ac- count of the tax imposed for such fiscal year by Title II of the Revenue Act of 1918 shall be credited toward the payment of the tax imposed for such fiscal year by this Act, and if the amount so paid exceeds the amount of such tax imposed by this Act, the excess shall be credited or refunded in accordance with the provisions of section 252.^®. . . . Regulation. In computing the tax attributable to the calendar year 1920 the net income computed for the entire period under Title II of the Revenue Act of 1918 shall be credited with the amount of the excess-profits tax computed for the entire period under Title III of the Revenue Act of 1918. In computing the tax attributable to the calendar year 1921 the net income computed for the entire period under the present statute shall be credited with the amount of the excess-profits tax computed for the entire period under Title III of this statute. .... Amounts previously paid by the taxpayer on account of tlie income tax for such fiscal year shall be credited to- ward the payment of the income tax imposed for such fiscal year by the present statute. Any excess shall be credited or refunded in ac- cordance with the provisions of section 252 (Art. 1623.) The tax is computed as follows : (a) At 1920 rates, on the entire "net income as if such entire net income were earned during the calendar year 1920, and as if the 19 18 law were still in force. See Chapter IX. 164 APPLICATION AND ADAIINISTRATION (b) At 1 92 1 rates, on the entire net income as if earned during the calendar year 1921 (under the 1921 law). (c) Add as many twelfths of the tax under (a) as there are months in 1920, to as many twelfths of the tax under (b) as there are months in 192 1. Fiscal years of individuals ended in 1921. — Assume an in- dividual taxpayer with fiscal year ended September 30, 192 1. married, with three dependents, and having net income of $20,000. At 1920 rates (under the 19 18 law) his total tax on $20,000 is $1,942. At 1921 rates (under 1921 law) his total tax is $1,894. The difference of $48 is accounted for by the fact that under the 1921 law the exemption for de- pendents is $400 each instead of $200 each. The total tax is : 3/12 of $1,942 $485-50 9/12 of 1,894 1,420.50 Total $1,906.00 • Fiscal years of partnerships and personal service corpora- tions. — Partners are taxable on their distributive shares of net income of the partnership for the taxable year of the partner- ship ending in the period for which the individual partner reports. Personal service corporations are taxed as ordinary corporations after December 31, 192 1. In both of these cases special problems arise which are treated in Chapter XXIV, "Income from Partnerships and Personal Service Corpora- tions." Fiscal years of corporations ended in 1921. — The income tax rates upon corporations for 1920 and 192 1 are the same, viz., 10 per cent. The net income on which the -tax is based may differ as computed for 1920 (under the 19 18 law) and for 1 92 1 (under the 1921 law) in such items as bad debts, interest paid to carry Liberty bonds, etc. All corporations which have a fiscal year ended in 1921 should prepare new returns under the 192 1 law, even though the tax rate is unchanged. RATES AND COMPUTATION OF TAX 165 Fiscal years ending in 1922. — Law. Section 205 (b) If a taxpayer makes return for a fiscal year beginning in 1921 and ending in 1922, his tax under this title for the taxable year 1922 shall be the sum of: (i) the same proportion of a tax for the entire period computed under this title (as in force on December 31, 1921) at the rates for the calendar year 1921 which the portion of such period falling within the calendar year 1921 is of the entire period, and (2) th^ same proportion of a tax for the entire period computed under this title (as in force on January i, 1922) at the rates for the calendar year 1922 which the portion of such period falling within the calendar year 1922 is of the entire period: Provided, That in the case of a personal service corporation the amount to be paid shall be only that specified in clause (2).-'^. . . . The principle of prorating the tax as indicated above in the case of 1920-192 1 fiscal years, is also applied to 192 1- 1922 fiscal years. The important change in the case of indi- viduals is the decrease in the surtax rates in 1922. The repeal of the excess profits tax in the case of corporations, as of December 31, 192 1, gives rise to a special problem in the fiscal years 192 1- 1922. Fiscat years of corporations ending in 1922. — In the case of fiscal years ending in 1922, there is, of course, no excess profits tax applicable to income earned in 1922. The law [section 236 (c-2)] provides that the excess profits tax applicable to 192 1 [computed under section 335 (b)] shall be credited against the net income computed for the zvJioIe period, in com- puting the income tax under section 205 (b). If section 236 of the law is interpreted hterally, the excess profits tax computed under section 335 (])) would be prorated l)efore being appHed as a credit against net income for the pur- pose of determining the amount subject to income tax. The following regulation permits the full excess profits tax to ]>e credited when computing income tax under 192 1 law. Regulation. In computing the tax for a fiscal year beginning in 1921 and ending in 1922 the procedure is as follows: (o) The tax attributable to the calendar year 1921 is found by computing the in- come of the taxpayer and the lax thereon in accordance with the ^"Sce Chapter XXIV. l66 APrUCATION AND ADMINISTRATION statute as in force on December 31, 1921, as if the fiscal year was the calendar year 1921 and determining the proportion of such tax which the portion of such period within the calendar year 1921 is of the entire period; before calculating the tax the net income computed for the entire period shall be credited with the excess-profits tax computed for the entire period under Title III of this statute as if the fiscal year was the calendar year 1921 ; (&) the tax attributable to the calendar year 1922 is found by computing the income of the tax- payer and the tax thereon in accordance with the statute as in force on January i, 1922, as if the fiscal year was the calendar year 1922, and determining the proportion of such tax which the portion of such fiscal year falling within the calendar year 1922 is of the entire period ; and (c) the tax for the fiscal year is found by adding the tax at- tributable to the calendar year 1921 to the tax attributable to the calendar year 1922 (Art. 1624.) The following illustration shows how the income tax is computed under the foregoing regulation : COMPUTATION OF INCOME TAX— FISCAL YEAR ENDING MAY 31, 1922 Net income for full year (before taxes) $240,000 Excess profits tax for full year 36,000 $20^.000 Income tax at 10% $20,400 Excess profits tax as above 36,000 Total tax $56,400 Tax for 7 months in ig_'i (7/12 of $56,400) $32,900 Net income $240,000 Income tax at I2|^% $ 30,000 Tax for 5 months in 1922 (5/12 of $30,000) 12,500 Total tax payable $45,400 Consisting of excess profits tax (7/12 of $36,000) $ 21,000 Income tax (7/12 of $20,400 plus 5/12 of $30,000) 24,400 $45,400 The computation set forth above, authorized by the regu- lations, prevents prorating twice the excess profits credit."^ "'For illustration of the imposition of excessive income tax due to method of prorating excess profits tax, for fiscal years ended in 1917, sec Income Tax Procedure, 1919, pages 125-128; for fiscal years ended in 1919, see Income Tax Procedure, 1920, pages 145-149. RATES AND COMPUTATION OF TAX 167 Return for period of less than one year — placing income on annual basis. — A new provision has been inserted in the 1 92 1 law whereby in the case of returns for less than one year the tax is to be computed after the income has been placed on an annual basis: Law. Section 226 (c) In the case of a return for a period of less than one year the net income shall be placed on an annual basis by multiplying the amount thereof by twelve and dividing by the number of months included in such period; and the tax shall be such part of a tax computed on such annual basis as the number of months in such period is of tvs^elve months. This change has a material effect on the tax payable ])y individuals who are subject to the graduated surtaxes^^ but should have no effect on the tax payable by a corporation. Corporations. — Whether the tax is computed on the basis of the actual income for the period, the various credits being proportionately reduced (the practice under the 19 18 law), or whether the income is placed on an annual Ijasis and the tax computed, full credits being allowed, and the resulting tax be- ing prorated, should make no dift'erence. This is shown by the following examples : Method A — Not Reducing Exemptions and Credits Net income (6 months) $ 12,000 12 Net income placed on an annual basis ( — X $12,000) [Section 6 226 (c) ] 24,000 Invested capital 150,000 Excess profits credit : 8% of invested capital (.$150,000) $12,000 Specific 3,000 Total 15,000 Net income (all in 20% bracket) 24,000 Less: Excess profits credit iS,ooo Subject to e.\cess profits tax 9,000 at 20% Excess profits tax 1,800 "' Sec page 169. l68 APPLICATION AND ADMINISTRATION Net income $24,000 Less: Excess profits tax $1,800 Specific 2,000 3,800 Subject to income tax 20,200 at 10% Income tax $ 2,020 Total 3.820 Tax for 6 months (^ of $3,820) 1,910 Method B — Reducing Exemptions and Credits Net income (6 months) 12,000 Invested capital 150,000 Excess profits credit : 8% of invested capital ($150,000) $12,000 Specific 3,000 Total 15,000 Yj of $15,000 7,500 Net income (all in 20% bracket) 12,000 Less: Excess profits credit 7.500 Subject to excess profits tax 4.500 at 20% Excess profits tax $ 900 Net income 12,000 Less: Excess profits tax $ 900 Specific (^ of $2,000) i.ooo 1,900 Subject to income tax «pio,ioo at 10% Income tax 1,010 Total tax i.Qio However, article 626 provides : This prorated credit shall be applied to the net income before such net income is placed on an annual basis, as provided in Section 22t (c). This regulation should be interpreted to apply only to the computation of normal tax, otherwise an application of the prorated $2,000 credit to the income before computing the excess profits tax would result in a reduction of the latter tax in a way obviously not intended by the law. RATES AND COMPUTATION OF TAX 169 Section 236 provides "That for the purpose only of the tax imposed by section 230" (the lo per cent corporation in- come tax), there shall be allowed as credits: A specific credit of $2,000 [subdivision (b)]. "The amount of any war-profits end excess-profits taxes imposed .... for the same taxable year" [sub- division (c)]. The amount of excess profits tax payable in the foregoing illus- tration is $ goo The prorated credit mentioned in article 626 above 0/2 of $2,000) is 1,000 Total $1,900 Deducting $1,900 from the net income, $12,000, leaves subject to income tax $10,100 12 Placing this amount on an annual basis ( — X $10,100) ^= $20,200 6 = Income tax 10% of $20,200 $ 2,020 Income tax for 6 months (^ of $2,020) $ 1,010 Add excess profits tax for 6 months 900 Total tax for 6 months period $ 1,910 This method of computation seems rather superfluous but it is apparently the only way in which the Treasury could recon- cile sections 226 (c) and 239 (b) of the law — the latter section being retained in the 192 1 law obviously by an over- sight. Individuals. — When an individual return is made for a period less than one year and the income is placed on an annual basis, the personal exemption and the credit for dependents are not reduced. An individual reporting for, say, six months ended December 31, 1921, with net income for that period of $20,000, would compute his tax as follows :"^ '^ [Former Procedure] Section 226 of the 1918 law provided for re- duction of the personal exemption and credit for dependents. 1918 Law. Section 226. " . . . . the credits provided in subdivisions (c) and (d) of section 216, shall be reduced respectively to amounts which bear the same ratio to the full credits provided in such subdivisions as the number of months in such period bears to twelve months." 170 APPLICATION AND ADMINISTRATION Income Taj Net income for six months $20,000 Placed on annual basis (20,000 x 12/6) $40,000 Less: Exemption (married, 3 children) 3,200 $36,800 Taxable at 4 per cent 4,000 $ 160 Taxable at 8 per cent $32,800 2,624 Surtax on $40,000 (1921 rates) 3,410 Total $6,194 Tax payable, 6/12 of $6,194 $3-097 Ruling. Where, under the Revenue Act of 1918, a taxpayer has been permitted to change his accounting period from a calendar to fiscal year basis and renders a return for the period from January i to the end of such fiscal year both the normal tax and the surtax shall be computed as though the return were filed for a full twelve- month period, after the reduction of the exemptions and credits pro- vided in section 216 (c) and (d) of the Act. (C. B. 3, page 230; O. D. 723.) Under the method prescribed Iw the 19 18 law the tax, using the illustration above, would be computed as follows : Income Tax Net income for six months $20,000 Less: Personal exemption (reduced one-half) 1,600 $18,400 Taxable at 4 per cent 4,000 $ 160 Taxable at 8 per cent $14400 1,152 Surtax on $20,000 710 Total tax $2,022 The effect of the new method of computation is to subject the income for part of a year to the higher surtax rates which would be applied if reporting for a full year and net income were received at the same rate, using the above illustration, for twelve months as for six months. Merely because an indi- vidtial receives a certain income in a six months' period, or any other period less than a year, is no reason for assuming RATES AND COMPUTATION OF TAX 171 that he will receive a proportionate part throughout the entire twelve months. He may never receive another dollar. He may lose all he gained, say, in the first six months and" more. To subject his income received for part of a year to the higher surtax rates applicable to a theoretical income which may never materialize, is inequitable. The larger the income for the period less than a year, the greater the relative difference in tax as compared with the old method, because of the increasing rates in the higher surtax brackets. The following illustration, given in Regulations 62, article 431, is here compared on the basis of the 1921 and 1918 laws: For the calendar year 1921 the income tax of a married person entitled to a personal exemption of $2,000, making a return for a six months' period of $10,000 net income, is $995, computed as follows: Net income , $ 10,000 Multiplied by 12 120,000 Divided by 6 20,000 Subtracting exemption of $2,000 18,000 Normal tax on $18.000 1,280 Surtax on $20,000 710 Total 1,990 Divided by 2 995 Computation Under 1918 Law Net income $10,000 Less: Exemption 1,000 $ 9,000 Normal tax on $9,000 $ 560 Surtax on $10,000 no Total $ 670 Increased tax $ 325 Reduction of personal exemption of individuals. — When the aggregate net income of husband and wife is in excess of $5,000, the personal exemption is reduced to $2,000. But the law provides : T.AW. Section 216 (c) In no case shall the reduction of the personal exemption from $2,500 to $2,000 operate to increase the 172 APPLICATION AND ADMINISTRATION tax, which would be payable if the exemption were $2,500, by more than the amount of the net income in excess of $5,000; .... An 'illustration of the two computations necessary to de- termine the tax payable under the above limitation is given in Chapter XII. The point is that when the net income is slightly in excess of $5,000 (up to $5,020), the taxpayer does not have to pay more tax, because of the reduction in the exemp- tion, than the amount of net income in excess of $5,000. When the specific credit of $2,000 is not allowed a cor- poration. — If the net income of a corporation is $25,000 or less, a specific credit of $2,000 is allowed. But Law. Section 2}^^. .... (b) .... if the net income is more than $25,000 the tax imposed by section 230 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000; and .... The necessary computation is shown in Chapter XII. Fractional part of a cent not to be disregarded in computa- tion of tax. — Regulation. In the payment of taxes a fractional part of a cent shall be disregarded unless it amounts to one-half cent or more, in which case it shall be increased to one cent. Fractional parts of a cent should not be disregarded in the computation of taxes. (Reg. 45, Art. 1721.) CHAPTER VIII ADMINISTRATION, ASSESSMENT AND PAYMENT Administration in General The administration of the Revenue Act is placed in the hands of the Commissioner of Internal Revenue, referred to hereafter as the "Commissioner," subject to the general supervision and control of the Secretary of the Treasury. Bureau of Internal Revenue, — The Bureau of Internal Revenue, referred to in this book as the "Bureau," as its name implies, is charged with the collection of all federal revenue from inland sources. There are five deputy commissioners^ and one assistant to the Commissioner, who is authorized to act in the Commissioner's place. Income and excess profits taxes are collected through the local collectors of internal rev- enue, who are also charged with the collection of all other internal revenue taxes. The collectors of internal revenue are the officers who come into the most direct touch with the taxpayers and they are held primarily responsible for the proper collection of the tax in their districts. At present there are some sixty-four collection districts, each with a collector at its head assisted by a staff of subordinates. In addition there are thirty-five internal revenue divisions with internal revenue agents or supervising internal revenue agents m charge. Law. Section T311. [Section 3172^ Rev. Stat.] Every collector shall, from time to time, cause his deputies to proceed through every 'The deputies are in cliarge of the following: 1. Income Tax Unit 2. Estate Tax Division 3. Sales Tax Unit 4. Accounts Divisions 5. Miscellaneous (publications, administration, etc.) 174 APPLICATION AND ADMINISTRATION part of his district and inquire after and concerning all persons therein who are liable to pay any internal-revenue tax, and all persons owning or having the care and management of any objects liable to pay any tax, and to make a list of such persons and enumerate said objects. Law. Section 131 1. [Section 3165, Rev. Stat.] Every collector, deputy collector, internal-revenue agent, and internal-revenue officer as- signed to duty under an internal-revenue agent, is authorized to admin- inster oaths and to take evidence touching any part of the administra- tion of the internal-revenue laws with which he is charged, or where such oaths and evidence are authorized by law or regulation authorized by law to be taken. They may summon any person residing or found within the state or territory in which their districts He, and even in other districts, and make examinations authorized by the law. If a return is not filed, the collectors are required to make returns from their own knowledge and from such in- formation as they can obtain through testimony or otherwise. Procedure of the Bureau of Internal Revenue. — The steps in procedure of the Bureau of Internal Revenue have been described as follows :^ 1. The taxpayer makes a return and pays to the collector who receives the return, one-fourth or all the tax shown due on the face of the return. 2. The collector lists the returns, shows the taxes due, makes a few obvious corrections in some cases and forwards the returns to Washington. 3. In Washington the returns are first checked against the collector's lists and the original tax is verified. 4. The "audit" of the returns begins and additional amounts of taxes due are determined; the taxpayer is infor- mally notified and the return is sent to a separate section of the Bureau for entry on a supplemental list. 5. Supplemental lists are transmitted monthly to the col- lectors; the taxpayer is formally notified and the tax is due for payment within 10 days after such notice. 'A. E. James, Bulletin of Njutioiial Tax Association, November, 1920. ADMINISTRATION, ASSESSMENT AND PAYMENT 175 Committee on Appeals and Review. — Under the 19 18 law^ the Commissioner was empowered to appoint an Advisory Tax Board.* The Board was appointed March 14, 1919, and abolished October i, 19 19. It is said that history cannot be written at or near the time events transpire. It is too soon to w^ite the history of the Advisory Board of 1919, but the author is willing to pre- dict now that when the history is vv'ritten it will be found that the Board performed a hard and thankless task in an energetic and equitable manner, that it decided almost in- soluble problems and retained the respect and earned the gratitude of taxpayers even though it did not always give them what they wanted. If we are ever able to evolve an organization which will enlist the active assistance of a considerable number of the best business and professional men of the country it probably will be necessary to make an arrangement whereby they will give their services for only a small part of each year. The sacrifice involved in accepting a full-time appointment is too great. The British Board of Referees decides many different problems for the British Treasury without calling upon its members for more than two weeks of service per year. In the place of the Board, a Committee on Appeals and Review was established, the membership of which has been re- cruited from within the Bureau. Organization. — The Committee"' is entirely independent ^Section 1301 (d-i). *For a full discussion of its powers and procedure see Income Tax Procedure, 1920, pages 159-161. "At the present time, the Connnittce is composed of the following: N. T. Johnson, Chairman G. R. Davis, Vice-Chairman Leslie Gillis C. P. Hoffman W. H. Lawder C. P. AIcGinley R. J. Service M. E. Stickley F. G. Smith, Secretary There are still two vacancies to be filled. 176 APPLICATION AND ADMINISTRATION of the Income Tax Unit and is responsible only to the Com- missioner. Its personnel embraces a chairman, vice-chair- man, eight members, and a secretary, who give their entire time and attention to all matters referred to the Committee for consideration. All of the members have held responsible positions in the Bureau as heads of divisions or chiefs of sec- tions and are either attorneys at law or accountants. Procedure. — The principal duties of the Committee are as follows : 1. Hearing and consideration of cases which have been appealed by taxpayers from the action of the Income Tax Unit. 2. Consideration of questions su1)mitted 1)y the Income Tax Unit upon which the advice of the Committee is asked. 3. Criticism or approval of letters making new rulings or new applications of old rulings which are submitted by the Income Tax Unit or the office of the Commis- sioner. 4. Criticism or approval of proposed Treasury decisions. 5. Consideration of matters presented in informal con- ferences by officers of the Bureau and by taxpayers upon questions of interpretation, policy, or procedure. Cases may be appealed to the Committee only after final disposition has been made of the case by the Income Tax Unit, and upon such questions, either as to the law or the facts, as are in controversy between the taxpayer and the Income Tax Unit." The taxpayer accordingly has no cause to appeal until a decision has been rendered by the Income Tax Unit which, in the opinion of the taxpayer, is not in accordance with the law and the facts. " Prior to the 1921 law, it was contrary to the policy of the Bureau to defer assessments pending the taking up of an appeal. This was an unjust rule which is now, in most cases, abolished by section 250 (d) of the 1921 law. See page 202. ADMINISTRATION, ASSESSMENT AND PAYMENT 177 The following ruling indicates the procedure which should be followed when making an appeal to the Committee : Ruling. The appeal must be filed in the office of the Commis- sioner in Washington within thirty-one days from the mailing of the notice,' but if it is mailed in time to be received by the Commissioner within such period in the ordinary course of the mails it will be considered as having been filed within such period. No particular form of appeal is required, but said appeal must set forth specifically the exceptions upon which said appeal is taken. The appeal shall be under oath and must contain a statement that it is not taken for the purpose of delay. Opportunity for a hearing shall be granted if requested within a reasonable time. The taxpayer in his appeal may rely upon the data previously submitted or he may obtain a reasonable extension of time if cause therefor is shown in which to file additional data, evidence or argument. Such request shall be under oath and must state specifically the reasons for additional time. (T. D. 3269, dated January 5, 1922.) The following ruling outlines the procedure in hearings before the Committee: Ruling. When an appeal is taken from a ruling of the Income Tax Unit to the Committee on Appeals and Review or a question is certified to that Committee at the request of the taxpayer and an oral presentation is desired, the record shall immediately be examined to ascertain as to whether there is a question of law involved. If it is found that a question of law is involved, the Solicitor shall be notified and he will thereupon designate one member of the Solicitor's office to sit with the Committee and himself for the purpose of hear- ing the appeal, or if the Solicitor finds it inconvenient to sit with the Committee he may designate two members of his office to do so.^ At the hearing before the Committee the taxpayer or his attorney or representative will be expected to make his full oral argument on the law as well as the facts, and this presentation shall be the only oral presentation except in unusual circumstances, or unless a further argument of the facts or the law is deemed desirable by either the Chairman of the Committee or the Solicitor. The attorney or attorneys so designated by the Solicitor for the hearing will be expected, in conjunction with the Solicitor and the Conference Committee in the Solicitor's office, if the Solicitor so de- sires, to consider the legal aspects of the case, and the Solicitor's recommendation in the form of an opinion or memorandum will then Notice to the taxpayer of the decision of the Income Tax Unit from which the taxpayer wished to appeal to the Committee. " As a general rule, tlie auditor who has handled the case attends the conferences of the Committee. 178 APPLICATION AND ADMINISTRATION be made to the Chairman of the Committee, and thereupon the Com- mittee's findings shall be prepared and submitted to the Commis- sioner for his approval (C. B. 4, page 370; O. D. 709.) Three copies of a sworn statement of fact or brief are re- quired. Upon receipt o'f written request appealing from the action of the Income Tax Unit, together with sworn statement of facts or brief, the Income Tax Unit is requested by the Com- mittee to submit the case and related papers to it and, upon receipt of case, the appeal is docketed for assignment to a member for consideration. Upon assignment of case the papers are carefully examined and in the event that additional information is desired or an oral hearing has been requested or is deemed advisable, the taxpayer is notified. In the event of an oral hearing, which is expected to be final, the taxpayer is expected to submit such arguments and presentation both as to the law and the facts as he desires to have considered by the Bureau. Tlie oral hearing may be supplemented by a written brief to be submitted after the hearing. Three copies of this brief should be furnished. The conclusions of the individual members of the Com- mittee, after being formulated and reduced to writing, are sub- mitted to a conference of the entire Committee and, when agreed to, are submitted to the Commissioner in the form of recommendations. Upon the approval of the recommendation of the Com- mittee by the Commissioner of Internal Revenue, the decision is final as far as the Bureau is concerned, and the decision will not be reconsidered except upon the presentation of new and material evidence, accompanied by an explanation satis- factory to the Committee of the failure to produce such evi- dence prior to the closing of the case. The taxpayer is notified by the Committee of its recom- mendation and the case and related papers are thereupon re- turned to the Income Tax Unit for such further action as ADMINISTRATION, ASSESSMENT AND PAYMENT 179 may be necessary in accordance with the decision of the Com- mittee of which action the taxpayer is duly notified by the Income Tax Unit. Tax Simplification Board. — The new law creates what is known as the Tax Simplification Board.^ Law. Section 1327. (a) That there is hereby established in the Department of the Treasury a board to be known as the "Tax Simplifi- cation Board" (hereinafter in this section called the "Board"), to be composed as follows: (i) Three members who shall represent the public, to be appointed by the President; and (2) Three members who shall represent the Bureau of Internal Revenue and shall be officers or employees of the United States serving in such Bureau, to be appointed by the Secretary. (b) Any vacancy in the Board shall be filled in the same manner as the original appointment. The members representing the public shall serve without compensation except reimbursement for traveling, subsistence, and other necessary expenses incurred in the performance of the duties vested in them by this section. The members represent- ing the Bureau of Internal Revenue shall serve without compensation in addition to that received for their service in such Bureau. (c) The Secretary shall furnish the Board with such clerical as- sistance, quarters and stationery, furniture, office equipment, and other supplies as may be necessary for the performance of the duties vested in them by this section. (d) It shall be the duty of the Board to investigate the procedure of and the forms used by the Bureau in the administration of the internal revenue laws, and to make recommendations in respect to the simplification thereof. The Board shall make a report to the Con- gress on or before the first Monday of December in each year. (e) The expenditures of the Board shall be paid upon vouchers approved by the Board and signed by the chairman thereof. For the 'The membership of the Board is as follows: Appointed by the President to represent the public: Mr. James H. Beal, of Reed, Smith, Shaw & Beal, Pittsburgh, Pa., Mr. Joseph E. Sterrett, of Price, Waterhouse & Co., New York, and Mr. William T. Abbott, Vice-President, Central Trust Company of Chicago, Illinois. Appointed by the Secretary of the Treasury to represent the Bureau of Internal Revenue : Mr. Charles P. Smith, Assistant Commissioner of Internal Revenue, Mr. Jesse D. Burks, Special Assistant to Deputy Commissioner of Internal Revenue, and Mr. George W. Skilton, Assistant to Supervisor of Collectors' Offices. l8o APPLICATION AND ADMINISTRATION expenditures of the Board for the fiscal year ending June 30, 1922, there is authorized to be appropriated, out of any money in the Treasury not otherwise appropriated, the sum of $10,000. (f) The Board shall cease to exist on December 31, 1924. This Board is in a position to render a distinct service to the pubHc, especially with reference to the simplification of the procedure before the Bureau. Regulations governing practice before the Treasury. — • The Commissioner has issued regulations (Circular No. 230, Form 23) governing the recognition of attorneys and agents and other persons representing taxpayers before the Treasury. The following extracts from Circular 230 are of interest : Applicants for enrollment pursuant to these regulations shall submit to the Secretary of the Treasury an application, prop- erly executed, on the form attached hereto (Exhibit A). Appli- cations in any other form will not be considered. Persons members of the bar of a court of record will apply for enrollment as "attor- ney"; all others will apply for enrollment as "agent." Members of a firm may apply for enrollment either individually or collectively. In the latter case application should be made in the firm name, giving the name of each member and the required information as to each, and the application should be signed in the firm name and by each member of the firm The Secretary of the Treasury may in any case require other and further evidence of qualification. Applicants will be notified of the approval or rejection of their application. The committee on enrollment and disbarment shall maintain in the office of the chief clerk, Treasury Department, a roll of attorneys and agents entitled to practice before the Treasury Department. It shall likewise maintain lists of those whose applications for enrollment have been rejected and those who have been suspended or disbarred. The chief clerk shall furnish copies of the said roll and lists, with such additions thereto or subtractions therefrom as may be made from time to time, to the bureaus, ofiices, and divisions of the Treasury De- partment. All bureaus, offices, and divisions of the Treasury Department are hereby prohibited from recognizing or dealing with anyone appearing as attorney or agent unless the name of such attorney or agent ap- pears upon the list of those entitled to 'practice before the Treasury Department. Nothing herein contained shall preclude individual parties or members of firms or officers of corporations from appearing, upon proper identification, as representatives of their own interests or of their respective firms or corporations in any matter before tiie ADMINISTRATION, ASSESSMENT AND PAYMENT i8l department in which such person, firm, or corporation is concerned as a principal ; but attorneys, counsel, or solicitors or other agents for such persons, firms, or corporations must be enrolled. It shall be the duty of the bureaus, offices and divisions of the Treasury Department to ascertain in each case whether the name of one appearing before them in a representative capacity appears on the roll of those entitled to practice. In any case where such enroll- ment does not appear, the requirement therefor shall be brought to the attention of such representative. The head of such bureau, office, or division may, in his discretion, temporarily recognize such represen- tative pending application for enrollment, provided his name does not appear on the list of those whose applications for enrollment have been rejected or on the list of those who have been suspended or disbarred. On July 25, 1921, the Coniniissioner issued the following statement with reference to these regulations : There is in operation now a new system of enrollment. Ap- plicants are enrolled and certified by a committee, which con- stantly is functioning for that purpose. They must submit a sworn statement that they are familiar with the laws and regulations of the Treasury Department, and are qualified to act as the represen- tative of others and "render them valuable service." Reply must be given to the question of whether or not they have ever been rejected, suspended or disbarred from appearing as an attorney or agent, or in any other representative capacity, before any branch of the Federal or any State Government, or municipality or court thereof. Scores of applications are now being held for investigation, which is conducted by field agents of the Bureau of Internal Revenue. Applicants are required also to state whether they have read and noted paragraph 5 of Treasury Department Circular 230 relating to the recognition of attorneys, agents and other persons representing claim- ants before the Treasury Department, and especially the following significant paragraph: "The Secretary of the Treasury regards as unethical any sug- gestion of acquaintance with officials or prior connection with tlie Treasury Department." Supplemental regulations provide that "no attorney or agent shall be permitted to appear in a representative capacity as attorney, or agent before the Treasury Department, or any of the bureaus, depart- ments, divisions, subdivisions, units or other agencies thereof, in re- gard to any claim, application or re-audit, refund, al)atement, rcduc-* tion in tax assessed, or in any other matter to which he gave actual personal consideration, or as to the facts of which he had actual per- sonal knowledge while in the service of the Treasury Department." l82 APPLICATION AND ADMINISTRATION On and after August i, 1921, power of attorney from the princi- pal in each case will be required of all attorneys, agents or other person representing claimants before the Bureau of Internal Revenue. Such power of attorney must be filed before such agent, attorney or other person is recognized by the Bureau. These regulations are intended to raise the standard of the practice before the Treasury. Measures of this kind should be encouraged. Unnecessary examinations. — The following is a new fea- ture of the 192 1 law: Law. Section 1309. That no taxpayer shall be subjected to un- necessary examinations or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Commissioner, after investigation, notifies the taxpayer in writing that an additional in- spection is necessary. ^Vhether or not taxpayers secure relief under the fore- going section depends entirely on the action of the Commis- sioner. In his sole discretion as many examinations may be made hereafter as have been made in the past. Retroactive regulations. — The following section per- mits the Commissioner to apply new regulations without retro- active effect. The Commissioners have assumed that changes in regulations automatically became retroactive to the effective dates of the laws to wdiich the regulations were applicable. Law. Section 13 14. That in case a regulation or Treasury de- cision relating to the internal-revenue laws made by the Commissioner or the Secretary, or by the Commissioner with the approval of the Secretary, is reversed by a subsequent regulation or Treasury decision, and such reversal is not immediately occasioned or required by a de- cision of a court of competent jurisdiction, such subsequent regulation or Treasury decision may, in the discretion of the Commissioner, with the approval of the Secretary, be applied without retroactive effect. If the Treasury should issue regulations interpreting a section of the law* and later should change the interpretation ADMINISTRATION, ASSESSMENT AND PAYMENT 183 by subsequent regulations, the author is of the opinion that, notwithstanding the foregoing section, a taxpayer overpaying a tax under the first interpretation can force a retroactive apphcation of the latest regulation. If the Commissioner objects, it would be necessary to institute suit. It should be noted that the language of the foregoing section is not manda- tory — "subsequent regulations may, in the discretion of the Commissioner, with the approval of the Secretary, be applied without retroactive effect." Organization of Bureau. — Those who have dealings with the Bureau will be interested in the organization of the Income Tax Unit, as set forth in the chart reproduced on page 184. Changes are being made from time to time, but the chart is recent enough to be of interest. ^° The Committee on Appeals and Review is entirely inde- pendent of the Income Tax Unit and is responsible only to the Commissioner. Criticism of overcentralization. — Criticism may be urged against the general organization of the Bureau of Internal Revenue on the ground of overcentralization. At present only the most routine matters can be handled in the offices of the local collectors, all others being carried to Washington for consideration. Uniformity of procedure is, of course, im- portant, but to secure it the present organization sacrifices the convenience of the taxpayer to an unjustifiable extent. More- over, with the increased volume of the work of the Bureau, due to the wider application of the law since 1917, it is important that decentralization in administration be introduced if intol- erable congestion and delay are to be avoided. At the present time every appeal must be carried to Wash- ington, even though a taxpayer lives on the Pacific Coast. Some method should be devised whereby local hearings could 'The chart here was approved Oct. 22, 1921. -o '-0. 1 1 <| f. J 5 p: 1 gtf ■3 ^ ^3 - "5 n S S £.1?' IJP III i^l" m l^ll P7 5 ^ o 2 -2 " i ^ < H i ^ o 7. 11 " :fl S H III! |;2 Is < 5 s '-s "Is a ^ 1 i 1 " 1 £ 1 g 1 1 Ilk 1 s 2 'i ^ 1 1 «)m»!.vi 1 P13g3u[jds aa^nonnit 1 < silHSS sillASiuo-l fl.-)3l3UCJJ UBS 1-wa Ji»iri oiuoiav nog 9i|oiiBoii!lJal dUB-i ling uo^saiiunn insj-W n[nluaoi( si.n»Tls 311.Ai.3i.40 5 ^^ .- purimtiJia ojoqsusaJO 5 1 ^ pQEl^OJ l.oji^a ■3 tjijiirini!,! jJAuaa 3 5 < 3- ? " < BinaiJi.cirqd rnniSASlJ ctioinn Tlnaui.iui.i ^ !1J0\ "'"J ,.3conio suosiio »3.VJ o|cunii aJACII -»3>J a.iisua ■J a, ■I " 1 ^ !0 (J 1 ^ itJi:«8\' sjominBa •"in^Hsn.'C Bionuv 1^1 < lis 1 1 t 1 ^ n 1 J a lis S H < ■n iz 1 Q -i < ^ 2 11 3 PI .1 a - < 3 < 1 ^ ffil 1"^ 1 1 to .2 M 11 g aits - t ^ &« " i— _— __ ___ —J 184 ADMINISTRATION, ASSESSMENT AND PAYMENT 185 be arranged." This is of especial importance in the case of individual returns. Of course no effort should be made to en- courage unfounded claims, but on the other hand nothing should be left undone to give an impartial and patient hearing to all just claims, and the way of the claimant should be made easy rather than hard. The degree of decentralization which can be adopted de- pends upon the quality and number of the administrators ob- tainable for the local work. Large discretion in dealing with important assessments cannot be entrusted to poorly trained or ignorant assessors. At the present time the rewards offered are not sufficient to attract and retain in the service men of the quality needed. Some method of making the career of the government officer attractive must be devised before the in- come tax administration can be put upon an entirely satisfac- tory basis. The following opinion is an argument against decentraliza- tion : I personally believe the entire review and appeal should be centered at Washington. Large taxpayers, except for those who might desire improperly to influence local collectors, should prefer this method since, in the event of an unfavorable decision before the local officials, an appeal would unquestionably be taken to Washing- ton. In view of the intricacy of income tax questions, local, non- expert boards are unsuited for the work. Even in Wisconsin the local boards of review have no jurisdiction over corpora- tions. ^- Criticism of the organization and procedure of the Income Tax Unit. — \'ery little, if any, fault, can be found with the general organization of the Income Tax Unit. The various divisions, subdivisions and sections have been organized along natural lines. The Bureau should be commended for this ex- cellent piece of work. "Such opportunity was given by the act of 1894, which in this matter took particular pains to make the remedy as inexpensive to the taxpayer as possible (Vol. 25, Congressional Record, 6828-6830). '" A. E. James, Bulletin of the National Tax dissociation, November, 1920. l86 APPLICATION AND ADMINISTRATION The author knows of no changes which should be made in this general plan, but it may be necessary to make a few changes to bring about a simplification of the procedure. The Income Tax Unit, like most of the government depart- ments, is bound hard and fast by "red tape." The chief fault of the Unit is that there are too many so-called checks and re- views. When one of the checkers or reviewers makes a de- cision he in turn is checked or reviewed — there are so many checks and they are so numerous and involved that the author is not able to state the number. These numerous checks not only add to the cost of collection, but they cause confusion, dis- please taxpayers, and destroy the initiative of the employees. Not long ago, it is understood, one of the heads of the sections remarked that he was more interested in having proper checks to prevent fraud than he was in production. There can be no question about the vital necessity of enough supervision to detect fraud on the part of taxpayers and col- lusion of one kind or another. It would be highly desirable for the Bureau to lessen the leaks regarding proposed assess- ments and other information which so frequently appear to be in the possession of so-called tax experts. The connections of each ex-employee who practices before the Department require careful inspection. The Bureau, no doubt, has thousands of claims which have been pending for over a year on which no definite action has been taken — the Unit is still auditing 191 7 returns. The author makes the following suggestion which he be- lieves will simplify the procedure, speed up the Unit and re- duce the cost of collection. Up to the time when the A-2 letter is issued, wdiich is based either upon an office audit or field examination, no change should be made in the procedure. Precaution should, how^ever, be taken to see that the conferees do not actively participate in the preparation of the A-2 letter, i.e., they should not make decisions on a point in a case which should disqualify them when the taxpayer presents his case. ADMINISTRATION, ASSESSMENT AND PAYMENT 187 After an A-2 letter has been issued, if the taxpayer makes a protest against the proposed additional assessment, the case should be referred to the conferees. All formal conferences should be attended by three repre- sentatives of the Bureau : a lawyer, from the Solicitor's office, an accountant, who should be attached to that particular sub- division or section, and an auditor. The lawyer should pass upon the legal points of the case. The accountant should handle all the accounting problems and dispose of them. These two men should co-operate, and many points will have to be passed upon by both. The auditor, in charge of the audit of the case, merely attends the conference so that he may be in a better position to carry out the decisions of the two con- ferees. The regulation requiring the filing of a brief (in duplicate and supported by an affidavit of the taxpayer) at least five days before the date for the conference is a good rule and should not be changed. When a taxpayer does not request a formal conference, a brief in duplicate and in affidavit form should be filed before the case is considered by the conferees. Where there are no formal conferences, the three representa- tives should meet and consider the case as though a formal conference were held. After a case has been heard and tlie conferees are convinced that all the facts have been developed, a decision should be announced on all the points involved. This decision should not, however, be announced in conference. A letter should be sent the taxpayer notifying him of the results. This letter would furnish the Bureau auditor with instructions on which to close the case finally. The procedure of these conferees should correspond with the procedure of a lower court. The chiefs of the sections should have no control whatever over their decisions. The chief should, however, control the assignment of cases for de- cision. It might be well for each subdivision or section to have a committee of conferees to which cases ready for atten- i88 APPLICATION AND ADMINISTRATION lion should be assigned. A head ccniferee should take care of the assignments. It might even be well to make the conferees an independent organization. Either the government or the taxpayer could appeal from the decision of the conferees. This appeal should be made to the Committee on Appeals and Review. The appeal on the part of the government would be made by the Chief of the subdivision or section if he were not satis- fied with the ruling. He should, of course, in every case re- view the decision of the conferees. He should also consult freely with the auditor. After the decision has been announced no appeal should be permitted by either party unless notice thereof is given within say thirty days after the decision was announced. Claims should be handled in the same manner. The author is of the opinion that all special subdivisions, sections, and re- view boards handling claims should be abolished.- Claims should be assigned to those general subdivisions or sections to wdiich they naturally belong. Under present procedure many of the conferences and decisions of conferees are farces. Review bodies are per- mitted to review decisions, and to reverse them without notify- ing the taxpayer. The taxpayer is not notified of the appeal within the Bureau, hence he is not allowed to appear to present his case. The reviewers do not attend conferences, hence do not hear the oral arguments. This is closely akin to "Star Chamber" proceedings. Administrative interpretation. — Pending the construction of the statutes by the courts and subject, of course, to such construction, the Treasury is called upon to supply an official interpretation of the law for the guidance of taxpayers. ^^ Until the statutes are completely adjudicated, disagreements may always be expected between taxpayers and the Treasury re- '^ For description of official publications see page 25. ADMINISTRATION, ASSESSMENT AND PAYMENT 189 garding the meaning of the law ; for, as a matter of policy, the Treasury interprets the law in a strict and narrow fashion. There are large sums continually involved in disputes turning upon close constructions of the law and taxpayers cannot as- sume that their interests will be adequately protected by a blind conformity to the Treasury rulings. Indeed the system rests upon the assumption that they will not follow the rulings blindly, but will rather contest doubtful points which operate to their disadvantage. This throws a heavy burden upon the taxpayer — one wdiich in some cases is essentially unjust. Es- pecially in the case of minor points which involve relatively small sums, the Treasury should make a reasonably liberal in- terpretation of the law at the very beginning, because a tax- payer w^ill not contest a trifling matter, but will, nevertheless, smart bitterly if he feels that the Treasury has imposed upon him. Common sense in the interpretation of doubtful points is absolutely essential to successful administration of the law. In recent regulations there has been evident a very com- mendable effort to make the interpretation as general and illuminating as possible. Regulations 45 and 62 are superior to their predecessors. Regulations 33 and Regulations 41. In- stead of restricting itself to the treatment of a very narrow, particular instance, the Treasury has in most cases essayed a comprehensive treatment of the problem of procedure in- volved and has not hesitated to enunciate general principles which are to serve as official guides to action by taxpayers. It must always be remembered, however, that the Supreme Court of the United States is the "last word" on income tax questions — not the Treasury through its regulations and deci- sions, nor, in fact, Congress. Many acts of Congress deal- ing with taxation have been held to be unconstitutional and many regulations of the Treasury have been overruled. In this chapter the author covers the procedure pcnnitted by the Treasury. In the following chapter the taxpayer's legal rights are discussed. 190 APPLICATION AND ADMINISTRATION The following statements, made in two recent cases, are of interest in a consideration of the regulations of the Treasury: ■ Decisions. The question has been decided both ways in the In- ternal Revenue Department [Montgomery's Income Tax Procedure (Ed. 1918) pp. 231, 232] ; and hence the effect usually given to an established practice of an executive department charged with the execution of a statute has no present relevancy. {United States v. Coulby, 258 Fed. 27; 169 C. C. A. 163.) A practical construction by public officers whose duty it is to enforce a statute is conceded to be entitled to great influence, provided the statute presents an ambiguity which is real and not captious. Where a statute that has been construed by the courts has been re-enacted in the same or substantially the same terms, the legisla- ture is presumed to have been familiar with its construction, and to have adopted it as a part of the law, unless a different intention is indicated ; and the same principle is applied to statutes and parts of statutes which have been re-enacted after they have been con- strued by the legislative or executive departments of the government. {Edwards v. Wabash Raihvay Co., 264 Fed. 610.) This is exemplified in the ruling of the Treasury, regarding the allowable deduction for gifts in Regulations 62, article 251, as well as in a letter to attorneys dated August 14, 1919. The basis was stated to be (subject to the 15 per cent lim- itation) the "fair market value of the property at the time given" in cases of gifts other than money. On the strength of this ruling donations were solicited by universities and elee- mosynary institutions which issued tabulations showing the saving in tax resulting from donations of securities as con- trasted with donations of cash. In T. D. 2998, issued in 1920, the Treasury changed its position on this point, holding that the basis must be "cost ! .... or its fair market value at March i, 19 13." Notwithstanding the official regulation, made in good faith the basis of action, those who made the donations of securities which cost less than their value at time of gift will no doubt be required to pay additional taxes. ADMINISTRATION, ASSESSMENT AND PAYMENT 191 Policy of the Bureau of Internal Revenue with REGARD to REQUESTS FOR RULINGS AND ADVICE UPON AB- STRACT propositions. Ruling. Requests are being received daily for rulings and ad- vice upon abstract cases or prospective transactions involving que's- tions of income tax and profits liability. These requests are so numer- ous and the insistence on prompt action so great that it seems ad- visable at this time definitely to outline the Bureau's policy which will govern the consideration of these requests. The Revenue Acts of 1918 and 192 1 depart widely at many points from prior law or practice, and have given rise to new questions of such importance, complexity, and number that the resources of the Bureau are no more than adequate to advise taxpayers promptly of their present liabilities arising out of past transactions. It is im- possible to answer every question which the invention or ingenuity of the inquirer may devise without neglecting the fundamental duty of determining tax liability upon the basis of actual happenings. Under these circumstances, the administrative necessity is obvious of giving precedence over abstract or prospective cases to actual cases in which the taxpayer desires to know what are his immediate liabilities under the law. It will be the policy of the Bureau not to answer any inquiry ex- cept under the following circumstances : (a) The transaction must be completed and not merely proposed or planned. (b) The complete facts relating to the transaction, together with abstracts from contracts, or other documents, necessary to present the complete facts, must be given. (c) The names of all the real parties interested (not "dummies" used in the transaction) must be stated, regardless of who presents the question, whether attorney, accountant, tax service, or other rep- resentative. (I-2-26; Mini. 2880.) Administrative efficiency — evasion. — There is no full and trustworthy information concerning the completeness of the income tax assessment. It is a tax which can be evaded, at least for a time, by those who are willing to perjure them- selves, but in spite of this there is reason to believe that upon the whole the law is well observed. The Annalist, of December 13, 1920, contained an article purporting to show that approximately as many persons liable to the tax are evading it as are paying it. The data 192 APPLICATION AND ADMINISTRATION supporting tliis cuiitcntion, although very interesting, are far from definite and conclusive. It was shown that while in 19 18 there were 4,409,588 personal returns filed, there were on December 31, 1919, no less than 7,523,664 motor owners in the country. It was shown that, whereas in the District of Col- umbia there were two and one-half returns for each automobile and in New York one return for each car, in South Carolina there were five automobiles to each income tax return." Recently the government has prosecuted several taxpayers for making false returns. Out of millions of returns there are sure to be some which are fraudulent. The Treasury should be unremitting in its efforts to punish the offenders. All reputable accountants and lawyers should lend their aid. If it be found that taxpayers have been advised how they can evade the law, the advisors should be indicted and punished as conspirators. There are, of course, thousands of cases in which there have been dififerences of opinion as to what is and what is not tax- able and as to what is and what is not deductible. The Treasury reverses its own decisions so often that procedure which is allowable one day results in technical "evasion" the next. Moreover, from a rather extensive inquiry, the author has come to the conclusion that in more than half the cases where additional sums were collected by assessments based on examinations the taxpayers made no mistakes whatever in their returns, the assessments being changed by incompetent revenue agents. The additional taxes, which would be classi- fied as evasions, are paid in many cases without protest, solely because of the expense and annoyance of bringing suit. "A very careful stud\' of income has recently been made by the staff of the National Bureau of Economic Research (Income in the United States, Harcourt, Brace and Company, 1921). According to their best estimates (page 136), there were in 1918 no less than 5,290,649 persons in receipt of incomes in excess of $2,000. In contrast, there were less than three milhon income tax returns filed in that year. However, it is not to be concluded that the evasion is as great as might be inferred .by these bare figures. "Income" as used in this study was not "taxable net income." It is significant also that 3,065,024 of the 5,290,649 persons, who were in receipt of incomes over $2,000, fell within the group of $2,000 to $3,000. The evasions are probably very largely those of persons just within the income tax paying class. ADMINISTRATION, ASSESSMENT AND PAYMENT 193 The great difficulties under which the Treasury labors in securing competent assistants are, of course, apparent. Im- provement in the quaHty of the administration, however, should be made steadily as the law becomes more clearly un- derstood and more fully adjudicated. There is imperative need for better administration if widespread evasion is to be avoided. The heavy rates, coupled with a growing distrust of the Treasury, promise to give rise to a lamentable situation. Legal effect of changes in form of organization which are made to reduce taxation. — The owners of the stock of a cor- poration dissolved the corporation and formed themselves into a partnership or trust, apparently in order to avoid paying excess profits tax on a contemplated sale of assets. The Treasury held that the tax nevertheless might be assessed against the corporation on the ground that the transaction was an attempt to evade a tax. Ruling. A change of form from that of a corporation or asso- ciation to that of a trust or partnership accompanied l)y a transfer of capital assets to trustees for the henefit of shareholders followed by a sale of such assets at a price in excess of the cost thereof to the corporation or association, and the distribution of proceeds to the beneficiaries (shareholders), such change being made for the main purpose of avoiding the tax which would accrue to the corporation had the sale been made by it, should be disregarded as a mere sham to avoid assessment of tax against the corporation or association upon the profit derived from such sale, and the corporation or asso- ciation should be required to return as income any profit derived as though the sale had been made by it directly. ( C. R. 2, page 203; s. 1385.) The taxpayer in the foregoing case appealed to the courts and the opinion of the Solicitor was reversed.^"' Decision. ^^ It is insisted in the opinion of the solicitor for the Bureau of Internal Revenue that this change is a sham and a sub- terfuge and is ineffective. This same opinion admits the right of an individual or corporation to regulate or change its business with a " The position taken by tlie author in this case has been sustained in the court decision above quoted. See Income Tax Procedure, 1921, page 444. "'Weeks V. Sibley, 269 Fed. 155. 194 APPLICATION AND ADMINISTRATION view of reducing or avoiding taxation in the future, but in contra- diction with this admission holds that the parties involved in this transaction could not do so. Supporting this view there are several cited cases, most of them by state courts. The case of Pollard v. Bank, 47 Kans. 406, 28 Pac, 202, cited by the solicitor, is directly op- posed to his contention Bearing in mind the rule of construction which the Supreme Court announced in the case of Gould v. Gould, 245 U. S. 151, 38 Sup. Ct. 53, 62 L. Ed. 211, and numerous other cases, to the effect that the provisions of the taxing statutes are not to be extended by implication beyond the clear import of the language used, and that they are to be construed most strongly against the government and in favor of the taxpayer, it is the opinion of this court that the right to change the status of an organization, or to dissolve an organization in any legal manner, is not made ineffectual because the motive im- pelling the change is to reduce or avoid taxation in the future. The right so to do is an incidental right inseparably connected with an individual's right to ow-n and control his property. It is practically identical with the sale by a citizen of tax-burdened securities and the investment of the proceeds thereof in tax-exempt ones, for the pur- pose of reducing or avoiding taxation. It is not unnatural that any thoughtful business man should take such steps. It is altogether different from tax dodging, the hiding of taxable property, or the doing of some unlawful or illegal thing in order to avoid taxation Assessment The function of assessing the tax is delegated to the Com- missioner. Law. Section 1311. [Section 3176, Rev. Stat.] .... The Commissioner of Internal Revenue shall determine and assess all taxes, other than stamp taxes, as to which returns or lists are so made under the provisions of this section The place of the assessment as a step in the administra- tive process is made clear in the following regulation. Regulation. When the returns are received at the collectors' offices they are examined and listed before being forwarded to the Commissioner. As soon as practicable after the returns are received in the office of the Commissioner they are carefully audited in con- nection with any reports of examination that may have been made by agents of the Department. If error in the amount of tax as stated in the return is detected the tax is recomputed and if the amount is less than that shown in the return the excess will be credited or refunded. ADMINISTRATION, ASSESSMENT AND PAYMENT 195 If the amount is greater than that shown in the return the deficiency will be handled as provided in section 250 (d) of the statute and article 1006 (Art. 1012.) The returns, or at least the larger ones, are exhaustively audited as soon as practicable [section 250 (b)], but this is usually long after the payment of the tax. If found incorrect, additional tax is demanded. The Commissioner may examine the books of the taxpayer for the purpose of discovering whether or not the net income has been properly reported and the tax liability of the individual or corporation has been sat- isfied. The auditing and examination of the books is per- formed by local internal revenue agents who are under the direction of the authorities at Washington, not of the local col- lectors. Assessment must be made within four years — exception. — The 1 92 1 law made some radical changes with reference to the period within which the Commissioner may summarily assess the taxpayer on any income he has failed to report. Law. Section 250. .... (d) The amount of income, excess- profits, or war-profits taxes due under any return made under this Act for the taxable year 1921 or succeeding taxable years shall be deter- mined and assessed by the Commissioner within four years after the return was filed, and the amount of any such taxes due under any re- turn made under this Act for prior taxable years or under prior income, excess-profits, or war-profits tax Acts, or under section 38 of the Act entitled "An Act to provide revenue, equalize duties, and encourage the industries of the United States, and for other purposes," approved August 5, 1909, shall be determined and assessed within five years after the return was filed, unless both the Commissioner and the taxpayer consent in writing to a later determination, assessment, and collection of the tax; and no suit or proceeding for the collection of any such taxes due under this Act or under prior income, excess-profits, or war- profits tax Acts, or of any taxes due under section 38 of such Act of August 5, 1909, shall be begun, after the expiration of five years after the date when such return was filed, but this shall not affect suits or proceedings begun at the time of the passage of this Act: Provided. That in the case of income received during the lifetime of a decedent, all taxes due thereon shall be determined and assessed by the Com- missioner within one year after written request therefor by the executor, administrator, or other fiduciary representing the estate of such de- 196 APPLICATION AND ADJ^IINISTRATION cedent: Provided furtlirr, That in the case of a false or fraudulent return with intent to evade tax, or of a failure to file a required return, the amount of tax due may be determined, assessed, and collected, and a suit or proceeding for the collection of such amount may be begun, at any time after it becomes due: Provided further, That in cases coming within the scope of paragraph (9) of subdivision (a) of section 214, or of paragraph (8) of subdivision (a) of section 234, or in cases of final settlement of losses and other deductions tentatively allowed by the Commissioner pending a determination of the exact amount deductible, the amount of tax or deficiency in tax due may be determined, assessed, and collected at any time; but prior to the assessment thereof the tax- payer shall be notified and given a period of not less than thirty days in which to file an appeal and be heard as hereinafter provided in this subdivision. It should be noted that the tax must be both determined and assessed within the Hmitation period. Limitation period five years under 19 18 and prior LAWS. — The hmitation period of the 1918 law has not been disturbed, but in the case of all acts prior to the 1918 law. the period has been increased to five years. Before this change, the government, notwithstanding the fact assessment could not be made, could bring suit at any time under laws prior to the 1918 act. The 192 1 law now provides that neither assess- ment nor suit under 1918 and prior laws shall be legal after the five-year limitation period has expired.^^ '" [Former Procedure] Prior to the enactment of the 1921 law, the government under the 1917 law fsection 14 (a)] was unable to make assess- ment and to enforce payment of an additional tax by the usual (summary statutory) proceedings after three years had elapsed since date at which the return was due. It could, however, when it discovered, or alleged that it had discovered, additional tax to be due, bring suit at any time against the taxpayer for the amount alleged to be due. This was a distinct advantage to a. taxpayer, because it shifted the burden of proof from himself to the government and made the case altogether different from one in which the government was able to send in a bill, compel payment and put upon the innocent ta.xpayer the cost of initiating a suit. The Bureau claims (C. B. 3, page 302; Sol. Op. 79) that if a "discovery" shall have been made within three years from the time the return was due assessment may be made at any time thereafter. Such, however, could hardly have been the intention of the law. The punctuation conveys to the author the very clear meaning that assessments must be made im- mediately after discovery and the additional tax must be paid upon demand and that the discovery and the assessment must be made within three years from the time when the return was due. Any other construction requires a vivid imagination. As the section covers the imposition of ADMINISTRATION, ASSESSMENT AND PAYMENT 197 Limitation period four years under 1921 law. — Any tax due under a return filed for the taxable year 1921, or any subsequent year, must be assessed within four years after the return was filed. If, however, any tax is due under any return made under the 1921 law for prior taxable years, the assessment must be made within five years after the return ^'as filed. The limitation period for taxes under the 1921 law is not die same for assessment and suit. Assessment must be made \vithin four years after the return was filed. Suit or proceed- ings must be instituted within five years after the return was filed. Limitation period one year in case of estates. — Section 250 (d) provides, "that in case of income received during the lifetime of a decedent, all taxes due thereon shall be determined and assessed by the Commissioner within one year after written request therefor by the executor, adminis- penalties it should be construed in favor of the taxpayer. The United States courts have not specifically passed upon this question. In a suit brought within three years from the time when a return was due (Eliot National Batik v. Gill, 218 Fed. 600; 134 C. C. A. 358) the court said that the tax could be assessed after three years if the fact that it was due was dis- covered within the three years. But the point in question was not before the court, so the statement is dictum, and need not be considered a precedent. It is well settled that where a tax of a fixed percentage is imposed by statute, or is so definitely described in the statute that its amount can be readily ascertained or determined, no assessment need be made in order to recover the tax. In the case of United States v. Grand Rapids, etc., Rail- way Company, 239 Fed. 153, the United States District Court held thai the limitation in the statute is a limitation upon the right of collectors to make assessment and to enforce payment by the customary summary pro- ceedings, but does not prevent suit for taxes, which will lie without an assessment. (Judgment affirmed, 256 Fed. 989 |mem.].) The Treasury has also held the fcjilowing with reference to the three- year limitation period : Ruling, "i. The extension of time granted by the Commissioner to taxpayers for filing their income returns operates to shift the due date for filing their returns to the expiration of the period of extension; the three- year limitation begins to run from the due date as thus shifted. "2. Where an excess amount of tax is assessed, the Commissioner is authorized by section 3220, R. S., as amended by the Revenue Act of 1918 to abate the excess amount. "3. Where the tax assessed is less than the amount due an assessment of the additional amount due can be made, where discovery was made within the three-year limitation period." (C. B. 4, page 32=;; Sol. Op. 92.) 198 APPLICATION AND ADMINISTRATION trator, or other fiduciary representing' the estate of such de- cedent." A request for determination must be made by the executor. Such an apphcation should be rendered unnecessary by more expeditious handhng of returns. This section does not apply to the income of the decedent's estate but only to that received by the decedent during his lifetime. The one-year period does not apply to suits. The govern- ment would have to institute suit within five years after the return was filed. No LIMITATION PERIOD IN CASE OF FALSE OR FRAUDULENT RETURN. — Where a taxpayer has filed a false or fraudulent return with intent to evade tax, or has failed to file a required return, an assessment may be made or suit instituted at any time.^^ Limitation period w^here amortization is claimed OR deductions are tentatively ALLOW' ED. — The following part of section 250 (d) is of especial importance to taxpayers who have filed amortization claims : Law. Section 250. .... (d) ... . That in cases coming within the scope of paragraph (9) of subdivision (a) of section 214, or of paragraph (8) of subdivision (a) of section 234, or in cases of final settlement of losses and other deductions tentatively allowed by the Commissioner pending a determination of the exact amount de- ductible, the amount of tax or deficiency in tax due may be deter- mined, assessed, and collected at any time; but prior to the assessment thereof the taxpayer shall be notified and given a period of not less than thirty days in which to file an appeal and be heard as hereinafter provided in this subdivision It would appear from the foregoing that the Commissioner may, in a case wdiere amortization has been claimed or where the Commissioner has tentatively allowed a deduction, reopen the case to make an assessment or bring suit at any time. The assessment or suit would have to be confined to amortization or to the deduction tentativelv allowed. The other limita- " Section 250 (d). ADMINISTRATION, ASSESSMENT AND PAYMENT 199 tion periods of section 250 (d) would apply to the other items of the return. There is an apparent conflict between section 250 (d) and section 214 (a-9). Section 234 (a-8) has the same language as section 214 (a-9). One applies to individuals and the other to corporations. Law. Section 214. (a) .... (9) .... At any time before March 3, 1924, the Commissioner may, and at the request of the tax- payer shall, reexamine the returns, and if he then finds as a result of an appraisal or from other evidence that the deduction originally allowed was incorrect, the income, war-profits, and excess-profits taxes for the year or years affected shall be redetermined; and the amount of tax due upon such redetermination, if any, shall be paid upon notice and demand by the collector, or the amount of tax overpaid, if any, shall be credited or refunded to the taxpayer in accordance with the pro- visions of section 252; .... The rule of law is that a specific section controls a general section. It might be thought that each section is specific. A careful reading shows, however, that section 214 is spe- cific with reference to the deduction for amortization, whereas section 250 is specific with reference to limitation. Should the courts hold that section 214 governs section 250, the Commissioner would have to re-examine amortization claims before March 3, 1924, but could make an assessment or bring suit at any time thereafter. Limitation period may be extended by agreement. — A new provision^" has been added to the 192 1 law which makes it possible for the Commissioner and the taxpayer to extend the limitation period with reference to assessment. This provision will no doubt be attacked in the courts if tax- payers should inadvertently sign waivers in ignorance of their legal rights. Taxpayers should not sign blanket extensions or waivers. The agreements should be carefully drawn. A limitation date should be specifically mentioned. ^° '* Section 250 (d) Section 250 (d). In December, 1920, the Commissioner notified many taxpayers that 200 APPLICATION AND ADMINISTRATION No LIMITATION PERIOD FOR EXAMINATION OF BOOKS. — • There is no limitation on the right of the Commissioner or his collectors to examine the books of a taxpayer beyond the five-year period, but no tax can be assessed by the government unless fraud is alleged. Examination of returns and accounts. — After the original returns are forwarded to Washington, the returns are filed and in due course audited. An audit is made of the return itself and, if necessary, another may be made of the books and accounts of the taxpayer. All of the auditing, whether done in the office or in the field, is under the direction of the Commissioner at Washington. Field agents, as a general rule, discuss their proposed re- ports very freely with taxpayers. When the examination has been made by an agent under the immediate supervision of the revenue agent in charge of a particular district, the tax- payer is sent a copy of the report after it has been reviewed by the agent in charge. If an examination is made by an agent directly from Washington, a copy of the report is not fur- nished the taxpayer. The A-2 letter"' is the first official notice to the taxpayer of the results of the examination. Procedure when audit discloses additional taxes, DUE. — If an examination of the original returns or of the ac- counts of the taxpayer indicates that an additional amount is due, an assessment will be made, unless the taxpayer is able to 1 there would not be sufficient time before March i, 1921, to audit all 1917 returns and asked for waivers. When taxpayers had good reasons to infer that the Bureau would rush through an audit and assess additional taxes without proper investigation (as the letter of the Commissioner inti- mated would be done), perhaps it was the part of wisdom to relinquish one's legal right and yield to the "hold-up." Those who had no definite knowledge of proposed additional assessments should not have signed the waivers. There is a serious question as to the validity of waivers executed after the expiration of the three-year limitation. The law does not authorize the Commissioner to extend this period. Furthermore, the consideration cited in the waivers is "unreal." Another criticism of the waiver is vagueness of the persons bound or the promisees. Their identity and authority are not disclosed. " See page 201, ADMINISTRATION, ASSESSMENT AND PAYMENT 201 satisfy the Treasury before the audit is closed that an error has been made by the inspector. The taxpayer may prepare a state- ment of all relevant facts, furnish one copy to the inspector with a request that it be forwarded to the Treasury and send another copy, with affidavit attached, to the personal or corporation audit department of the income tax unit at Wash- ington. This does not constitute an amended return, but is merely a presentation of the case of the taxpayer for con- sideration by the audit section, which will also have before it the report of the insp£ctor. If the taxpayer does not feel that his statement, unsupported by oral evidence, is sufficient, he may in the statement forwarded to Washington request a hearing and an opportunity to submit additional evidence if it should appear to the audit section that an adverse report is likely to be made. If this request is filed the taxpayer will be granted a hearing in person or by attorney before any addi- tional tax is assessed against him. After the hearing a decision will be made by the audit section from which an appeal can be taken, as herein after explained. A-2 LETTER. — If after the Treasury has made an examina- tion of a taxpayer's return (either office or a field audit) it appears that an assessment is required, a letter, which the Treasury has designated as the "A-2 letter," is sent notify- ing the taxpayer that an examination shows that he is liable for an additional amount of tax. The new law [section 250 (d)]" requires that the tax- payer must be notified by registered mail. The A-2 letter not only states the amount of the tax, but also sets forth the reasons for it. The amount of detail given varies, some letters giving very full details of adjustments and computations, others giving only meager details. The letter also notifies the taxpayer that if he does not, within thirty days from the date of the letter, file an appeal and show cause " See page 208. 202 APPLICATION AND ADMINISTRATION Of reason why the tax should not he paid, the collector of his district will notify him in due course as to the time and man- ner of making payment. The letter usually concludes with a paragraph similar to the following: In accordance with the Revenue Act of 1921, you will be given thirty days to present any exceptions to the additional assessment referred to in the enclosed letter, and to show cause or reason why the same should not be paid. This may be done either by way of a sworn statement of facts and exceptions submitted within thirty days from the mailing date of the attached letter, or at a conference, which may be arranged upon request, for a date prior to the expiration of the 30-day period. The foregoing notice, while it usually mentions a thirty- day period, is not intended to cover the thirty-day period men- tioned in the law. Therefore, if the taxpayer believes that the proposed assessment, or any part thereof, is erroneous, he should immediately take proper steps to protest against it. Section 250 (d) of the new law reads as follows: Law. Section 250. .... (d) .... If upon examination of a return made under the Revenue Act of 1916, the Revenue Act of 1917, the Revenue Act of 1918, or this Act, a tax or a deficiency in tax is dis- covered, the taxpayer shall be notified thereof and given a period of not less than thirty days after such notice is sent by registered mail in which to file an appeal and show cause or reason why the tax or de- ficiency should not be paid. Opportunity for hearing shall be granted and a final decision thereon shall be made as quickly as practicable. Any tax or deficiency in tax then determined to be due shall be assessed and paid, together with the penalty and interest, if any, applicable there- to, within ten days after notice and demand by the collector as herein- after provided, and in such cases no claim in abatement of the amoimt so assessed shall be entertained: Provided, That in cases where the Commissioner believes that the collection of the amount due will be jeopardized by such delay he may make the assessment without giving such notice or awaiting the conclusion of such hearing The following ruling indicates the procedure which should be followed when a taxpayer receives an A-2 letter or any kind of a notice showing a proposed additional assessment. Regulation. Section 250 (d) of the Revenue Act of 1921 pro- vides that if upon examination of a return made under the Revenue ADMINISTRATION, ASSESSMENT AND PAYMENT 203 Act of 1916, 1917, 191S, or 1921, an income or excess profits tax or a deficiency tlierein (which deficiency is defined in section 250 (b) as meaning the difference, to the extent not covered by any credit due to the taxpayer under section 252, between the amount of the tax already paid and that which should have been paid) is discovered the taxpayer shall be notified thereof and shall have the right of an ap- peal and a hearing before an assessment is made. As soon as prac- ticable, therefore, after a return is filed, whether by the taxpayer or as provided in section 3176 Revised Statutes, as amended, it is examined, and if a tax or a deficiency in tax is discovered, the taxpayer shall be notified thereof by letter in which he shall be given a reasonable time in which to protest and file exceptions specifying the reasons why the tax or deficiency should not be assessed. (a) If the taxpayer protests against the proposed assessment after the first notification by mail as above set forth, he will present his exceptions in writing to the income tax unit in Washington or to the division thereof where the said proposed assessment is being consid- ered. Such exceptions must state fully the facts and grounds upon which the taxpayer relies. A reasonable additional time in which to file other data in support of the taxpayer's contentions may be allowed upon request showing cause for such extension. A hearing by the income tax unit shall be granted the taxpayer if requested by him; if no hearing is requested a decision will be made by the income tax unit upon the written data submitted. Whether a hearing is had or not a decision shall be made by the income tax unit at the earliest practicable date and the taxpayer notified thereof. The notification of the decision of the income tax unit shall be made by registered mail and a period of not less than thirty days given the taxpayer in which to file an appeal to the Commisisoner and show catise or reason why such tax or de- ficiency should not be paid. Full thirty days from the mailing (not the receipt) of such notice to file an appeal shall be given the tax- payer. The appeal must be filed in the office of the Commissioner in Washington within thirty-one days from the mailing of the notice, but if it is mailed in time to be received by the Commissioner within such period in the ordinary course of the mails it will be considered as having been filed within such period. No particular form of ap- peal is required, but the appeal must set forth specifically the excep- tions upon which it is taken. The appeal shall be under oath and must contain a statement that it is not taken for the purpose of delay. Opportunity for a hearing shall be granted if requested within a reasonable time. The taxpayer in his appeal may rely upon the data previously submitted, or he may obtain a reasonable extension of time if cause therefor is shown in which to file additional data, evi- dence or argument. Such request shall be under oath and must state specifically the reasons for additional time. When a decision has been made by the proper officer, employee or employees of the bureau and 204 APrUCATION AND ADMINISTRATION approved by the Commissioner, an assessment, if any, shall be made forthwith in accordance with the terms of such decision. (b) If the taxpayer does not protest within the time fixed by the first notification by mail, then and in that case the proposed assessment shall be the decision of the income tax unit and the taxpayer shall be notified thereof. This notification of the decision of the income tax unit shall be made by registered mail and a period of not less than thirty days given the taxpayer in which to file an appeal to the Commissioner and to show cause or reason why such tax or deficiency should not be paid. The procedure on said appeal shall be the same as in the case of an appeal to the Commissioner as provided in (a) above. In the case of a return which is examined in the collector's office where a tax or deficiency of tax is discovered and notice of the pro- posed assessment is sent out by the collector, the procedure shall be the same in said collector's office as herein provided for in the income tax unit. The decision of the collector may be appealed from, which appeal shall be to the Commissioner at Washington, and shall follow the same procedure as provided for in (a) or (b) above. No assessment under section 250 (d) shall be made without notifi- cation to the taxpayer of his right to appeal and show cause, except that in any case where the Commissioner believes that the collection of the amount due will be jeopardized by delay, he may make the assess- ment without giving such notice or awaiting the conclusion of a hearing. Where a taxpayer has been given an opportunity to appeal and has not done so, as above set forth, and an assessment has been made, or where a taxpayer has appealed and an assessment in accordance with the final decision on such appeal has been made, no claim in abatement of the assessment shall be entertained. Where an assessment has been made without giving the taxpayer an opportunity to appeal or without awaiting a decision on an appeal that has been perfected, a bona fide claim in abatement of the assess- ment, filed within ten days after notice and demand by the col- lector, may be entertained. (Art. 1006.) The author is of the opinion that the foregoing regula- tion brings about a greater delay than was intended by Con- gress. It is probable that the procedure will be changed so that the first notice may be sent out by registered mail, and thus meet the requirements of the statute. Under the present ruling, it would appear that a taxpayer may ignore the first notice and wait for the second notice which entitles him to fight the case out before the Committee on Appeals and Re- ADMINISTRATION, ASSESSMENT AND PAYMENT 205 view, which body acts for the Commissioner. This should not and probably will not be permitted. If the taxpayer does not file his protest within the first thirty-day period, it will not be unreasonable that the assessment be made. In other words, taxpayers who do not protest at once should not be entitled to the second notice provided for by the foregoing ruling. To accomplish this, the first notice would have to go out by registered mail. In order to stop the assessment of the proposed tax, the taxpayer must (i) file his protest within thirty days from the date the notice was sent, and (2) the protest must show the cause or reason why the tax should not be paid. In most cases the taxpayer will wish to take the matter up in conference. In such cases a request should be made for an oral hearing. The protest should also make a specific demand for a hearing before the Committee on Appeals and Review if the decision of the Income Tax Unit, or any part thereof, is ad- verse to the contentions of the taxpayer. In many cases, especially where the amount involved is very large, it will not be possible to file a complete brief taking up in detail the proposed assessment. In such cases, it should be sufficient, as is contemplated by article 1006, to file the formal protest within thirty days, setting forth the items which will be contested and the reasons in a general way why the tax should not be paid. These reasons should not be too general, but should be specific enough to enable the Treasury to decide whether or not the contentions arc meritorious. Taxpayers should make all protests in good faith and as soon as practicable. This will encourage a fair administra- tion of the law. 1'axpayers should request reasonable exten- sions of time in which to prepare properly the details of their cases. In all conii)licated cases an oral hearing should be re- quested, since the questions involved are of the same nature as in litigated cases and no one would think of taking a case into the courts and of waiving the right to a trial before a judge or a jury. 2o6 APPLICATION AND ADMINISTRATION After a case has been heard ])y the Income Tax Unit, an appeal hes to the Committee on Appeals and Review before the assessment is made.^^ While the law and article 1006 do not state that notice of intention to appeal to the Committee must be given within the thirty-day period, the safest procedure is, as suggesed above, to give such notice at the time of filing the formal protest. Since the language of article 1006 is somewhat involved, the following analysis may prove helpful : I. Abatement claims may Ijc filed only in the following cases: (a) When the taxpayer is not notified of the intenlion of the Treasury to make an additional assessment; and the Treasury does not send notices by registered mail. It is not likely that assessments will be made unless notice is given. (b) If the taxpayer has appealed to the Commissioner of In- ternal Revenue, or has had a hearing before the Commis- sioner or his representatives, or has filed objections and has had a hearing, 'and pending the promulgation of the Commissioner's decision, the proposed assessment has nevertheless, been made. (c) If unable to pay. II. Taxpayers are to be notified by mail that, as a result of the examinations of their returns, the government finds that additional taxes are due. Thereupon, (a) The taxpayer has a right to file exceptions to the proposed assessment, and also (b) The taxpayer is entitled to a hearing before the Income Tax Unit. A reasonable time will be afforded taxpayers in which to file their exceptions or to ask for a hearing or to do both. There is no statu- tory time. The Treasury will probably suggest a fixed time, prob- ably thirty days, and give taxpayers additional time if circumstances warrant. III. If the taxpayers exercise the right referred to in II above, and submit their objections, (a) A decision is made either on the basis of the taxpayer's original data, or on the basis of the taxpayer's written ^For procedure before Committee on Appeals and Review, see page 175 et seq. ADMINISTRATION, ASSESSMENT AND PAYMENT 207 presentation, or on the basis of his oral presentation, or on the basis of both presentations, (b) The decision of the Unit must be communicated to the taxpayer by registered mail. (c) Thereupon, the taxpayer has thirty days in which to appeal to the Commissioner from the decision. This appeal must be in writing. After the filing of the appeal, an oral hearing may be had. (d) The assessment, if any, is thereupon made and this decision is final. IV. If taxpayers fail to exercise the right referred tu in II above, (a) The decision of the Unit nuist be communicated to the tax- payer by registered mail. Thereupon, the procedure is as in III above and the result is as in III (d), above. V. If the collector's ofiicc discovers apparent cause for an addi- tional assessment, the collector notifies the taxpayer whose procedure thereafter may be either as outlined in II or in IV above. VI. When the assessment is made, no abatement claim with refer- ence to such assement may be filed, except in the specific instances indicated in I above. If taxpayers, after receiving notices of proposed addi- tional assessments, file appeals within the specified time, as- sessments cannot be made until hearings have been granted and final decisions are made. After final decisions are made, or if appeals are not made within the specified time, the proposed assessments are included in the next list sent to the collector."* Upon receipt of the lists, the collector issues notice and demand for payment as soon as possible. The tax must be paid within ten days after notice and demand. The collector cannot accept a claim for abate- ment.^'"' If the taxpayer still wishes to contest the assessment, a claim for refund may, however, be filed immediately after payment is made — a procedure which is necessary in order to ** Lists are usually sent to the collectors about the 19th of each months Sometimes, however, a special Hst is sent. '■''See page 202. 2o8 APPLICATION AND ADMINISTRATION file suit."" Under all circumstances payments should be made under protest.'' Section 250 (d) provides that in cases where the Com- missioner believes that the collection of the tax will be jeopar- dized by the delay due to the appeal, he may make the assess- ment without giving notice or awaiting the conclusion of a final hearing. In such a case, if the collector will accept it, a claim for abatement may be filed."* If a claim is accepted, the collector will no doubt require a bond or security. The merits of the case would then be fought out under a claim in abate- ment. If the collector refuses to accept a claim in abatement, the tax must be paid and a claim for refund filed. "^ Can assessments be made if taxpayer has not been properly notified? — The 192 1 law provides that in the case of an addi- tional assessment : Law. Section 250 (d) .... the taxpayer shall be noti- fied thereof and given a period of not less than thirty days after such notice is sent by registered mail in which to file an appeal Opportunity for hearing shall be granted and a final decision thereon shall be made as quickly as practicable The foregoing section applies to the 1916, 191 7, 1918, and 192 1 laws. Therefore, any assessment made after Nov- ember 23, 1 92 1, the date of enactment of the 1921 law, is il- legal if the above section has not been followed. No doubt there were many assessments in the hands of col- lectors and still others ready to be sent to collectors by the Commissioner under the old procedure when the 192 1 law was approved. These proposed assessments cannot legally be made until the Treasury has complied with section 250 (d). Additional assessments bear interest. — Prior to the enact- ment of the 192 1 law, additional assessments did not bear in- "° See page 263. ^ See page 286 ct scq. "' See page 202. =» Ibid. ADMINISTRATION, ASSESSMENT AND PAYMENT 209 terest unless they were not paid within ten days after receipt of notice and demand from the collector. Under the new law, the assessment bears interest from the date the tax was due. Law. Section 250 (b) .... If the amount already paid is less than that which should have been paid, the difference, to the extent not covered by any credits due to the taxpayer under section 252 (hereinafter called "deficiency"), together with interest thereon at the rate of one-half of i per centum per month from the time the tax was due (or, if paid on the installment basis, on the deficiency of each installment from the time the installment was due), shall be paid upon notice and demand by the collector The foregoing provision ap[)lies only to returns for 192 1 and subsequent years. Assessment when consolidated returns are filed. — The new law continues the right given corporations making consoli- dated returns by the 1918 law, to elect in what proportions the tax shall be assessed against each corporation in the group. Law. Section 240 (b) In any case in which a tax is as- sessed upon the basis of a consolidated return, the total tax shall be computed in the first instance as a unit and shall then be assessed upon the respective affiliated corporations in such proportions as may be agreed upon among them, or, in the absence of any such agreement, then on the basis of the net income properly assignable to each. There shall be allowed in computing the income tax only one specific credit computed as provided in subdivision (b) of section 236. The foregoing formula for apportionment of taxes when consolidated returns for 19 17 are filed by corporations and partnerships is modified in the following : Ruling. It is held, therefore, that where corporations and part- nerships are consolidated the excess profits tax should be allocated to the partnerships as a group according to the invested capital and net income assignable to the partnership group. After the proper amount of the excess profits tax has been allocated to the partnership group, article 78 may then be applied within the partnership group as it is now applied within the corporation group. (B. I-3-37; L. O. 1083.) Final determination and assessment. — The 1921 law pro- vides that a case, under certain conditions, may be finally de- 2IO APPLICATION AND ADMINISTRATION termined, thus overcoming the uncertainty which has hereto- fore existed as to when a tax case was actually closed. Law. Section 1312. That if after a determination and assessment in any case the taxpayer has without protest paid in whole any tax or penalty, or accepted any abatement, credit, or refund based on such determination and assessment, and an agreement is made in writing between the taxpayer and the Commissioner, with the approval of the Secretary, that such determination and assessment shall be final and conclusive, then (except upon a showing of fraud or malfeasance or misrepresentation of fact materially affecting the determination or assessment thus made) (i) the case shall not be reopened or the de- termination and assessment modified by any officer, employee, or agent of the United States, and (2) no suit, action, or proceeding to annul, modify, or set aside such determination or assessment shall be enter- tained by any court of the United States. The foregoing applies to all the various kinds of taxes. A question may arise as to whether this section applies only to the 192 1 law. The language is broad enough, however, to cover all previous laws. To bring about such a final determination, there must be (i) an agreement in writing between the taxpayer and the Commissioner, and (2) the agreement must be approved by the Secretary of the Treasury. In case of a corporation a certified copy of the minutes of the board of directors authorizing an of- ficer to sign the agreement must be filed with the Treasury. The agreement should be executed in duplicate. (See article 1141). Aside from the general question as to whether the fore- going section is constitutional, a question may arise as to its breadth. What is meant by "after a determination and assess- ment in any case .... the case shall not be reopened?" What do the words "in any case" and *'the case" include? Generally speaking, the words "any case" or "the case" include only those particular questions under consideration. Such an interpretation would make invalid any agreement be- tween the taxpayer and Commissioner to the effect that no question would be raised by either with reference to the tax return for any particular year or years. The law does not refer to tax returns or vears. ADMINISTRATION, ASSESSMENT AND PAYMENT 21 1 Webster's Dictionary defines the word "case" to mean : "The matters of fact or conditions involved in a suit, as distinguished from the questions of law; a suit or action in law or equity; a cause." Under the sMionyiiis of the same dictionary appear the following- : "Case made, Law, a case stated submitted to the court for a decision on the law without previous proceedings." "Case on appeal, Law, the statement which an appellant lays before the court for the prosecution of his appeal as the presentation of the facts on which the appeal is based." "Case stated, Law, an agreed statement of facts made for presentation to a court in order to obtain a decision of law upon the facts stated." Against the foregoing definitions are the facts which con- fronted Congress when this section was written. Taxpayers have complained that they never know that their tax cases, meaning tax returns, have been finally closed. Arguments have been advanced that this fact has prevented many busi- ness transactions. It is possible that Congress realized that the subject of such a l)road agreement would be too indefinite and vague, and therefore not legal. Final determination of claims. — It is difficult to distin- guish the following [jrovision from section 1312: Law. Section 13 13. That in the absence of fraud or mistake in mathematical calculation, the findings of facts in and the decision of the Commissioner upon (or in case the Secretary is authorized to approve the same, then after such approval) the merits of any claim presented under or authorized by the internal-revenue laws shall not be subject to review by any other administrative officer, employee, or agent of the United States. The foregoing section falls under that division of the law which Congress terms "Administrative Review." It is the 212 APPLICATION AND ADMINISTRATION only section under this division and follows immediately section 13 12. The language of section 13 12, which states that "the case shall not be reopened or the determination and assess- ment modified by any officer, employee, or agent of the United States," should be broad enough to stop all administrative review. It is possible, notwithstanding the heading, that Congress intended this section to apply only to claims filed by the tax- payer. Section 13 12 is confined to "a determination and assessment in any case the taxpayer has without protest paid in wdiole any tax ......... or accepted any abate- ment, credit, or refund based on such determination and assess- ment." It is possible that section 1312 is intended to apply to cases initiated by the government, and section 1313 to cases initiated by the taxpayer. It is significant to note that the conference committee in- serted the word "other" immediately before the phrase "ad- ministrative officer, employee, or agent of the United States." Procedure to reopen a case. — The following ruling applies to cases which have been finally settled by the Treasury. It does not apply to cases closed under sections 13 12 and 13 13 of the new law. Ruling. Where any case in the Bureau of Internal Revenue has been finally closed after the taxpayer, or other party thereto, has had a hearing or has been afforded by written notice an opportunity to present oral or written arguments or statements of fact in support of his contentions, the case will not be reopened except (i) where a showing is made of new and material facts, accompanied by an ex- planation, satisfactory to the Commissioner of Internal Revenue, of the failure to produce such facts prior to the closing of the case, or (2) where the case is materially affected by the change of regula- tions or by the final decision of another case either by the Commis- sioner of Internal Revenue or by a court of competent jurisdiction. The application for reopening a case should be addressed to the Com- missioner of Internal Revenue, should state succinctly the facts and circumstances upon which the application is based, and must be sup- ported by the affidavit of a person having knowledge of the facts. This decision is not to be construed as modifying the regulations ADMINISTRATION, ASSESSMENT AND PAYMENT 213 relating to the filing of claims in abatement or claims for refund, nor as denying the right of a taxpayer to a hearing or to an appeal at any stage of his case until the case has been finally closed. After the taxpayer has exhausted his remedies within the Bureau, how- ever, and the case has been finally closed, it will be reopened only under the conditions stated in the decision. (B. 46-21-1927; T. D. 3240.) Procedure in cases arising prior to T. D. 3269. — Prior to the passage of the 1921 law (November 23, 1921) and the is- suance of T. D. 3269,''" it was contrary to the poHcy of the Treasury to permit an appeal to Committee before assessment. That is, a proposed assessment was not withheld pending an appeal. Consequently, there are many cases pending before the Committee on Appeals and Review. There are others which have been assessed and formal appeal not yet made. The present procedure should not affect any of these cases. Taxpayers were advised to file claims in abatement pending an appeal, ^^ and collectors should be notified by the Secretary of the Treasury to postpone any action looking to collection until final decisions by the Committee are handed down. Claims procedure should be revised. — The word "claiius," as used above, includes claims for abatement, refund, and credit. The procedure of the Treasury should provide for an orderly appeal to the Committee on Appeals and Review in cases where the Unit has ruled adversely on a claim. Hereto- fore in the case of claims for abatement and credit, taxpayers did not know that their claims were denied until collectors de- mand payment. Tn view of the provisions of the 1921 law, all decisions of the Unit should be sent to taxpayers and their right to dissent and appeal made clear. A rule should be made that taxpayers should be notified by letter that the Unit has rejected their claims and that they *'This Treasury Decision now appears as Art. 1006, page 202. "' C. B. 4, page 370; O. D. 709. 214 APPLICATION AND ADMINISTRATION have, say, thirty days, to give notice of appeal to the Com- mittee. If notice of appeal is not filed, collectors may reason- ably demand payment in case of rejected claims for abatement or credit. Until such a rule is promulgated, taxpayers should notify the Treasury when claims are filed that if the decision of the Unit is adverse, the right of appeal to the Committee is re- quested before the claims are formally rejected. Summary proceedings in case of contemplated evasion. — Law. Section 250 (g) If the Commissioner finds that a taxpayer designs quickly to depart from the United States or to remove his property therefrom, or to conceal himself or his property therein, or to do any other act tending to prejudice or to render wholly or partly ineffectual proceedings to collect the tax for the taxable year then last past or the taxable year then current unless such pro- ceedings be brought without delay, the Commissioner shall declare the taxable period for such taxpayer immediately terminated and shall cause notice of such finding and declaration to be given the taxpayer, together with a demand for immediate payment of the tax for the tax- able period so declared terminated and of the tax for the preceding taxable year or so much of said tax as is unpaid, whether or net the time otherwise allowed by law for filing return and paying the tax has expired; and such taxes shall thereupon become immediately due and payable. In any action or suit brought to enforce payment of taxes made due and payable by virtue of the provisions of this subdivision the finding of the Commissioner, made as herein provided, whether made after notice to the taxpayer or not, shall be for all purposes pre- sumptive evidence of the taxpayer's design. A taxpayer who is not in default in making any return or paying income, war-profits, or excess- profits tax under any Act of Congress may furnish to the United States, under regulations to be prescribed by the Commissioner with the approval of the Secretary, security approved by the Commissioner that he will duly make the return next thereafter required to be filed and pay the tax next thereafter required to be paid. The Commissioner may approve and accept in like manner security for return and pay- ment of taxes made due and payable by virtue of the provisions of this subdivision, provided the taxpayer has paid in full all other income, war-profits, or excess-profits taxes due from him under any Act of Congress. If security is approved and accepted pursuant to the pro- visions of this subdivision and such further or other security with respect to the tax or taxes covered thereby is given as the Commis- sioner shall from time to time find necessary and require, payment ADMINISTRATION, ASSESSMENT AND PAYMENT 215 of such taxes shall not be enforced by any proceedings under the provisions of this subdivision prior to the expiration of the time other- wise allowed for paying such respective taxes.''- In the case of a citizen of the United States about to depart from the United States the Commissioner may, at his discretion, waive any or all of the re- quirements placed on the taxpayer by this subdivision. No alien shall depart from the United States unless he first secures from the col- lector or agent in charge a. certificate that he has complied with all the obligations imposed upon him by the income, war-profits, and excess-profits tax laws. If a taxpayer violates or attempts to violate this subdivision there shall, in addition to all other penalties, be added as part of the tax 25 per centum of the total amount of the tax or deficiency in the tax, together with interest at the rate of i per centum per month from the time the tax became due Congress wisely empowered the Commissioner, in cases of intent to evade, to declare all taxes to be due and payable. Persons going abroad must present certificates of compliance. Ruling. In order to obtain income tax clearance, American citi- zens planning to leave the United States are required to present their certificates of compliance or receipts showing payment of in- come tax, at the office of the internal revenue agent in charge at the port of embarkation, rather than to the internal revenue agent at the pier. (C. B. 3, page 301 ; O. D. 666.) The new law gives the Commissioner power to waive this requirement as to citizens of the United States. Collectors have attempted to collect instalments not due from citizens going abroad for a short time. The law was intended only to reach those who attempt to evade payment, and collectors are not empowered to impose unreasonable re- quirements. Aliens departing from the United States must present evi- dence that they have satisfied their income tax obligations. Detailed procedure is set forth in Chapter XXXVI, "Non- Resident Aliens." Many aliens when leaving the United States are classed as non-residents. ^The portion of this subdivision following this point was added to the' provision of the lyiS law. 2i6 APPLICATION AND ADMINISTRATION Certificate of compliance. — Rulings. Certificates of compliance with income tax obligations may be procured either from the office of a collector of internal rev- enue or from the branch office of the collector within the same collec- tion district. The deputy collector or revenue agent acting for the collector will issue the certificates. (C. B. i, page 252; O. D. 324.) Inasmuch as this office has not presj:ribed a form of certificate o"f compliance for the use of resident aliens, a letter or statement from the collector is acceptable to show to the revenue agent at the port of embarkation that the resident alien has satisfied all income tax obli- gations up to date of departure. The letter or statement should set forth the facts that the alien is a subject of (insert name of country), that he is a resident of the United States, satisfactory proof of such claim of residence having been submitted, that he has satisfied all in- come tax obligations for the years 1918, 1919, 1920, and up to date of departure and has satisfactorily proved to the collector that his ab- sence is to be only temporary. This statement should be attached to the duplicate Form 1040-A issued to the alien to be presented to the revenue agent at the . port of embarkation. The duplicate Form 1040-A should contain a notation by the examining officer in the collector's office to the effect that the alien is a resident leaving the United States for a temporary visit abroad. (C. B. 4, page 329; O. D. 840.) The servants of a diplomatic representative of a foreign country should not be examined for income tax purposes when such servants accompany the diplomat upon his departure from the United States. (C. B. 4, page329;0. D. 812.) Consular receipts acceptable. — Ruling. Consular receipts showing payment of United States income taxes through a United States consulate by citizens of this country residing abroad will be accepted by revenue agents at ports of embarkation as evidence of satisfaction of income tax obligations in the case of departure of such citizens who are temporarily in this country. (C. B. 2, page 244; O. D. 500.) Payment Payment may be made in instalments.^^ — The 1921 as well as the 1 9 18 law permits the taxpayer either to divide his tax " The payment of the excess profits tax is made in exactly the same manner as the income tax. (See section 336.) ADMINISTRATION, ASSESSMENT AND PAYMENT 217 into four instalments, spread evenly throughout the year,^* or to pay it in a Uimp sum at the time of fiVmg the return. Law. Section 250. (a) That except as otherwise provided in this section and sections 221 and 237 [payment at the source] the tax shall be paid in four installments, each consisting of one-fourth of the total amount of the tax. The first installment shall be paid at the time fixed by law for filing the return,-^ and the second install- ment shall be paid on the fifteenth day of the third month, the third installment on the fifteenth day of the sixth month, and the fourth installment on the fifteenth day of the ninth month, after the time fixed by law for filing the return. Where an extension of time for filing a return is granted the time for payment of the first installment shall be postponed until the date of the expiration of the period of the extension, but the time for payment of the other installments shall not be postponed unless the Commissioner so provides in grant- ing the extension. In any case in which the time for the payment of any installment is at the request of the taxpayer thus postponed, there shall be added as a part of such installment interest thereon at the rate of K' of I per centum per month from the time it would have been due if no extension had been granted, until paid. If any installment is not paid when due, the whole amount of the tax unpaid shall be- come due and payable upon notice and demand by the collector. The tax may at the option of the taxpayer be paid in a single pay- ment instead of in installments, in which case the total amount shall be paid on or before the time fixed by law for filing the return, or, where an extension of time for filing the return has been granted, on or before the expiration of the period of such extension It should be noted particularly that the extension of time for filing the return ordinarily operates to extend the time of payment of the first instalment only."" Ruling. Where an understatement of the tax in a return is not attributable to negligence or fraud and a taxpayer accordingly fails to pay at least one quarter of the tax due at the time for filing the re turn, he does not lose his right to make installment payments. (C. B. 4, page 317; O. D. 96:.) "[Former Procedure] Under the 1909 and 1913 laws the tax was due June 30; under the 1916 and 1917 laws the tax was due June 15. "The fifteenth day of the third month following the close of the taxable year — March 15 in case the calendar is used. " [Former Procedure] Extension of time for making a return for- merly did not n])cratc to postpone the ])ayincnt of the tax. If an extension carried beyond the regular date of payment, the tax was payable "upon notice and demand." (Reg. 33, 1918, Art. 230.) 2i8 APPLICATION AND ADMINISTRATION Notice of payment due. — The law states that the tax "shall be paid" at dates fixed by section 250 (a) quoted above, but penalties cannot be imposed until notice and demand has been made in accordance with the following: Law. Section 250 (e) .... In the case of the first installment provided for in subdivision (a) the instructions printed on the return shall be sufficient notice of the date when the tax is due and sufficient demand, and the taxpayer's computation of the tax on the return shall be sufficient notice of the amount due. In the case of each subsequent installment the collector may, within thirty days and not later than ten days before the installment becomes due, mail to the taxpayer notice of the amount of the installment and the date on which it is due for payment. Such notice of the collector shall be sufficient notice and sufficient demand under this section Subdivision (h) of this section makes this change retro- active with respect to the 191 7 and 19 18 laws. The foregoing is an enactment of T. D. 3136^' in which the 1918 law was erroneously interpreted. This section of the law was intended to cure one of the known defects of the 1918 law which the Department attempted to change by regula- tion.^^ The author knows of at least one case where payment was withheld in order to test the regulations, but the Depart- ment would not assess the penalty. There is no advantage in waiting for notice from the col- lector on the second and third instalments. Subdivision (a) of section 250, which fixes the dates when the instalments must be paid, provides that "if any installment is not paid when due, the whole amount of the tax unpaid shall become due and payable upon notice and demand by the collector." In the case of the fourth instalment the taxpayer can post- pone payment until he receives notice in accordance with sec- tion 250 (e). No penalty or interest can be assessed until proper notice has been given. Additional notice in cases of absence. — The Treas- ury recognizes that "by reason of absence in foreign countries " C. B. 4, page 316. " See Income Tax Procedure, 1921, for procedure under 1918 law, pages 178-183. ADMINISTRATION, ASSESSMENT AND PAYMENT 219 or on account of traveling abroad, or of absence from their homes or places of business in the military or other service of the country, and the consequent delay in receiving mail, it is impossible for many individuals to receive notice and de- mand on form 17 and make payment of the taxes assessed thereon so that such taxes can be received by the collector within the ten-day period." In such cases additional time is allowed. Regulation By reason, however, of the absence from home or place of business in a foreign country or in the military or other service of the country and the consequent delay in receiving mail, or by reason of the location of the residence of an individual or of the office of a corporation to which the notice was addressed at a distance from the collector's office, it is frequently impossible for a taxpayer to receive notice and demand and to make payment of the tax so that such payment may be received by the collector within the lo-day period (following the service of notice and demand). In all such cases the collector will enter on the notice as the date on which the tax becomes due and payable a date as nearly as possible 10 days after the time that the notice should be received in the ordinary course of the mails by the taxpayer. In such cases where it is established that a remittance for the tax was placed in the mails within the lo-day period after the due date specified in the notice, and tardiness was oc- casioned because the notice was not delivered in due time by reason of delay in the mail and satisfactory evidence of that fact is furnished, the penalty and interest will not be collected. (Art. 1007.) A few immaterial changes have been made in this article. Ruling. A taxpayer having filed his return and paid the first installment of tax is aware of his liability to pay the balance of the tax on the respective due dates, and failure to receive notice and de- mand for the payment of the later installments by reason of his ab- sence from this country does not constitute a sufficient cause for waiv- ing the penalty and interest on any installment of the tax not paid when due. (C. B. 2, page 236; O. D. 408.) Notice required in all cases. — It appears that some col- lectors are too arbitrary in their demands for additional re- turns, collection of additional taxes, etc. Taxpayers may be assured that precipitate action is illegal. Reasonable notice of any proposed action must be given or the act is illegal, because 220 APPLICATION AND ADMINISTRATION it is in violation of the constitutional guarantee of due process of law.'^ The courts have held that as a general principle of law a proceeding for the assessment of property for taxation is judicial in its character, and in order to assure its validity the law authorizing it must provide some kind of notice.^" The law binds the Commissioner and the collectors to give ample notice of all proceedings, including the im.position of penalties. The notices must allow sufficient time to the tax- payer to produce evidence supporting his original returns, or to pay within the statutory time of lo days after formal demand. Method of calculating interest. — Ruling, (a) Where interest is collectible at the rate of i per cent per month from the due date interest must be collected for the fractional part of a month where the tax is not paid within lo days from notice and demand for payment. (b) Under sections 502, 504, 629, 903, and 905/^ interest is col- lectible at the rate of i per cent for each full month, and fractional parts of a month must be disregarded. (c) Interest is collectible from the month tax becomes due. (C. B. I, page 244; O. 884.) Who pays the tax w^hen a corporation liquidates? — The question as to who shall pay the tax in case a corporation is dissolved is satisfactorily answered in the following regula- tions :*' Regulations. A corporation going into liquidation during any tax period may, at the time of such liquidation, prepare a "final re ■ " See Alex. M. Hamburg, "Limitations upon the Federal Taxing Power," 3 National Tax Association Bulletin, pages 34-39. *" County of Santa Cla7-a v. Southern Pacific Railway Co., 18 Fed. 385; judgment affirmed, 118 U. S. 394; 30 L. Ed. 118; 6 Sup. Ct. 11 32. " Section 502 relates to taxes due on transportation and telegraph, etc., service ; section 504, to taxes due on insurance policies issued ; section 629 ; to taxes due on soft drinks ; sections 903 and 905, to taxes due on luxuries. In the detailed ruling by the Treasury, it is stated: "Heretofore this office has held repeatedly that no interest for a fraction of a month shall be demanded." " See also C. B. 4, page 262; O. D. 768. Also C. B. 4, page 279; O. D. 821. ADMINISTRATION, ASSESSMENT AND PAYMENT 221 turn" covering the income received or accrued to it during the frac- tional part of the year during which it was engaged in business, and immediately file the same with the collector of the district in which the corporation has its principal place of business. Before distributing its assets, a dissolving corporation should reserve funds sufficient to pay any income tax assessable against it. Otherwise the tax may be collected by suit against the stockholders. (Reg. 33, 1918, Art. 612.) When a corporation is dissolved, its affairs are usually wound up by a receiver or trustees in dissolution. The corporate existence is continued for the purpose of liquidating the assets and paying the debts, and such receiver or trustees stand in the stead of the corpora- tion for such purposes. Any sales of property by them are to be treated as if made by the corporation for the purpose of ascertaining the gain or loss (Art. 548; Reg. 45, Art. 547.) A federal coiirt*'^ has recently held that collection by dis- traint, of taxes assessed by a collector ex parte against a long since dissolved corporation, the business being continued by the former stockholders as a partnership (Pennsylvania), and the property against which the collector is proceeding being that of the partnership, may not be enjoined by the members of the partnership, they being taxable persons and the property itself being such as to be liable to distraint for any tax assessed against them. It was held that a corporation which liquidated in 19 17 before the passage of the 191 7 law was nevertheless liable to taxation under that law.** Similarly the Treasury expressly declared that a corporation liquidating in 1918 or early in 1919 was subject to the rates imposed by the new act of 1918, even though it was not passed until 19 19. Regulation A corporation which was dissolved in 1921 prior to the enactment of the present statute is not relieved from the necessity of rendering returns thereunder for such portion of 1921 as elapsed before its dissolution (Art. 621.) It is, of course, important to consider the liability for taxes whenever a corporation liquidates, but it is difficult to provide for a liability so uncertain as subsequent tax legisla- ' Markle et al. v. Kirkendall, 267 Fed. 498. ' U. S. V. McHatton et al., 266 Fed. 602. 222 APPLICATION AND ADMINISTRATION tion. In Brady v. Anderson^^ the estate was not settled when the law of 19 13 was passed. But a corporation which dis- solved, say, in February, 19 18, could hardly foresee the exact liability to be incurred under a law which was not passed until a full year later. In the meantime the corporation might have dissolved as it had a legal right to do. It was willing to set aside all taxes accrued under existing laws. To assess a tax in 1919 under a law passed in February, 1919, on a corpora- tion which was dissolved in February, 1918, would certainly appear to be reviving a dead corporation.*" Ruling. Where a corporation dissolves and disposes of its as- sets without making provision for the payment of its accrued Federal income tax liability for the tax follows the assets so distributed, and upon failure to secure the unpaid amount suit to collect the tax should be instituted against the stockholders and other persons receiving the property, except bona fide purchasers for a valuable consideration. The penalties prescribed in section 253 of the Revenue Act of 1918 will attach to the principal officers of the corporation upon failure to comply with the provisions of that section. (C. B. 3, page 300; O. D. 597.) The foregoing conforms with a recent court decision. Stockholders of a corporation, who received in distribution the entire proceeds of its property on its dissolution in 1916, after payment of its federal excise tax, but before the passage of the Income Tax Act of September 8, 1916, increasing the amount of the tax on the net income of all corporations for that year, were held liable for the increased tax.*® A stockholder received a liquidating dividend in 191 7. It was found that the distribution was excessive because federal taxes had not been sufficiently paid. Held, that the stock- holder may file an amended return for 19 17 deducting the assessment paid in 1920. (I-3-27; I. T. 1164.) Receivers personally responsible — when? — In the case of Pennsylvania Cement Company and Bradley Constructing "240 Fed. 665; 153 C. C. A. 463. ■"' See "Retroactive legislation," page 21. *' U. S. V. Mcllailon, 266 Fed. 602. ADMINISTRATION, ASSESSMENT AND PAYMENT 223 Company {2.y^ Fed. 1003), receivers were directed not to declare a dividend to creditors before federal taxes had been adjusted, because they could be held personally responsible for the taxes under sections 3466 and 3467 of the Revised Statutes. Delinquent assessment payable "upon notice and de- mand." — Law. Section 250 (c) If the return is made pursuant to section 3176*8 of the Revised Statutes as amended, the amount of tax determined to be due under such return shall be paid upon notice and demand by the collector Erroneous or illegally assessed taxes must be paid. — In all cases it must be remembered that the tax levied by the col- lectors must be paid if (after an appeal to the Commissioner) the assessment is confirmed, even if it is clearly in error. The United States Supreme Court has held that Congress has af- forded a complete and adequate remedy at law open to all per- sons aggrieved by the collection of an erroneous or illegal revenue tax, and that the taxpayer must pay the tax and may then bring an action to recover it after appeal. The Supreme Court has affirmed this old rule under the income tax laws. In a fairly recent case*° the court reiterated the provision in section 3224, Revised Statues, that "no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court."^° In a pending case in Delaware a taxpayer is attempting to enjoin a collector from collecting a tax imposed for the year 191 5, on the ground that no assessment was made or suit com- menced prior to March i, 192 1, that date being five years after the 191 5 return was filed. ■"Section 3176 deals with the subject of false and fraudulent returns and is quoted on page 136. *' Dudge v. Oshorn, Commissioner 240 U. S. 118; 36 Sup. Ct. 275; 60 L. Ed. 557 (February 21, 1916). '" See page 250. 224 APPLICATION AND ADMINISTRATION Media of payment. — Payment may be made by mailing uncertified CHEQUES. — Taxes may be paid to the collector by cheque and should be mailed at least a day or two before the date fixed for payment. During the last few days of the payment period many taxpayers pay in person at the offices of the collectors, and this causes congestion and long delays. The use of the mails is, therefore, preferable and is on the whole trustworthy. Until the enactment of the 191 7 law, practically all taxes were paid by certified cheques. The law^^ now authorizes the collectors of internal revenue to accept uncertified cheques in payment of income and excess profits taxes. Cheques should be made payable to "Collector of Internal Revenue at (City), (State)" and be made collectible at par without deduction for exchange. Ruling. A taxpayer who tenders a check whether certified or uncertified in payment for taxes is not released from his obligation until the check is paid. Where such a check is lost in the mails, a Collector of Internal Revenue is not required, as a condition prece- dent to the issuing of a duplicate check by a taxpayer, to furnish bond indemnifying him against possible loss in connection with the first check. (C. B. 3, page 371 ; O. D. 626.) Payments in treasury notes or certificates of in- debtedness. — L.\w. Section 132V That collectors may receive, at par with an adjustment for accrued interest, notes or certificates of indebtedness issued by the United States .... in payment of income, war-profits and excess-profits taxes and any other taxes payable other than by stamp,'- .... This practice was begun in 19 17." The purchase of certificates of indebtedness affords a con- venient and economically sound method of providing in ad- '' Section 1325. See also Art. 1733. [Former Procedure] The 1917 law (section loio) was the first to authorize collectors to accept uncertified cheques in payment of taxes. (See T. D. 2627 and 2666.) °"' With exception of the words "notes or" after the words "accrued interest," this section is the same as section 1314 of the 1918 law. " Section lOio, 1917 law. ADMINISTRATION, ASSESSMENT AND PAYMENT 225 vance for taxes. They may be purchased at par, they bear interest at a fair rate and mature at various dates. Tax- payers can accumulate the certificates, as funds are available, at any time before the tax payments are due and on the due dates present them with the tax bills. In the meantime in- terest will have accrued. The latest available instructions relative to the acceptance of certificates of indebtedness are as follows : Regulations. Collectors of internal revenue are authorized and directed to receive at par United States Treasury certificates of in- debtedness of series TM-1922 dated March 15, 1921, series TM-2, 1922, dated August i, 1921, and series TM-3, 1922, dated September 15, 1921, all maturing March 15, 1922, in payment of income and profits taxes payable on March 15, 1922- Treasury certificates of indebted- ness of series TJ-1922, dated June 15, 1921, and series TJ-2, 1922, dated December 15, 1921, both maturing June 15, 1922, in pay- ment of income and profits taxes due on June 15, 1922; series TS- 1922, dated September 15, 1921, TS-2, 1922, dated November i, 1921, both maturing on September 15, 1922, in payment of income and profits taxes payable on September 15, 1922; and TD-1922, dated December 15, 1921, maturing on December 15, 1922, in payment of income and profits taxes payable on December 15, 1922. Col- lectors are further authorized and directed to receive at par, in payment of income and profits taxes payable at the ma- turity of the certificates, respectively, Treasury certificates of indebtedness of any other series which may be issued ma- turing on March 15, June 15, September 15, or December 15, 1922. Collectors are not authorized hereunder to receive in payment of income or profits taxes any Treasury certificates of indebtedness not expressed to be acceptable in payment of income and profits taxes^ nor any Treasury certificates maturing on a date other tlian the date on which the taxes are payable. Collectors are authorized to receive Treasury certificates of indebtedness which are acceptable as herein provided in payment of income and profits taxes in advance of the respective dates on which the certificates mature. Treasury cer- tificates acceptable in payment of income and profits taxes have one or more interest coupons attached, including as to each series a coupon payable at the maturity of the certificates, but all interest coupons must in each case be detached by the taxpayer before presentation to the collector, and collected in ordinary course when due. The amount, at par, of the Treasury certificates of indebtedness presented by any taxpayer in payment of income and profits taxes must not exceed the amount of the taxes to be paid by him, and collectors shall in no case 226 APPLICATION AND ADMINISTRATION pay interest on the certificates or accept them for an amount other or greater than their face value. (Art. 1731.) .... Collectors of internal revenue are not authorized, unless express instructions otherwise are given by the Secretary of the Treasury, to receive in payment of income or profits taxes interim receipts issued by Federal reserve banks in lieu of definitive certificates of the series herein described For the purpose of saving taxpayers the expense of transmitting such certificates as are held in Federal reserve cities or Federal re- serve branch-bank cities to the ofiice of the collector in whose district the taxes are payable, taxpayers desiring to pay income and profits taxes by such Treasury certificates of indebtedness acceptable in pay- ment of taxes, should communicate with the collector of the district in which the taxes are payable and request from him authority to de- posit such certificates with the Federal reserve bank in the city in which the certificates are held. Collectors are authorized to permit deposits of Treasury certificates of indebtedness in any Federal re- serve bank with the distinct understanding that the Federal reserve bank is to issue a certificate of deposit in the collector's name cover- ing the amount of the certificates of indebtedness at par and to state on the face of the certificate of deposit that the amount represented thereby is in payment of income and profits taxes. The Federal re- serve bank should forward the original certificate of deposit to the Treasurer of the United States, with its daily transcript, and trans- mit to the collector the duplicate and triplicate, accompanied by a statement giving the name of the taxpayer for whom the payment is made in order that the collector may make the necessary record and forward the duplicate to the office of the Commissioner of Internal Revenue. (Art. 1732.) Victory notes in coupon form accepted for income AND PROFITS TAXES PAYABLE MaRCH 1 5, 1^22. Collectors of Internal Revenue are authorized and directed to re- ceive at par Victory notes of either the 4% per cent or the 3% per cent series, in coupon form, in payment of income and profits taxes pay- able on March 15, 1922. Registered Victory notes are not acceptable. Coupon Victory notes tendered in payment of income and profits taxes payable March 15, 1922, must have all unmatured interest coupons attached (that is to say, coupons for June 15 and December 15, 1922, and May 20, 1923), but all matured coupons must be de- tached and collected in ordinary course when due. The amount, at par, of the Victory notes presented by any taxpayer in payment of income and profits taxes must not exceed the amount of the taxes to be paid by him, and collectors shall in no case pay interest on the notes or accept them for an amount other or greater than their face ADMINISTRATION, ASSESSMENT AND PAYMENT 227 value. Accrued interest on the notes accepted, from December 15, 1921, to March 15, 1922, will be remitted to the taxpayer by the Federal Reserve Bank with which the collector makes his deposits, on the basis of the schedules furnished by the collector. Receipts given by collectors to taxpayers should show the amount of notes of each series received in payment of taxes (T. D. 3281, dated February 7, 1922.) Commissioner may extend date of payment. — The new law permits the Commissioner, under certain condiiions, to extend the date of payment of additional assessments. Law. Section 250 (f) In the case of any deficiency (except where the deficiency is due to negligence or to fraud with intent to evade tax) where it is shown to the satisfaction of the Com- missioner that the payment of such deficiency would result in undue hardship to the taxpayer, the Commissioner may, with the approval of the Secretary, extend the time for the payment of such deficiency or any part thereof for such period not in excess of eighteen months from the passage of this Act as the Commissioner may determine. In such case the Commissioner may require the taxpayer to furnish a bond with sufficient sureties conditioned upon the payment of the deficiency in accordance with the terms of the extension granted. There shall be added in lieu of other interest provided by law, as a part of such deficiency, interest thereon at the rate of two-thirds of i per centum per month from the time such extension is granted; except where such other interest provided by law is in excess of interest at the rate of two-thirds of i per centum per month. If the deficiency or any part thereof is not paid in accordance with the terms of the extension granted, there shall be added as part of the deficiency, in lieu of other interest and penalties provided by law, the sum of 5 per centum of the deficiency and interest on the deficiency at the rate of I per centum per month from the time it becomes payable in accord- ance with the terms of such extension Subdivision (h) of this section provides that the above shall also apply to any assessments which may be made imder the 1917 and 1918 laws. Regulation. Section 250 (f) of the Revenue Act of 1921 con- tains a special relief provision which will be in effect for only eighteen months after November 23, 1921, the date of the passage of the Act. . It provides that in the case of any deficiency in tax ' revealed on the examination of an income or profits tax return (except ■ where the deficiency is due to negligence or to fraud with intent to evade tax) where it is shown to the satisfaction of the Commis- 228 APPLICATION AND ADMINISTRATION sioner that the payment of such deficiency would result in undue hardship to the taxpayer, the Commissioner may, with the approval of the Secretary, extend the time for the payment of such deficiency or any part thereof for a period not to extend beyond i8 months from November 23, 1921. Where such an extension is granted there is to be added as part of the deficiency in lieu of other interest pro- vided by law, interest at the rate of two-thirds of I per cent per month from the time the extension is granted. Where such other interest provided by law, however, is in excess of two-thirds of I per cent per month the higher rate will be charged. If the deficiency or any part thereof is not paid in accordance with the terms of the ex- tension agreement, there is to be added as part of the deficiency, in lieu of other interest and penalties provided by law, the sum of 5 per cent of the deficiency together with interest on the deficiency at the rate of i per cent per month from the time it became payable under the terms of the extension agreement. The extension will be granted only in case the taxpayer establishes to the satisfaction of the Com- missioner that without such extension undue hardship will result to the taxpayer. The term "undue hardship" means more than an incon- venience to the taxpayer. It is defined as meaning that substantial financial loss or sacrifice will result to the taxpayer from making payments of the deficiency at the due date. This provision of the statute is applicable only to deficiencies in taxes which have accrued or may accrue under the Revenue Act of 1917, the Revenue Act of 1918, or the Revenue Act of 1921, and the deficiency referred to is only such deficiency in tax as is revealed on the examination of an income or profits tax return. It has no application to deficiencies in taxes other than deficiencies in income and profits taxes under the three Acts named. No extension of time may be granted under sub- division (f) of section 250 for the payment of any regular install- ment of tax due as showing by the original return of the taxpayer. Any application for the extension must be made under oath on Form 1 127''* in accordance with instructions printed thereon and must be accompanied by evidence showing that undue hardship to the taxpayer would result if the extension were refused. The ex- tension will not be granted on a general statement of hardship, but in each case there must be furnished a statement of the specific facts showing what, if any, financial loss or sacrifice will result if the ex- tension is not granted. Teh application should, whenever practicable, contain a certified statement of assets and liabilities of the taxpayer. The application, with the evidence, must be filed with the collector, who will at once transmit it to the Commissioner with his recom- mendations as to the extension. When it is received by the Com- missioner it will be examined and within thirty days either rejected or tentatively approved. See Appendix B. ADMINISTRATION, ASSESSMENT AND PAYMENT 229 Where the application is tentatively approved and a bond is re- quired it must be filed with the collector within 10 days after the noti- fication by the Commissioner that a bond is required. It shall be conditioned for the payment of the deficiency and applicable penalties, if any, and interest in accordance with the terms of the extension to be granted and shall be executed by a surety company holding a certificate of authority from the Secretary of the Treasury as an acceptable surety on Federal bonds and shall be subject to the approval of the Commissioner. In lieu of such a bond the taxpayer may file a bond secured by deposit of Liberty bonds or other bonds or notes of the United States equal in their total par value to the amount of the deficiency and applicable penalties, if any, and interest, as provided in section 1329 of the Revenue Act of 1921. (Art. 1014.) If collectors insist on surety bonds in all cases, the "relief" will be barren because most taxpayers who cannot pay are also unable to comply with the requirements of surety com- panies. If taxpayers are able to furnish bond, that fact alone should make the filing of bonds unnecessary. The United States has a first lien on the property of tax- payers and this is reasonable protection. It is not fair to creditors whose claims are subordinate, that surety bonds be demanded when taxpayers are unable to furnish them. Receipts for taxes paid. — The law requires collectors to give receipts only when requested to do so by taxpayers. Law. Section 251. That every collector to whom any payment of any tax is made under the provisions of this title shall upon re- quest give to the person making such payment a full written or printed receipt, stating the amount paid and the particular account for which such payment was made; and whenever any debtor pays taxes on ac- count of payments made or to be made by him to separate creditors the collector shall, if requested by such debtor, give a separate receipt for the tax paid on account of each creditor in such form that the debtor can conveniently produce such receipts separately to his several creditors in satisfaction of their respective demands up to the amounts stated in the receipts; and such receipt shall be sufficient evidence in favor of such debtor to justify him in withholding from his next pay- ment to his creditor the amount therein stated; but the creditor may, upon giving to his debtor a full written receipt acknowledging the pay- ment to him of any sum actually paid and accepting the amount of tax paid as aforesaid (specifying the same) as a further satisfaction of the debt to that amount, require the surrender to him of such collector's receipt. 230 APPLICATION AND ADMINISTRATION Ruling Receipts are documents required by provisions of the internal revenue laws and by regulations made in pursuance thereof, within the meaning of section 3451, Rev. Stat., making it an offense to simulate or falsely or fraudulently execute or sign any docu- ment required by the internal revenue laws, or any regulation made in pursuance thereof, or to procure the same to be falsely or fraudu- lently executed, or to advise, aid in, or connive at such execution thereof The offense may be committed either where the receipt itself is a genuine receipt of the kind kept for that purpose in the office of the internal revenue collector but signed by the defendant without au- thority, or where, even if not a blank of the kind required to be kept, the. blank itself is simulated or falsely or fraudulently executed and issued by a person who has no power or authority to do so (T. D. 2874, June 23, 1919.) The author is informed that some taxpayers have not re- ceived receipts although specific requests were made for them, and that such failure has caused great inconvenience when tax- payers have gone abroad. Moreover, inconvenience is often caused by the lack of receipts when taxpayers file claims for refund. If receipts are not available to accompany claims, photostated copies of paid cheques should be used. Collection of Taxes by Suit and Summary Process In view of the possibility that during the coming year certain taxpayers may be unable to pay the tax assessed upon them, it may be of interest to include the articles of the regu- lations dealing with collection by suit and by summary process peculiar to United States practice. Collection by suit. — ^^Obviously the government will not resort to an action at law if taxes can be collected by sum- mary assessment followed by distraint on the property of the taxpayer. In the latter case the government "gets the money," in the former case a long period of time elapses before the action can be tried and in very many cases the government fails in its action. Therefore taxpayers who have meritorious cases cannot be criticized for not signing waivers in order to ADMINISTRATION, ASSESSMENT AND PAYMENT 231 enable the government to force the collection of taxes illegally assessed. If the taxpayer agrees that the additional tax is due, the waivers should be signed, but not otherwise.^^ Specific and not blanket waivers should be signed. Under the 19 17 and prior laws there was no limitation on the time within which the government could bring suit. The 19 1 8 law provided that, except in the case of fraud, suit had to be brought within five years from the time when the return was due. The 1921 law has made some radical changes with reference to limitation. There is now a limitation period both as to suits and assessments^*^ for all laws. Suits for taxes barred after five years. — Law. Section 1320. That no suit or proceeding for the collection of any internal revenue tax shall be begun after the expiration of five years from the time such tax was due, except in the case of fraud with intent to evade tax, or willful attempt in any manner to defeat or evade tax. This section shall not apply to suits or proceedings for the collection of taxes under section 250 of this Act, nor to suits or proceedings begun at the time of the passage of this Act. The foregoing section applies to all internal revenue taxes. While included in the 192 1 law, it also covers all prior laws. Collection of tax by distraint. — The Revised Statutes" authorize collectors- to collect taxes by distraint and sale. The following regulation summarizes sections 3187 and 3196 of the Revised Statutes : Regulation. If any person lia1)lc to pay any taxes neglects or refuses to pay them within ten days after notice and demand, it shall be lawful for the collector or his deputy to collect such taxes with 5 per cent additional and interest at 12 per cent per annum by distraint and sale of the goods, chattels or effects, including stocks, securities, and evidences of debt, or other property or rights of property, of the person delinquent. When goods, chattels, or effects sufficient to satisfy the taxes and penalties imposed upon any person are not found by 'For discussion of legality of waivers, see footnote 20, page 199. ' See page 195. Sections 3187 to 3196, inclusive. 232 APPLICATION AND ADMINISTRATION the collector or deputy collector, he is authorized to collect such taxes by seizure and sale of real estate (Art. 1009.) Rulings. The property of one spouse is not subject to distraint to enforce payment of an income tax obligation of the other spouse unless there has been a transfer of property from one spouse to the other after a tax has been assessed and demand made for pay- ment thereof. (B. 40-21-1856; O. D. 1056.) Property possessed by a taxpayer at the time a lien for tax at- tached under section 3186, R. S., is subject to distraint for the col- lection of the tax and interest in the hands of a person who acquired it by reason of his death. (B. 51-21-1986; O. D. 1144.) Enforcement of tax lien by bill in equity. — The govern- ment may secure a lien for unpaid taxes. The following regu- lation outlines the procedure which must be followed under section 3186 of the Revised Statutes: Regulation. In the event of nonpayment of a tax and penalties after demand, the amount becomes a lien in favor of the United States from the time when the assessment list was received by the collector upon all property and rights to property belonging to the taxpayer, except that the lien is not valid as against any bona fide mortgagee, purchaser, or judgment creditor until notice thereof is filed in the proper public office or offices on Form 668. The collector may file such notice of lien upon making demand for payment of the tax, unless payment is made immediately upon demand. What is im- mediate payment will depend upon the nature of the demand. Where the collector contemplates filing such notice of lien on demand, when- ever practicable, the demand should be made upon the taxpayer in person. In any case where there has been refusal or neglect to pay the tax and it has become necessary to seize and sell real estate to satisfy it, a bill in equity may be filed in a district court of the United States to enforce the lien of the United States for tax upon any real estate in which the delinquent has any right, title, or interest subject to the lien. This remedy does not supersede distraint but is cumulative. (Art. loio.) The district courts of the United States are invested with jurisdiction to render such judgments and decrees, both in law and in equity, as may be necessary or appropriate for the enforcement of the provisions of the law.^* "Section 1318. ADMINISTRATION, ASSESSMENT AND PAYMENT 233 Compromise of taxes and penalties. — Section 3229 of the Revised Statutes gives the Commissioner power to compro- mise cases of taxes and penalties both before and after suit has been commenced. The nature and extent of this power are explained in the following regulation. Regulation. The Commissioner, with the advice and consent of the Secretary of the Treasury, may compromise any civil or crim- inal case arising under the internal revenue laws instead of commenc- ing suit thereon, and with the advice and consent of the Secretary and the recommendation of the Attorney General may compromise any such case after suit thereon has been commenced by the United States. Accordingly, the power to compromise extends to (a) civil and criminal cases; (b) cases whether before or after suit; and (c) taxes and penalties, except that taxes legally due from a solvent taxpayer may not be compromised. Refunds can not be made of accepted offers in compromise in cases where it is subsequently ascertained that no violation of law was involved (Art. loii.) A letter, similar in content to the following, suitably modi- fied if the delinquent was a corporation, has been used in the past by the collectors in charging taxpayers with delinquency and in notifying them of their privilege to submit offers in compromise. Sir: Your return of net income was not received in this office until , thereby involving you in liability to a specific penalty of not less than $20.00, or more than $1,000, under the act of , in addition to the 50 per cent additional tax which will be assessed and collected. The provisions of the act are mandatory, and no excuse or ex- planation can be accepted, except a showing that a complete or tenta- tive return was in fact mailed in time to have reached this office, or a Deputy Collector, in the ordinary course of business on or before March i, However, before instituting proceedings in court for the imposi- tion of the specific penalty, I am directed to call your attention to the provisions of section 3229, revised statutes, which reads in part as follows : "The Commissioner of Internal Revenue with the advice and consent of the Secretary of the Treasury, may compromise any civil or criminal case arising under the internal revenue laws instead of commencing suit thereon, . . . ." Should you desire to take advantage of your privilege under this 234 APPLICATION AND ADMINISTRATION section and to submit an offer in compromise, the amount offered should be forwarded promptly to this office in the form of cash, pos- tal money order, or certified check which can be cashed without cost, payable to my order, accompanied by an affidavit substantially in the following form: "To the Commissioner of Internal Revenue: "I hereby solemnly swear (or affirm) that my delinquency in filing return of net income as required by the act of was not due to any intent to violate the law or evade taxation, but was due to (here insert, concisely and clearly, the reason for delay). "Desiring to compromise my liability I hereby tender the sum of $ , which I request be accepted in compromise of the specific penalty only." To be signed and sworn to before a deputy collector, notary, or other officer authorized to administer oaths. This affidavit will then be forwarded by me, together with the sum offered, to the Commissioner for consideration, and you will be notified by him of his acceptance or rejection of your proposal. In the latter event, you may increase your offer, if you so desire. In an opinion dated June 3, 1919,°^ the United States At- torney General held that claims falling in the following classes may be compromised by the Commissioner whenever, in his judgment, such compromises are for the interest of the United States : Claims for sums of 5 per cent on amounts of income and excess- profit taxes not paid when due and interest at the rate of i per cent per month on said taxes, the collection of which is authorized by sec- tions 9(a) and 14(a) of the act of September 8, 1916, and section 212 of the act of October 3, 1917. The Treasury has also held in a law opinion*'" that an ad valorem fraud penalty "may at any stage be compromised by the Commissioner and the approving officials, whether or not it be formally assessed." "31 Op. Alt. Gen. 459. "^ Bulletin 41-21-1864; L. O. 1072. CHAPTER IX APPEALS, REFUNDS AND ABATEMENTS OF OVER-ASSESSMENTS The preceding chapter deals with the administrative pro- cedure in connection with assessments and payments of taxes. This chapter deals with the remedial procedure provided by the Treasury or the courts whereby the taxpayer may abate the assessment and either secure a cancellation of the assessment or obtain a refund of taxes overpaid. Prior to the passage of the 1921 law, the Treasury acted on the theory that additional assessments should be made as soon as possible, usually upon the recommendation of the audit section/ in order that interest would commence to accrue to the government. The present law should bring about a reversal in the policy of the Treasury. Additional assessments for the taxable year 192 1 and subsequent years will bear interest at the rate of 6 per cent per annum from the time the tax was originally due.^ Proposed additional assessments should be carefully con- sidered before demand for payment is made. The new law also provides that interest shall be paid on taxes illegally col- lected and later refunded.^ The policy of the Treasury prior to 1922 in making assess- ments of additional taxes before final decisions, had the in- evitable result — the majority of taxpayers filed claims in abate- ment instead of paying the assessments. The Treasury recog- nized that the claim in aljatcmcnt evil had grown to serious proportions. ' See Income Tax Procedure, 1921, page 171. ' Section 250 (b). ° Section 1324. 236 Al'PLlCATION AND ADMINISTRATION The great defect has been that taxpayers inevitably gained the iinpression that conferees had little discretion and that the assessment would be made as a matter of course. A sharp distinction should be drawn between the work of an auditor, whether done in the field or in the office, and the work of the conferees. The auditors, in effect, must attempt to assess the maximum amount of tax which under any interpretation of the regulations can be assessed. The conferees, however, should act as disinterested judges.* The hearings before the conferees should be as impartial as those before the Committee. Subdivision (d) of section 250 permits an appeal to the highest body in the Treasury before assessment. This sub- division provides that after a taxpayer has been notified of a proposed additional assessment, he shall be given "a period of not less than thirty days .... in which to file an ap- peal." This subdivision further provides that, "Opportunity for hearing shall be granted and a final decision thereon shall be made as quickly as practicable." These two changes should result in more deliberate action by the Treasury in the assessing of additional taxes. ^ Importance of filing claims. — The preceding chapter fully covers appeals from the findings of revenue agents, and in general all remedial measures up to the time of- assessment. After an assessment has once been entered on the collectors' lists, there is no recourse except by a claim for abatement (be- fore the tax is paid)*^ or refund (after the tax is paid). Many of the additional assessments following examina- tions of taxpayers' returns are based upon erroneous conclu- sions drawn by examiners, which the courts would promptly reverse if the taxpayers brought suit. But suits at law are so expensive, or are thought to be, and delays and postponements * For discussion of procedure of Income Tax Unit, see page 174. ° See page 241. ' Qaims for abatement may now be filed in only a few instances. See page 242. APPEALS, REFUNDS, ABATEMENT 237 are so frequent and annoying, that most of those reassessed pay even when they are sure of the injustice of the tax. Because of the many erroneous assessments which have been made, taxpayers should be informed as to the details of steps to be taken to question an assessment. If a claim is refused, the necessary procedure to secure from the courts an impartial opinion as to the sufficiency of the taxpayer's side of the contention should be understood. Until the case reaches the courts it cannot always be said that the facts are passed upon impartially.^ Many of the inequalities which existed under past practice were due to the thought on the part of those administering the law that there was no middle ground. Any doubtful point, no matter how great an injustice it might work, was decided against the' taxpayer. During recent years the Treasury has, however, shown some improvement in this respect. It is probable that many court decisions will be required before the rights of taxpayers are fully protected. In the meantime, all legal formalities should be observed by tax- payers so that they may secure the benefit of any future deci- sions which reverse past rulings of the Treasury. Taxpayer's right to question assessment. — Vast numbers of persons pay too much tax for a variety of reasons: igno- rance ; the desire to overpay rather than to underpay ; the tend- ency to follow Treasury rulings even though obviously il- legal; fear of penalties; fear that failure to pay will be called unpatriotic; and many others. In view of the fact that in a democracy the people are supposed to be sovereign and public officers their servants, this tendency is hard to understand. It probably results from the disinclination of the average well-to-do American to go to any trouble about overcharges of any kind. He will pay a cab driver an extortionate fare rather than question the rate. He will tip an insolent and 'For appeals to tlie Committee of Appeals and Review, see page 175 et scq. 238 APPLICATION AND ADMINISTRATION inefficient waiter rather than be looked at unkindly or spoken to offensively. It is so with taxes. But there should be a change. Public officers, at least those in Washington, are not to blame. An effort has been made to render the remedy of an aggrieved taxpayer as inexpensive and as little troublesome as possible. Taxpayers who refuse to acquaint themselves with the reme- dies and means for correcting erroneous assessments have only themselves to blame. Right to question Treasury rulings. — Regarding the taxpayer's right to question rulings and assessments, the fol- lowing authoritative quotation is pertinent : And it follows that it will be a legitimate mode of construing the present income tax law, in cases where its language in relation to a particular point or subject is obscure, confusing, or unintelligible, to compare it with the corresponding provisions on the same point in the earlier acts, which may be more clear and precise, and to presume that Congress intended its words to be understood in the same sense as before, unless there is such a distinct change of language as to compel the inference that a change in legislation was certainly in- tended.* Also the following quotations from decisions of the United States Supreme Court are of interest. The first quotation is taken from Gould v. Gould.^ Decisions. In the interpretation of statutes levying taxes it is the established rule not to extend their provisions, by implication, beyond the clear import of the language used, or to enlarge their operations so as to embrace matters not specifically pointed out. In case of doubt they are construed most strongly against the govern- ment, and in favor of the citizen. United States v. Wigglesworth, 2 Story 369, Fed. Cas. No. 16,690; American Net and Twine Co. v. Worthington, 141 U. S. 468, 474, 35 L. Ed. 821, 824, 12 Sup. Ct. Rep. 55; Bcnzinger v. United States, 192 U. S. 38, 55, 48 L. Ed. 331, 338, 24 Sup. Ct. Rep. 189. Keeping in mind the well-settled rule, that the citizen is exempt from taxation, unless the same is imposed by clear and unequivocal language, and that where the construction of a tax law is doubtful, 'Black, Income and Other Federal Taxes, 4th edition, page 36. •24S'U. S. 151; 38 S. Ct. 53; 62 L. Ed. 211. APPEALS, REFUNDS, ABATEMENT 239 the doubt is to be resolved in favor of those upon whom the tax is sought to be laid.^" .... Taxpayers should inform themselves as to the attitude of the courts on doubtful points which arise in the course of the administration of the law as indicated by the foregoing quota- tions and by the following clear-cut statement in a recent case. Decision. Where there is an ambiguity in the language of a statute imposing a tax, and that ambiguity raises a doubt as to the legislative intent, the persons upon whom it is sought to impose the burden arc to be given the benefit of the doubt.^^ In an earlier case this is found : Decision. At the outset it may be remarked that a statute pro- viding for the imposition of taxes is to be strictly construed, and all reasonable doubts in respect thereto resolved against the government and in favor of the citizen. ^- The question of the authority of Treasury regulations is most aptly discussed in Black's Income Taxes (4th edition), page 9. But of course it is not within the lawful power of these officers to go a step beyond the limits of the act of Congress under which their authority is exercised. They could neither bring within the purview of the law or of their regulations anything not definitely within the words of the act, nor except from its operation anything not clearly meant to be excluded, nor add to the burden of the tax- payer anything which Congress did not intend to impose upon him. But within the limits of their rightful authority, regulations pre- scribed by the Commissioner of Internal Revenue, pursuant to statu- tory authority, with the approval of the Secretary of the Treasury where necessary, in respect to the assessment and collection of in- ternal revenue taxes, or for the government of the officers of the revenue department, have all the force and effect of law, and are as binding as if incorporated in the statute law of the United States; and the acts of the Commissioner are presumed to be the acts of the Secretary. But the construction given to an act of Congress impos- ing internal revenue taxes by the Commissioner of Internal Revenue, though officially published, is not a construction of so much dignity ^"Spreckles Sugar Co. v. McCla'm, 192 U. S. 397; 24 S. Ct. 376; 48 L. Ed. 496. " Edwards v. Wabash Raihvay Co., 264 Fed. 610, 619. "Mutual Benefit Life Ins. Co. v. Herold, ig8 Fed. 199; affirmed 201 Fed. 918; 120 C. C. A. 256. 240 APPLICATION AND ADMINISTRATION that a re-enactment of the statute subsequent to the construction is to be regarded as a legislative adoption of that construction, and especially when the construction would make a proviso to the act repugnant to the body of the act. In T hacker v. United States, ^^ the court said : Decision. The Commissioner of Internal Revenue cannot alone, or in connection with the Secretary of the Treasury, alter or amend the internal revenue law. All he can do is to carry into effect that which Congress has enacted. His regulations in aid of the execution of the law must be reasonable, and made with a view to the due assess- ment and collection of the revenue. Changed interpretation — retroactive effect. — It should be borne in mind that Treasury interpretations are, after all, merely interpretations. Therefore, if the courts decide that the law means something different from what the Treasury has held it to mean, the rulings must be reversed and redress granted or additional levies made back to the date of the passage of the law. The new law provides : Law. Section 13 14. That in case a regulation or Treasury decision relating to the internal-revenue laws made by the Commissioner or the Secretary, or by the Commissioner with the approval of the Secretary, is reversed by a subsequent regulation or Treasury decision, and such reversal is not immediately occasioned or required by a decision of a court of competent jurisdiction, such subsequent regulation or Treasury decision may, in the discretion of the Commissioner, with the approval of the Secretary, be applied without retroactive effect. It is not easy to make a general statement as to how far a Treasury ruling which reverses some previous Treasury ruling is retroactive. Much depends upon the circumstances. Certainly administrative difficulties are .sufficient to justify the prohibition of wholesale readjustments of returns unless the changes are of considerable importance. In the language of the regulations, "cases previously adjusted in contravention of law, as pronounced in such decisions, are subject to read- justment in accordance with the decisions." 15 Blatch 15, Fed. Gas. No. 13851. APPEALS, REFUNDS, ABATEMENT 241 Abatement When notice of assessment of additional tax was received prior to the 1921 law, it was difficult to decide whether to file claim for abatement and at least defer payment of the tax, or to pay the tax and file claim for refund. Under the new law a claim for abatement may be filed only in a few instances. Law. Section 250 (d) .... If upon examination of a return made under the Revenue Act of 1916, the Revenue Act of 1917, the Revenue Act of 1918 or this Act, a tax or a deficiency in tax is discovered, the taxpayer shall be notified thereof and given a period of not less than thirty days after such notice is sent by registered mail in which to file an appeal and show cause or reason why the tax or deficiency should not be paid. Opportunity for hearing shall be granted and a final decision thereon shall be made as quickly as prac- ticable. Any tax or deficiency in tax then determined to be due shall be assessed and paid, together with the penalty and interest, if any, applicable thereto, within ten days after notice and demand by the col- lector as hereinafter provided, and in such cases no claim in abatement of the amount so assessed shall be entertained: Provided, That in cases where the Commissioner believes that the collection of the amount due will be jeopardized by such delay he may make the assessment without giving such notice or awaiting the conclusion of such hearing There can be no doubt as to the meaning of the foregoing section. Except in those cases where the Commissioner may believe the additional tax is in jeopardy, an application in the nature of a formal appeal must be allowed. Whether the ap- peal is heard by the Commissioner himself through the Com- mittee on Appeals and Review, or before some other appeal body of unquestioned standing,, is immaterial. The reference of an appeal to a subordinate section or to anyone who had theretofore passed upon the case will not be an appeal within the meaning of the law. Decision must be made before assessment, provided, of course, notice of appeal is filed in accordance with the statu- tory provision. 1 If notice of appeal is not given within the specified time, 242 APPLICATION AND ADMINISTRATION the assessment must be paid in due course. The collector is not authorized to accept a claim for abatement. In such a case a claim for refund is the only recourse. Abatements may be filed — when? — Claims for abatement have not, however, been entirely abolished. Use for such claims may be found in the following cases : 1. Where the Commissioner believes the tax is in jeopardy. 2. Where it is necessary to postpone payment of one or several instalments. Cases of this kind may occur where an error has been discovered before all instal- ments of a tax have been paid. 3. Where a claim for abatement or credit on file with the Treasury has been disallowed without the taxpayer having had an opportunity to be heard on appeal. Cases of this kind can be eliminated by changing the procedure with regard to claims of all kinds. This change is discussed elsewhere." 4. Where an erroneous assessment is made. It is pre- dicted that assessments will be made where the taxpayer has not been notified in accordance with the law. Also, taxpayers will often file a notice of appeal and yet the assessment will be made. It is natural for mistakes of this sort to happen, especially in government offices. Experience will no doubt show that other cases will arise, because a claim for abatement may be used where there is any good reason to hold a payment in abeyance ; provided, however, that the case is of a kind in which the law does not specifically forbid the acceptance thereof. Interest payable on abatement — when? — When claim for abatement is filed there is in any case some chance that the claim of the taxpayer will be denied. Therefore it is important " Sec page 213. APPEALS, REFUNDS, ABATEMENT 243 that the claim for abatement be filed within ten days from date of assessment in order to prevent the 5 per cent penalty from being imposed. Law. Section 250 (e) If any tax remains unpaid after the date when it is due, and for ten days after notice and demand by the collector, then, except in the case of estates of insane, deceased, or insolvent persons, there shall be added as part of the tax the sum of 5 per centum on the amount due but unpaid, plus interest at the rate of I per centum per month upon such amount from the time it became due: Provided, That as to any such amount which is the subject of a bona fide claim for abatement filed within ten days after notice and de- mand by the collector, where the taxpayer has not had the benefit of the provisions of subdivision (d), such sum of 5 per centum shall not be added and the interest from the time the amount was due until the claim is decided shall be at the rate of one-half of i per centum per month on that part of the claim rejected If the claim or any part of it is denied, interest at the rate of 6 per cent per annum^^ will be added to the amount disallowed. Where, however, a claim for an abatement is filed under the 1918 act, based on the grounds of a loss in inventory," interest at the rate of 12 per cent per annum will be added to the tax not abated, beginning with the original due date." Section 250 (e) applies to claims for abatement under both the 1918 and 192 1 laws. The 192 1 law does not make any important change in this section. Under laws previous to that of 1918, interest at the rate of I per cent a month is imposed upon the amount disallowed." The author is of the opinion that this interest may in certain cases be reduced to 6 per cent by paying any additional assess- ment for the year 1917 and filing a claim for credit against any instalments which will fall due within that year. The taxes " If it is held that the claim is not made in good faith the rate of inter- est is 12 per cent. '"Income Tax Procedure, 1921, page 188. "Section 214 (a-12), 1918 law. "C. B. 4, page 318; O. D. 798. 244 APPLICATION AND ADMINISTRATION against which the credit would be claimed would of course be a year subsequent to 191 7. Under the 19 18 and 1921 laws a claim for credit bears interest at 6 per cent per annum. The 191 7 payment should of course be made under protest and it would also be well at that time to advise the collector of the taxpayer's intentions. Ruling. Advice is requested whether it is permissible for an individual to file a claim for abatement of tax and penalties assessed after service of second notice and demand on Form 21 and issuance of warrant of distraint on Form 69. Held, that a bona fide claim for abatement may be filed at any time prior to payment of the tax. The filing of a claim for abatement, however, does not necessarily operate as a suspension of the collection of the tax or make it any less the duty of the collector to exercise due diligence to prevent the collection of the tax being jeopardized. He should, if he considers it necessary, collect the tax and leave the taxpayer to his remedy by claim for refund. H a claim for abatement of a tax is filed after the taxpayer has incurred the 5 per cent penalty and i per cent a month interest for nonpayment within the prescribed time, the penalty and interest should not be collected unless the claim is decided adversely to the taxpayer. In the case of an adverse decision, the amount disallowed in claim for abatement, plus interest thereon, at the rate of I per cent a month from the original due date of the tax until the date of filing abatement claim, and at the rate of one-half of i per cent per month from the latter date until the date of the adverse decision, together with the 5 per cent penalty on the amount of tax disallowed, should be collected from the taxpayer. (P.. 51-21-1985; O. D. 1143.) May abatement be allowed if an equivalent amount of tax is due? — Since very few abatement claims will be filed under the 1921 law, the following ruling applies principally to cases arising under the 1918 and prior laws: Ruling. The validity of an assessment depends upon the law and actual facts existing. Therefore, an assessment made upon an er- roneous theory or by mistake may not be remitted or abated because so made if, at the time its validity is passed upon the Commissioner is in possession of evidence which shows an equivalent amount of tax is properly due in connection with the income, transaction or matter upon which the assessment is predicated. (B. 49-21-1967; T. D. 3251-) APPEALS, REFUNDS, ABATEMENT 245 The validity of the foregoing riihng is questioned. Under the laws prior to 192 1, interest did not begin to run until after assessment was made. This ruling may subject taxpayers to interest charges from the dates of the illegal assessment, with- out proper compliance by the Treasury with the sections of the law dealing with other assessments (even though meritori- ous) barred by limitation of time, as well as where interest is specifically held to conunence when collectors give notice of assess!::ents. Content of claim in abatement must be supported by sworn statement. — The foll< wing regulation sets forth the details of procedure in claims for abatements : Regulation. Claims for abatement of taxes illegally or er- ro icously assessed shall be made on Form 843. They must be sus- tained by the affidavits of the parties against whom the taxes were assessed, or of other parties cognizant of the facts. When a tax has been assessed and turned over to the collector, the presumption is that the assessment is correct. The burden of proof in rebutting the pre- sumption and showing that it was improperly or illegally assessed, or that relief should be given under a remedial statute, rests upon the applicant for abatement. The affidavits must therefore contain full and explicit statements of all the material facts relating to the claim in support of which they are offered and to the proper consideration of which they are essential. The legality of the claim is to be determined by the Commissioner upon the facts presented to him. The filing of a claim for abatement does not necessarily operate as a suspen- sion of the collection of the tax or make it any less the duty of the collector to exercise due diligence to prevent the collection of the tax being jeopardized. He should, if he considers it necessary, collect the tax and leave the taxpayer to his remedy by a claim for refund. Claims for abatement may not be filed where the taxpayer has had the benefit of the provisions of section 250 (d).^" .... (Art. 1032.) Provision has been made in this article for appeal under section 250 (d) ; otherwise there is no change. The author's experience has been that many claims for abatement are denied because the foregoing reasonable and " Section 250 (d) gives the taxpayer the right, upon notice of assess- ment 4:o be made in thirty days, to appeal before such assessment is finally made. 246 APPLICATION AND ADMINISTRATION legal procedure is not followed by taxpayers. It is not enough to make a short affidavit to the effect that the tax is illegally or wrongfully assessed. It should be remembered that the additional assessment is often the result of a long and careful audit of the returns. The taxpayer is entitled to and should have full particulars of the basis of the assessment. The claim for abatement should contain complete references to the law and regulations bearing on the matters in dispute and should cite such authorities, precedents and business prac- tices as are applicable. The author has never known of a case where the presentation of a carefully prepared claim has not received equally careful attention. Meaning of term "bona fide claim." — Section 250 (e) of the law provides that, when the claim for abatement is made in good faith and subsequently denied, interest at the rate of ^ o'f I per centum per month shall be charged on the tax from the time it was due until the claim is decided. It is therefore of great importance not to invoke the law unless the abate- ment can be proved to be "the subject of a bona fide claim." It has been shown that taxpayers have an undoubted right to question assessments, but the questioning of an assessment must be founded on more than mere doubt in order to support a contention that a claim for abatement is filed in good faith. When the taxpayer is confident that his original return was properly prepared there can be little doubt as to the im- position of the 6 per cent interest rate if the claim for abate- ment is denied. The Commissioner, in order to impose the 12 per cent interest rate, would have to hold that the claim was made in bad faith. Taxpayers should be able to make a good showing in the hearing of their cases and leave no doubt in the minds of the reviewing authorities as to the good faith involved in the claim. Collector may require a bond. — As it is within the discre- tion of a collector to accept or reject a claim for abatement APPEALS, REFUNDS, ABATEMENT 247 and, as he is charged personally with the assessment, he may require a bond at the time of accepting a claim for abatement. Ruling While there is no provision of law expressly au- thorizing the collector to require a bond as a condition of suspending the collection of the tax, he is personally charged with the amount of the assessments made against taxpayers in his district and he is re- quired to use due diligence in collecting such taxes. If he fails to exer- cise due diligence, it is clear that he becomes personally liable for any tax which may be lost through such failure. He may require the tax to be paid and leave the taxpayer to his remedy by a claim for refund, and if he see fit to suspend the collection of the tax in any case where a final collection may thus be jeopardized he does it at his own risk. It is within his discretion to protect himself by requir- ing the taxpayer to execute a bond in the amount of the tax the col- lection of which is postponed (C. B. i, page 257; O. 957.) Section 1329 provides that the collector may accept as security Liberty bonds or other bonds or notes of the United States. When may a collector reject a claim for abatement? — The question has arisen as to whether or not a collector, after he has accepted a claim for abatement and has forwarded it to the Commissioner, may send out a second notice and demand, although the Commissioner has neither allowed nor rejected the claim, requiring payment within 10 days. These second notices and demands not only include the original amount of the assessment but add the 5 per cent penalty and interest at the rate of i per cent a month. If the tax is not paid or if a bond is not filed, may the collector proceed to collect by dis- traint? Since a large number of collectors passed out of office with the change in administration, the above procedure was followed to establish the requirement of due diligence in en- deavoring to collect the tax. After a collector accepts a claim for abatement and for- wards it to the Commissioner for consideration, the collector should not send out a second notice and demand until the Com- missioner has notified him that it has been rejected. If, how- 248 APPLICATION AND ADMINISTRATION ever, the second notice is sent, the collector should be informed that a claim in abatement is already on file. Form 843 can be used for this purpose, a copy of the former claim being at- tached. By this means, it is possible that summary action by the collector may be prevented. At the time when the claim is accepted the collector must be convinced that it is a "bona fide claim,'' and that the taxpayer is in a position to pay and will pay the tax if the Commissioner, after consideration, rejects it. Of course, if after a claim has been accepted some unforeseen event takes place which may jeopardize the government's interest, it would be reasonable to demand either a bond or payment. But this certainly should be done only with the approval of the Commissioner, because there are many taxpayers who have claims pending with the Treasury which have been on file many months. In any event, it is improper to include the 5 per cent pen- alty and interest at the rate of i per cent a month, because the penalty has been made inoperative by the filing of the claim for abatement, and interest can only be collected on the amount of the claim disallowed by the Commissioner. Claim for abatement filed by receivers. — Ruling. Where the property of a corporation is in the hands of a receiver who files a claim for abatement of an additional assess- ment of income and profits taxes for 1917, no bond should be required as security for the payment of such taxes. The government, how- ever, has the right under section 3466, R. S., to receive payment of these taxes from the receiver in preference to the creditors of the corporation. (B. 47-20-1316; O. D. 733.) Method of calculation of interest under 1918 law when a claim for abatement or credit is rejected. — Ruling. Where a claim for abatement (section 250 (e) ) or a claim for credit (section 252) is rejected, the tax which is the subject of the claim is chargeable with interest at the rate of one-half of I per centum per month from the time the tax was originally due until the claim is decided adversely to the taxpayer; notice of the adverse decision is sent to the collector who must send to the claim- APPEALS, REFUNDS, ABATEMENT 249 ant a notice and demand for payment of the assessment; if the tax is paid within the ten day period following the sending of the notice the 5 per cent penalty is not collectible, and the only interest col- lectible is that at the rate of one-half of i per centum per month from the time the tax was originally due until the date of the Com- missioner's decision; if the tax covered by the rejected portion of the abatement claim is not paid within ten days from the date of the notice and demand for payment, the penalty of 5 per cent attaches, and in addition thereto, interest at the rate of one-half of i per centum per month from the original due date to the date of the adverse decision by the Commissioner and at the rate of i per cen- tum per month from that date to the date of payment. (B. Digest 31-20-1106; S. O. 32.) If some time has elapsed, as is usually the case, between the date of the Commissioner's adverse decision and the plac- ing of the assessment on the list, and if the taxpayer pays the tax within 10 days after notice and demand from the collector, he is charged interest only up to the date of the adverse de- cision, which may be a considerable time before the taxpayer actually pays the taic without penalty. In the detailed opinion of the solicitor, it is stated: .... the date of the adverse decision by the Commissioner be- comes a newly established due date and is subject to all the provisions of law relating to penalties and interest. Failure to pay within 10 days involves additional interest at I per cent a month from the date of the adverse decision to date of payment. Actions to Restrain Payment of Taxes If no claim for abatement is made, or if one is not per- mitted because a final decision has been made, or if claim is made and denied, the tax imposed must ordinarily be paid. Suits to restrain collection of taxes — not maintainable. — Law. Section 3224. [Rev. Stat.] [Barnes' Federal Code, Sec- tion 5123.] No suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court. 250 APPLICATION AND ADMINISTRATION The- federal courts in construing this provision have uni- formly held that no injunction will issue for this purpose. It is of interest to note, in the case of Snyder v. Marks/° that, although it was alleged that the "assessment was made more than fifteen months after the time which it embraced had elapsed," a bill in equity will not He to enjoin a collector of internal revenue from collecting the tax. The following lan- guage of the court is of particular importance because it relates to section 3224, which is still in effect : Decision. The inhibition of section 3224 applies to all assess- ments of taxes, made under color of their offices, by internal reve- nue officers charged with general jurisdiction of the subject of assess- ing taxes against tobacco manufacturers. The remedy of a suit to recover back the tax after it is paid, is provided by statute, and a suit to restrain its collection is forbidden. The remedy so given is exclusive, and no other remedy can be substituted for it. Such has been the current of decisions in the circuit courts of the United States, and we are satisfied it is a correct view of the law. It would appear that if Congress says in one section of the law that no assessment shall be made after the expiration of a certain period, and says in another that «o suit shall be brought against the government to restrain the payment of taxes, the two sections should be construed together. If an injunction cannot be secured in case the assessment is made after the limitation period, the intention of Congress cannot be carried out. Otherwise the section in regard to the 3 or 5 years' limitation might as well have been omitted. Certainly, the enactments of Congress should have some effect. A more recent case, Markle v. Kirkendall,"^ confirms the principle of the Snyder case. In the Markle case an attempt was made to restrain the collector from collecting a tax which the Commissioner had assessed against a taxpayer as a cor- poration, whereas the taxpayer was a copartnership when the tax was assessed. The court held that as long as the taxpayer can be brought within the terms of the law as taxable, the col- ' 109 U. S. i8g; 27 L. Ed. 901 ; 3 S. Ct. 157; decided November 12, 1883. 267 Fed. 498. APPEALS, REFUNDS, ABATEMENT 251 lector may not be enjoined, although his proceeding is errone- ous or irregular. The tax must be paid and if an appeal for refund is disallowed a suit may then be brought against the collector for recovery of the tax paid. In the case of Dodge Bros. v. Oshorn,^^ Chief Justice White intimated that an injunction might be secured in exceptional cases. Decision the statute plainly forbids the enjoining of a tax unless by some extraordinary and entirely exceptional circum- stance its provisions are not applicable. The cases which hold that a stockholder may restrain col- lection in case of an unconstitutional tax were decided subse- quent to 1888, the date of the Snyder case. It may very well be, therefore, in case it can be shown that a suit against a collector to. recover the tax paid and interest would not afford the taxpayer an adequate remedy, because, in order to pay the tax he would be compelled to dispose of property at a figure below its real worth, for which, of course, the return of the tax and interest, would not reimburse him, that a court of equity, in the exercise of its inherent juris- diction to afford relief where a suitor has no adequate remedy at law, would act by injunction to prevent the collection of a tax illegally assessed. Such an injunction has recently been applied for in Delaware. Article 1050 states that the "restrain- ing" provision does not apply to suits for injunctive relief. Stockholders' suits. — In cases where a speedy determina- tion of the constitutionality of the tax is desirable, a pro- cedure has been followed which appears to be a justifiable evasion of the statutory inhibition against litigating the validity of taxes before their payment. This is done under the color of a stockholder's suit, brought to restrain the corporation from an alleged illegal use of the corporate assets. The right of a stockholder to maintain such a suit is now well estab- '240 U. S. 118; 36 S. Ct. 275; 60 L. Ed. 557- 252 APPLICATION AND ADAIINISTRATION lished.^^ The application of this procedure to tax cases was first resorted to in the Income Tax Cases/* and has been sub- sequently upheld as proper in view of the confusion and in- justice which would result if the corporation paid the tax."^ Refunds After a tax has been paid and a taxpayer believes that it was unlawfully or wrongfully assessed or collected he may make claim for refund (on form 843). Generally speaking, the government imposes no restrictions against claims for refund and such claims are considered on their merits. This practice must not be confused with the procedure in case of suit against the government. When suit is brought the gov- ernment interposes all the legal obstacles at its command. Refund of taxes erroneously collected. — The following regulation gives the details of procedure in claims for refund. Regulation. Claims by the taxpayer for the refunding of taxes and penalties erroneously or illegally collected shall be made on form 843. In this case the burden of proof rests upon the claimant. All the facts relied upon in support of tbe claim should be clearly set forth under oath. In tlie case of the taxpayer's death, certified copies of the letters of administration or letters testamentary, or other similar evidence, must be annexed to the claim to show the authority of the administrator or executor. The affidavit may be made by an agent of the person assessed, but in such a case a power of attorney must accompany the claim. Checks in pay- ment of claims allowed will be drawn in the names of the per- sons entitled to the money and shall, unless otherwise directed, be sent directly to the proper persons. The Commissioner has no authority to refund on equital)le grounds penalties legally collected.-" .... (Art. 1036.) ''^" Dodge v. Woolsey, 18 How. 331 ; 59 U. S. 331 ; i Miller 284; 15 L. Ed. 401; Halves v. Oakland, 104 U. S. 450; 14 Otto 450; 26 L. Ed. 827. (See equity rule 94.) "* Pollock V. Farmers' Loan & Trust Co., 157 U. S. 429; 39 L. Ed. 759. " Brushaber v. Union Pacific Ry. Co., 240 U. S. i ; 36 S. Ct. 233 ; 60 L. Ed. 493; Stanton v. Baltic Mining Co., 240 U. S. 103; 36 S. Ct. 278; 60 L. Ed. 546. ^ For cases in which refund is made through collectors, see Income Ta.x Procedure, 1920, page 217. APPEALS, REFUNDS, ABATEMENT 253 It should be noted that the new regulations do not require that claims for refund must be accompanied by the collector's receipt or by the paid cheque showing payment of the tax. If claim for abatement was not made the claim for re- fund should be supported by satisfactory evidence as de- scribed on page 245. If claim for abatement was made and denied it cannot be expected that the claim for refund will be allowed, but the taxpayer has nothing to lose by attempting to improve his case and by securing any new evidence which will strengthen it. Claims for refund may not be filed with Commissioner direct. — Prior to the issuance of the following ruling, refunds could be filed with the Commissioner direct. ^^ Ruling. Claims for refund should in all cases be filed with the collector of internal revenue to whom the tax was paid or with the deputy collector of the division of such district in which the claimant resides. Warrants in payment of such claims will be made to the order of the claimants as provided in section 6, Department Circular 230 (not published in the Bulletin Service). The Bureau will recognize a general power of attorney as suffi- cient authority for the filing of more than one claim for refund on behalf of the grantor of such power. It should be noted, however, that under the provisions of section 6 of the above-mentioned circu- lar special powers are required in certain cases. In cases where a number of claims are to be filed under a general power of attorney the original power should be attached to the first claim filed on behalf of the claimant granting the power, and a copy thereof should be annexed to each succeeding claim, special reference being made in each copy to the claims to which the original instrument was at- tached. The Bureau does not require that a power of attorney to file a claim for refund be in any special form. It is merely necessary that the instrument meet the legal requirements of powers of attorney in general. A power of attorney given by a corporation should be signed by the officers who are duly authorized to execute such instrument. (C. B. 4, page 341; O. D. 867.) 212. See Letter dated March 29, 1919, Income Tax Procedure, 1921, page 254 APPLICATION AND ADMINISTRATION Formal claims for refund may not be necessary in some cases. — The Commissioner may now issue warrants to cover overpayment without requiring the taxpayer to file a formal claim for refund or credit. Cases of this kind arise when the Treasury's examination shows an overpayment by the tax- payer. The following instructions have Ijeen issued to collectors of internal revenue : Ruling. For the more expeditious handling of refund, credit, and abatement claims, and to provide for the refund or credit of overpayments of revenues where no claims have been filed, the follow- ing- procedure is established to become effective December i6, 1921 : I. Reduction of internal revenue assessments and adjustments of overpayments of revenues will hereafter be accomplished in one of three ways : (a) On the basis of an application submitted by a taxpayer on Form 46, 47 or 47A, together with appropriate supporting evidence to be filed in the office of the collector of internal revenue of the district in which the tax is assessed. (b) On the basis of a certificate of overassessment prepared by the appropriate administrative unit in the Bureau in each case in which an overassessment of tax is disclosed through the audit of a return. (c) On the basis of a blanket claim (Form 751) ; a schedule of taxes found to be uncollectible (Form 53) ; or a schedule of duplicate payments and overpayments due to obvious error on all forms of taxable returns (blanket form 47 or 47B) submitted by a collector of internal revenue. Form 751 will be used only in cases where credit balances exist, regardless of the class of return filed. (T. D. 3260, dated December 8, 1921.) Item (c) is of interest to collectors only. It is the pro- cedure which must be followed to clear their records. Forms 46, 47 and 47A have been consolidated into form 843- Claims for refunds by resident or non-resident aliens. — Ruling. When a claim for refund is filed by aliens, resident or non-resident, on Form 46, a copy of the form upon which the alien was assessed and taxed should loe attached to Form 46. (C. B. i, page 258; O. D. 472.) APPEALS. REFUNDS, ABATEMENT 255 Claims for refund must be filed within five years. — The government is required, under the 1918 and 1921 laws to make any additional assessments arising from examinations within five years from the date when the return was due, unless fraud is established. Likewise taxpayers, in order to secure credits or refunds of taxes overpaid, must file their claims before the expiration of five" years from the dates when the returns v/ere made. Law. Section 252. That if, upon examination of any return of income made pursuant to this Act, the Act of August 5, 1909, entitled "An Act to provide revenue, equalize duties, and encourage the in- dustries of the United States, and for other purposes," the Act of October 3, 1913, entitled "An Act to reduce tariff duties and to pro- vide revenue for the Government, and for other purposes," the Reve- nue Act of 1916, as amended, the Revenue Act of 1917, or the Revenue Act of 1918, it appears that an amount of income, vs^ar-profits or excess- profits tax has been paid in excess of that properly due, then, notwith- standing the provisions of section 3228 of the Revised Statutes, the amount of the excess shall be credited against any income, war-profits or excess-profits taxes, or instalment thereof, then due from the tax- payer under any other return, and any balance of such excess shall be immediately refunded to the taxpayer: Provided, That no such credit or refund shall be allowed or made after five years from the date when the return was due, unless before the expiration of such five years a claim therefore is filed by the taxpayer: Provided further, That if upon exam- ination of any return of income made pursuant to the Revenue Act of 1917, the Revenue Act of 1918, or this Act, the invested capital of a tax- payer is decreased by the Commissioner, and such decrease is due to the fact that the taxpayer failed to take adequate deductions in previous years, with the result that an amount of income tax in excess of that properly due was paid in any previous year or years, then, notwith- standing any other provision of law and regardless of the expiration of such five-year period, the amount of such excess shall, without the filing of any claim therefor, be credited or refunded as provided in this section: And provided fiirtlicr, That nothing in this section shall be construed to bar from allowance claims for refund filed prior to the passage of the Revenue Act of 1918 under subdivision (a) of section 14 of the Revenue Act of 1916, or filed prior to the passage of this Act under section 252 of the Revenue Act of 1918. "If the claim for refund is not occasioned by the fact that an examina- tion of the taxpayer's returns discloses an overpayment, the claim for refund must be filed witliin five years from the date tlie tax was paid. See page 263. 256 APPLICATION AND ADMINISTRATION The 19 1 8 law was changed by adding that part which starts with "Provided further." Under this provision the Treasury may grant refunds for all years subsequent to 1909 when based upon inadequate depre- ciation or other deductions to which the taxpayer was entitled in such years. These refunds must be made in connection with examination of returns made under the 191 7, 1918 or 1 92 1 laws. Many concerns have paid additional taxes assessed for 19 1 6 and prior years which should now be refunded unless the procedure under memorandum 106'^ and the La Belle Iron Works case^° makes the application for refund undesirable. Ruling. Reference is made to a letter of April 7, 1921, wherein the following statement was made and questions asked: The taxpayer's books and accounts are examined by a revenue agent. The agent finds that for the year 1914 the taxpayer has over- paid the amount of tax due. He also finds that the taxpayer owes additional tax for the year 1916, and in the adjustment of the agent's report the overpayment for 1914 is applied as a credit against the additional tax found due for 1916 and the balance of the 1914 over- payment is refunded. It later develops that the taxpayer instead of being liable for additional tax for the year 1916, as found by the revenue agent, has overpaid his tax for that year. The taxpayer files a claim for credit of this overpayment against tax due for subsequent years. The question presented is, how much tax may be assumed to have been paid by the taxpayer for the year 1916, i.e., the amount actually paid in cash or the cash payment plus the credit' on account of the overpayment for 1914? If it is held in the foregoing that the taxpayer has paid the cash payment plus the amount credited on account of the overpayment for 1914, and a claim for refund is filed, how should the refund claim be adjusted? It is to be understood that in both instances mentioned above no record of a credit for overpayment of 19 14 tax against additional tax originally found due for the year 1916 appears on the assessment list. The Government in the present instance was expressly authorized to refund the taxes erroneously collected or to accept such taxes as a credit. The credit having been duly made, it seems clear that if the real remedial purpose of section 252 is to be effected, "paid" must be construed in its broader sense as including a credit duly made. It is accordingly held that where there has been an overpayment of 'See Aiipeiulix A, Chapter VIII. 'Advance opinions 65 L. Ed., page 604. I I APPEALS, REFUNDS, ABATEMENT 257 taxes on an income return for a certain year and within five years from the date the return was due the overpayment is credited to taxes due on an income return for a subsequent year, such credit constitutes payment or part payment of the taxes i'or the year in which it was appHed. In reply to your second question, you are advised that the cash payment plus the amount allowed as a credit on account of the over- payment for 1914 should be adjusted for the year 1916 where the tax- payer files a claim for refund covering the latter year. The fact that no record of a credit for overpayment of 1914 taxes appears on the 1916 assessment list does not affect the treatment of the credit as a payment for the year 1916, where the credit was in fact made within five years from the date the 1914 return was due. (C. B. 4, page 336; Sol. Op. 107.) Section 3228 of the Revised Statutes was amended to read :^^ Law. Section 1316. [Section 3228, Rev. Stat.] AH claims for the refunding or crediting of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty alleged to have been collected without authority, or of any sum al- leged to have been excessive or in any manner wrongfully collected, must be presented to the Commissioner of Internal Revenue within four years next after payment of such tax, penalty, or sum. This section, except as modified by section 252, shall apply retro- actively to claims for refund under the Revenue Act of 191 6, the Revenue Act of 1917, and the Revenue Act of 1918. The foregoing section of the ivevised Statutes cHffers from the 1918 law in two respects: 1. The period is changed from two to four years. 2. Time is computed from the date of payment instead of from the date "after the cause of action accrued." Generally speaking, the distinction between section 252 and section 3228 (Revised Statutes) is that the former applies only to income, excess profits and war profits taxes ; while the latter applies to all taxes specified in the Revenue iVct. Furthermore, "Before amendment this section read as follows: Law. Section 3228. [Rev. Stat.] "All claims for the refunding of any internal tax alleged to have been erroneously or illegally assessed or collected, or of any jjenalty alleged to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, must be presented to the Commissioner of Internal Revenue within two years next after the cause of action accrued " 258 APPLICATION AND ADMINISTRATION under section 3228 relief is granted in cases not covered by section 252. Section 252 computes time "from the date when the return was due." Section 3228 determines time from the date of payment. Further, section 252 relates to claims for refund occasioned by examinations of a taxpayer's income and profits tax returns, whereas section 3228 refers to any claim for refund originating in any other manner. Some time during 1919, the opinion of the Solicitor was requested as to whether or not section 3228 of the Revised Statutes permits the filing of claims for refund of taxes paid under any of the acts specified in section 252 of the Revenue Act of 1918 after five years from the date return was due. Ruling The view has been expressed that section 252 does not repeal section 3228, but merely supplements the latter, and whatever rights a taxpayer may have under section 3228 are pre- served and further extended by section 252. In other words, it is said that a claim for refund may be filed under section 252 within five years after the due date of the return for the year involved, and that a claim for refund may also be filed within two years after pay- ment of the tax, or the time when the cause of action accrued, as provided in section 3228. This construction is advanced for the reason that taxpayers would otherwise have no relief by way of filing claims for refund with reference to assessments under the Revenue Act of 1918, made just prior to the date when the five-year limitation ex- pired. No suit may be brought for the collection of any taxes alleged to have been erroneously collected until an appeal has been made to the Commissioner of Internal Revenue and a decision of the Com- missioner has been had therein. (R. S. 3226.) Consequently if the taxpayer is required to pay the taxes assessed agamst him at a time when the period within which a claim for refund may be filed has expired he could never maintain a suit to recover the taxes paid. Nor could the collection of the tax be enjoined. It is therefore held that section 252 of the Revenue Act of 1918 was not intended to take away the right given a taxpayer under section 3228 of the Re- vised Statutes to make a claim for refund within two years after the cause of action accrued or the date of the payment of the tax under protest. As another has said, "perhaps the mere textual construction is in favor of the other view," but a contrary con- struction would not be harmonious with the spirit of the present law, which is designed to grant relief in cases when Revised Statutes 3228 works injustice (B. 4-19-235; O. 833.) APPEALS, REFUNDS, ABATEMENT 259 The foregoing interpretation also applies to section 252 of the 1 92 1 law. Interpretation of section 252. — The following questions and answers regarding section 252 of the 1918 law were pre- pared for the guidance of the Income Tax Unit. These inter- pretations also apply to the 192 1 law. Ruling. Q. What is the closing date governing the five-year limitation ? A. Five years from the date on which the return for the year in- volved was due to be filed (taking into consideration any extension of time granted for filing the original return). (a) Returns for 1913 which were due to be filed March i, 1914, have as their closing date March i, 1919. Does this mean that the warrant must be actually issued by the Commissioner before the expiration date March i, 1919, or will the auditor's results of the ex- amination of the return be the governing date? A. With respect to this question there appears to be an inaccuracy in statement. The question speaks of the warrant for payment of a claim for refund as being issued by the Commissioner. Such is not the practice. The Commissioner signs the allowance schedule, and the warrant is issued by the Division of Bookkeeping and Warrants after the allowance has been passed upon by the Auditor for the Treasury Department. The correct answer to this question, there- fore, is that the schedule authorizing the allowance of a claim for refund must be actually signed by the Commissioner within five years from the date when the return was due, taking into considera- tion any extension of time granted for filing th& original return. (b) Does the fact that a revenue agent's report, or a valuation engineer's report, determining an overpayment within the five-year period, is not audited until after the five-year limit, bar the auditor from allowing same as an offset, it being recognized that taxpayer is not in possession of the valuation engineer's finding and in some cases not in possession of the revenue agent's report, and, therefore, could not have filed claim within the five-year limitation? A. Neither a refund nor a credit claim could be allowed under these circumstances. If a claim for refund is filed and the overpay- ment considered in connection with the refund claim, it would be barred by the five-year limitation. If it is proposed to allow credit for the overpayment, the fact that an overpayment has been made is not conclusively determined until audit of the agent's or engineer's report which is subsequent to the expiration of the five-year limita- tion. 26o APPLICATION AND ADMINISTRATION (c) The auditor in auditing a case finds overpayment for 1913 and offsets this overpayment in an A-2 letter to taxpayer dated February 25, 1919. The taxpayer takes exception to depletion allowed and after several conferences with the valuation engineers a greater de- pletion for all years is allowed and a reaudit of his return is made October 10, 1919. The five-year limitation on 1913 has expired at the time the latter audit was made. Can this credit be allowed in view of the fact that a portion was allowed in the audit of February 25, 1919, or is the entire amount now barred by the statute? Had the taxpayer filed a claim for abatement of the 1913 taxes prior to pay- ment thereof, would that have operated to his advantage? A. The additional overpayment determined subsequent to the ex- piration of tlie five-year limitation could neither be refunded nor credited. Relative to the second question in (c), it appears that the prin- ciple laid down by the Supreme Court in the case of the Rock Island, Arkansas & Louisiana Railroad Company versus The United States in a decision rendered November 22, 1920 (Income Tax Service Rul- ing 1-21-1380), is equally applicable to the present case. As stated in the above-cited case, the regulations have established a procedure and a form to be used in an application for abatement and separate and distinct ones for a claim for credit or a claim for refund. A taxpayer must file claim for the relief sought, i.e., a claim for credit, if a credit is what is desired or is required. Section 252 of the Revenue Act of 1918 provides in part as follows: No such credit or refund shall be allowed or made after five years from the date when the return was due, unless before the expiration of five years a claim therefor is filed by the taxpayer. The language of the statute is clear. If at the expiration of five years from the date the return was due no credit or refund has been allowed by the Commissioner and no claim for either a credit or a refund has been filed by the taxpayer, then the taxpayer is precluded from relief under either of the methods provided by law. A claim for abatement does not take the place of a claim for credit. These are two separate and distinct claims, and although the result accomplished may be the same in both cases, nevertheless, the requirements of the statute are not satisfied by permitting the use of these two claims interchangeably. (d) A taxpayer, on April 15, 1918, filed amended returns for 1913 and subsequent years which showed an overpayment for 1913. The amended returns were not audited until July i, 1919 — four months after the expiration of the five-year limitation placed on the original return. Does the filing of an amended return within the five-year period act in the same capacity as a claim, as far as being allowed APPEALS, REFUNDS, ABATEMENT 261 to offset the overpayment against an additional tax, or is it barred due to the fact that the final audit was not reached before the expira- tion of the five-year limitation on 1913 return? A. The same principle applies as in (c). Amended returns do not take the place of a claim for refund or credit, and if filed, unsup- ported by such claim or claims, do not in themselves constitute a sufficient claim within the meaning of the statute to warrant the crediting or refunding of any taxes thereunder after the expiration of the five-year period. (e) A revenue agent's report dated May 8, 1919, discovers addi- tional tax for the year 1913, $150.00. Waiver was secured and the additional tax was assessed and paid by taxpayer November, 1919. In a reaudit of this case, based on conference held in the Unit with taxpayer, additional depletion was allowed in which the correct tax for 1913 was determined to be $100.00. Thus: Original return filed No tax due A-2 letters, November, 1919 — tax due $150.00 Correct tax assessable for 1913 — October, 1920, audit 100.00 Overassessed and paid 50.00 As the original return as filed reported no income, therefore no tax, the first assessment against the taxpayer appears in A-2 letter of November, 1919, against the year 1913 for $150.00. The final audit of October, 1920, determines the tax to be $100.00. Can the overpayment for 1913, made by the assessment letter of No- vember, 1919, be offset against an additional tax for subsequent years, due to the fact that the only assessment made for 1913 was made on a revenue agent's report dated May 8, 1919, in which in- suflficient depletion was allowed by the revenue agent? A. No offset or credit can be allowed. Notwithstanding the fact that the assessment for 1913 was made and paid in 1919, no credit for overpayment for refund was allowed or made within five years from the date when the return was due, and none can be allowed or made subsequently under section 252 of the Revenue Act of 1918. Section 3220 of the Revised Statutes, however, authorizes the Com- missioner of Internal Revenue to refund taxes erroneously collected, but the claim for refund thereunder must be presented to the Com- missioner within two years next after the cause of action accrued, as required by section 3228 of the Revised Statutes. The taxpayer in this case, therefore, is confined to his rights under section 3220, R. S., but any claim for refund of overpayment of taxes based on this section must be made within two years after the date of payment thereof. (C. B. 4, page 332; M. 2764.) 262 APPLICATION AND ADMINISTRATION Revival of claims for refund for 1914 and prior years. — The Treasury during 1920 issued a ruling holding that claims for refund pending at the time the 19 18 law was passed, could not be allowed.^^ These claims have been revived by the following provision of the 192 1 law : Law. Section 252 nothing in this section shall be con- strued to bar from allowance claims for refund filed prior to the pas- sage of the Revenue Act of 1918 under subdivision (a) of section 14 of the Revenue Act of 1916, or filed prior to the passage of this Act under section 252 of the Revenue Act of 1918. Payment of refunds. — Law. Section 131 5. That section 3220 of the Revised Statutes, as amended, is reenacted without change, as follows: "Section 3220. The Commissioner of Internal Revenue, subject to regulations prescribed by the Secretary of the Treasury, is authorized to remit, refund, and pay back all taxes erroneously or illegally assessed or collected, all penalties collected without authority, and all taxes that appear to be unjustly assessed or excessive in amount, or in any manner wrongfully collected; . . . ."^-^ The Solicitor issued the following opinion interpreting the 1918 law. It is equally applicable to the 1921 law. Ruling Section 3220, Revised Statutes, was amended by Congress at the instance of the Treasury Department. Before amend- ment section 3220, Revised Statutes, provided that the Commissioner could remit or refund taxes subject to regulations made by the Sec- retary only upon appeal to him made. The Treasury Department believed that a taxpayer should in every case be advised of every overpayment of tax and that the overpayment should be refunded, and it was believed that it would facilitate the work of the Internal Revenue Bureau if the Commissioner could make a refund without the necessity of a claim being filed. It was not the intention of the Treasury Department that the Commissioner should have authority to allow claims which were barred by any statute of limitation, or to refund a tax where the taxpayer had no right to file a claim for the refurfd therefor. It was apparently not the intention of Congress to make it possible for the Commissioner, subject to regulations made "C. B. 3, page 302; Sol. Op. 79. For the author's criticism of this opinion, see Income Tax Procedure, 1921, pages 214-215. " Section 1323 (section 1316 of the 1918 law) re-enacts section 3225 of the Revised Statutes which limits refunds to cases in which the return was not zvilfully false. APPEALS, REFUNDS, ABATEMENT 263 by the Secretary, to ignore statutes of limitation. It must therefore be held that the Commissioner has authority to refund a tax only in a case where a claim has been filed which is not barred by any statute of limitation or where the taxpayer has a legal right to file a claim for the refund of the tax. (C. B. 3, page 302; Sol. Op. 79.) Suits for recovery must be started within five years after payment. — An appeal to the Commissioner in the form of a claim for refund is the first step in seeking relief by a tax- payer. If the Commissioner delays action on claim for re- fund, suit may be brought against the collector after six months, without awaiting the Commissioner's decision. Law. Section 1318. That section 3226 of the Revised Statutes is amended to read as follows: "Section 3226. No suit or proceeding shall be maintained in any court for the recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any smrK alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Com- missioner of Internal Revenue, according to the provisions of law in that regard, and the regulations of the Secretary of the Treasury established in pursuance thereof. No such suit or proceeding shall be begun before the expiration of six months from the date of filing such claim unless the Commissioner renders a decision thereon within that time, nor after the expiration of five years from the date of the payment of such tax, penalty, or sum." This section shall not affect any suit or proceeding instituted prior to the passage of this Act, but shall apply to all suits and proceedings instituted after the passage of this Act, whether or not barred by prior Acts of Congress. The change in the above section reduces the time in which claims for refund may be filed and suits instituted.^* For instance, if taxpayers file claims for refund four years, six months and one day after the day the tax was paid and the Commissioner does not render a decision within six months, suits cannot be instituted. No suit can be instituted "after the expiration of five years from the date of the payment of the tax." •* [Former Procedure] For details of procedure under former laws, see Income Tax Procedure, 1921, page 220. 264 APPLICATION AND ADMINISTRATION The Treasury will probably not be able to pass upon all 191 7 and 1918 claims before the expiration of five 3^ears. Taxpayers, therefore, should be careful not to permit the period to expire before instituting suit. Section 3227 of the Revised Statutes has been repealed. This repeal does not, of course, affect any suit or proceeding as described in section 3227, instituted prior to the 192 1 law/^ Before this section was repealed it was possible to post- pone suit for six years or more."" The government in the case of Rockefeller v. United States of America (unreported) as- serted that the claim was barred two years and six months after the appeal to the Commissioner. The United States Supreme Court considered this case on its merits, hence this decision may l)e accepted as finally disposing of this point. Suits must now be instituted within five years after pay- ment. Proof of appeal to Commissioner. — The court of claims of the United States has decided that when suit is brought by a taxpayer against the collector for recovery of the tax, the burden of proof is upon him to show that his appeal to the Commissioner has been taken and decided, or else that decision was delayed more than six months from the date of appeal. ^^ Decision. The written appeal was the best evidence of which the case was susceptible and if it was not in his power to have pro- duced the original it was, nevertheless, his duty to have produced an authentic copy thereof, or accounted for its absence. ^^ Decision. The lodging of an appeal (claim for refund) made out in due from with tbe proper collector of internal revenue, for the purpose of transmission to the commissioner in the usual course of business mider the requirements of the regulations of the secretary, was in legal effect a presentation of the appeal to the Commissioner.'-'' (Reg. 33, 19 1 8, Art. 270.) " Section 1319. "See Income Tax Procedure. ig2i. pages 219 and 220. " Lauer v. U. S., 5 Ct. CI. 447. ''Hubbard v. Kellx. 8 W. Va. 46. '■'U. S. V. Savings Bank, 14 Otto 7^8; 104 C. S. 728; 26 L. Ed. 908; Int. Rev. Rec. 87. APPEALS, REFUNDS, ABATEMENT 265 Claim for abatement does not constitute an appeal to the Commissioner. — Two recent decisions, one by thai United States Supreme Court, the other by the Circuit Court of Appeals for the Eighth Circuit, conflict on the question as to whether or not the filing of a claim for abatement acts as an appeal to the Commissioner. Of course, the decision of the Supreme Court controls; but since the reasoning of the Cir- cuit Court is more logical and appears to be the more reasonable interpretation of the law, both decisions are quoted. Decisions. This is a claim for a sum paid as an internal revenue tax under the Act of August 5, 1909, c. 6, §38, 36 Stat. 11, 112. It is alleged that the claimant was not engaged in or doing business in the year for which the tax was collected and that therefore it was not due. The Court of Claims dismissed the petition on the ground that the claimant had not complied with the conditions imposed by statute and the claimant appealed to this court. The facts are simple. After the tax was assessed a claim for an abatement was sent to the Commissioner of Internal Revenue in July, 1913. On December 18 of the same year the Commissioner rejected the application, whereupon on December 26 the claimant paid the tax with interest and a penalty. So far as appears there was no protest at the time of payment and it is found that after it nothing was done to secure repayment of the tax. By Rev. Stats., section 3226, amended by Act of February 27, 1877, c. 69, § i, 19 Stat. 248, no suit shall be maintained in any court for the recovery of any tax alleged to have been illegally assessed "until appeal shall have been duly made to the Commissioner of Internal Revenue, according to the provisions of law in that regard, and the regulations of the Secretary of the Treasury established in pursuance thereof, and a decision of the Commissioner has been had therein, provided," etc. Regulations of the Secretary established a procedure and a form to be used in applications for abatement of taxes and distinct ones for claims for refunding them. The claimant took the first step but not the last. By Rev. Stats., section 3220, the Commissioner of Internal Reve- nue is authorized "on appeal to him made, to remit, refund, and pay back" taxes illegally assessed. It is urged that the "appeal" to him to remit made a second appeal to him to refund an idle act and sat- isfied the requirement of section 3226. Decisions to that effect in suits against a collector are cited, the latest being Loomis v. Wattles (266 Fed. Rep. 876). But the words "on appeal to him made" mean, of course, on appeal in respect of the relief sought on appeal — to refund if refunding is what he is asked to do. The words of section 3226 also must be taken to mean an appeal after payment, especially 2r>6 APPLTCATTON AND AD^[TNTSTRATION in view of section 3228 requiring claims of this sort to be presented to the Commissioner within two years after the cause of action ac- crued. So that the question is of reading an impHed exception into the rule as expressed, when substantially the same objection to the assessment has been urged at an earlier stage. ]Men must turn square corners wlieii they deal with the Govern- ment. If it attaches even purely formal conditions to its consent to be sued those conditions must be complied with. Lex non praecipit inutilia (Co. Lit. 127b) expresses rather an ideal than an accom- plished fact. But in this case we cannot pronounce the second appeal a mere form. On appeal a judge sometimes concurs in a reversal of his decision below. It is possible as suggested by the Court of Claims that the second appeal may be heard by a different person. At all events the words are there in the statute and the regulations, and the Court is of opinion that they mark the conditions of the claimant's right. See Kings County Savings Institution v. Blair (116 U. S. 200). It is unnecessary to consider other objections that the claimant would have to meet before it could recover upon this claim. ^"^ The right of the plaintiff to maintain this suit is challenged in this court for the reason that the plaintiff did not appeal to the Com- missioner of Internal Revenue after the tax was paid. This conten- tion is based upon section 3226, Rev. Stat. U. S. (Comp. Stat., section 5949). The object of the statute requiring a party to exhaust his remedies in the Internal Revenue Department before he shall bring suit is to give the department an opportunity to decide vi^hether in its judgment the tax is legal or illegal, and thus save the delay and expense of litigation. The point under consideration was not made in the court below, nor is it mentioned in the assignment of errors ; but, as it may be claimed to be jurisdictional, it will be considered. We had a similar question before us in Weaver v. Ewers (195 Fed. 247, 115 C. C. A. 219), and we then held that, notwithstanding section 3226, an appeal to the Commissioner, before the tax was paid, an- swered the purpose for which the statute was enacted. In the case cited we said : "What the Commissioner of Internal Revenue thought about the assessment had been obtained upon full statement of the facts, and it would have been a useless form again, after the tax was paid, to appeal to the Commissioner and obtain the same judgment. The reason for the appeal did not exist, and hence the appeal after tax was paid was not necessary." The following cases sustain our ruling: Schwarzchild, etc., Co. v. Rucker (C. C, 143 Fed. 656) ; San Francisco Sav. & Loan Soci- ety V. Carey (2 Sawy. 333, Fed. Cas. No. 12,317) ; Grier v. Tucker "'Rock Island, Arkansas & Louisiana Railroad Co. v. U. S., November 22, 1920, 254 U. S. 141. APPEALS, REFUNDS, ABATEMENT 267 (C. C, 150 Fed. 658); Tucker v. Grier (160 Fed. 611, 614, 615, 87 C. C. A. 513) ; De Bary et al. v. Dunne (C. C, 162 Fed. 961). Counsel for defendant cites Savings Bank v. Blair (116 U. S. 200, 6 Sup. Ct. 353, 29 L. Ed. 657) ; Stewart v. Barnes (153 U. S. 456, 14 Sup. Ct. 849, 38 L. Ed. 781); and Hastings v. Herold (C. C, 184 Fed. 759). These cases have been examined, and when the facts of each case are considered they sustain the ruHng of this court in Weaver v. Ewers, supra. We therefore see no reason for departing from the ruling heretofore made, and hence decide that the conten- tion is without merit.*^ It should be noted that the foregoing case is cited by the Supreme Court, but is dismissed with the statement that the words "an appeal" mean an appeal after payment. It is there- fore important that taxpayers file a claim for refund after a claim for abatement is rejected if they wish to reserve their legal rights. The 192 1 law amended section 3226, Revised Statutes, making it more specific as to the nature of the "appeal .... to the Commissioner of Internal Revenue,"*^ which is a pre- requisite to bringing suit for refund and to which reference was made in the Supreme Court's opinion in Rock Island, Arkansas and Louisiana R. R. Co. v. United States.^^ The section as amended by the 192 1 law states that "no suit .... shall be maintained .... until a claim for refund or credit has been duly filed with the Commissioner "** Suit must be brought against collector who collected tax and not against his successor. — The United States Circuit Court of Appeals for the Seventh Circuit certified the follow- ing two questions to the United States Supreme Court :*'' Decision, i. Assuming- that the declaration states a good cause of action had the suit been brought against S. M. Fitch, the internal revenue collector who actually collected and received the taxes, does it state any cause of action whatever against said S. M. Fitch's suc- " Loomis V. Wattles, 266 Fed. 876. ^'The text of section 3226, Rev. Stat., as it appeared before amendment by the 1921 law. appears in Income Tax Procedure, 1921, page 216. "254U. S. 141. " See page 263 for text of section 3226, Rev. Stat., as amended. " Smietanka v. Indiana Steel Co., advance opinions, 66 L. Ed. page 3. 268 APPLICATION AND ADMINISTRATION cessor in office, the plaintiff in error, against whom tlic suit was brought, but who had no participation in the collection, receipt or dis- bursement of such taxes? 2. May suit in the district court of the United States properly be brought and maintained against a United States collector of inter- nal revenue for the recovery of the amount of a United States in- ternal revenue tax, unlawfully assessed and collected, but in the col- lection and disbursement of which such collector had no agency, the entire transaction of such assessment, collection, and disbursement hav- ing occurred during the incumbency of such office of a predecessor in office of such collector? The court answered both questions in the negative.*^ Suits where collector is dead. — I'rior to the passage of the 1 92 1 law, if the amount involved exceeded v$io,ooo, suit could not be brought in a federal district court if the collector were dead, but the Court of Claims had sole jurisdiction. Section 1310 (c), by an amendment of section 24 of the Judicial Code, now gives a district court concurrent jurisdiction with the Court of Claims in such circumstances. T>AW. Section 13 10 (c) Paragraph Twentieth of section 24 of the Judicial Code is amended by adding at the end thereof the following new paragraph: "Concurrent with the Court of Claims, of any suit or proceeding, commenced after the passage of the Revenue Act of 1921, for the recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority or any sum alleged to have been excessive or in any manner wrongfully collected, under the internal- revenue laws, even if the claim exceeds $10,000, if the collector of internal-revenue by whom such tax, penalty, or sum was collected is dead at the time such suit or proceeding is commenced." State courts have no jurisdiction to determine federal taxes. — Two interesting cases'*' have been decided by the Su- preme Court of Errors for the State of Comiecticut. "The District Court for the Southern District of Ohio, Western Divi- sion, has made a similar ruling. Cincinnati Gas & Electric Co. v. GiUigan (not reported). See B. 29-21-1738; Ct. D. 16. See also Philadelphia, Har- rishurg & Pittsburg R. R. Co. z'. Lederer, 242 Fed. 492. *' IVillmann, ct al. v. Walsh, 1 12 Atl. 804; and application of Willmann, ct al. 112 Alt. 806. APPEALS, REFUNDS, ABATEMENT 269 Ruling. Under the Connecticut laws of 1918 (Sections 3446 and 3447), upon voluntary dissolution of a corporation, upon vote of the stockholders, the directors are made trustees in the liquidation of the affairs of the corporation. Such trustees may apply (Section 3448) to the Superior Court for the county in which such corporation is located for the limitation of a period for the presentation of claims against the corporation. Upon the limitation of such a period by the court, it is provided that such trustees shall proceed to wind up the affairs of the corporation under the direction of the court in the same manner as if they were receivers. It is provided (Section 3449) that any claim not presented within the time limited shall be barred, unless the owner thereof shall commence an action to enforce the same within four months after notice from the trustees of rejection. (T. D. 3166.) The facts of the two cases and the decision of the lower court appear in the following ruling: Ruling. On February 27, 1919, Joseph Willmann, et al., trustees in liquidation, petitioned the court for the issuance of an order limit- ing a period within which all claims against the corporation should be presented and for such additional orders from time to time relative to the winding up of the affairs of the corporation as might be proper and necessary in accordance with the statutes of the State of Connec- ticut. On the same date the Superior Court for New Haven County, Connecticut, issued an order providing that all claims against the Derby Manufacturing Company should be presented to said trustees witliin four months from February 27, 19 19. Among the claims presented pursuant to this order was one of the United States, pre- sented by James J. Walsh, Collector of Internal Revenue for the District of Connecticut for additional income, excess profits and war profits taxes for the years 1916, 1917 and 1918; and also for taxes not then determined for that portion of 1919- up to the date of the cessation of business by such corporation. On June i, 1920, the trustees reported the claims of the United States wherein they disallowed the major portion thereof. The court entered an order approving the report and providing that writ- ten notice should be given to the United States, through the Com- missioner of Internal Revenue, and to James J. Walsh, Collector, that unless the disallowed portion of the claim was made the subject of application to the court for allowance within two weeks, the same should be barred. Thereafter, the United States Attorney for the District of Connecticut filed a petition on behalf of the United States for the allowance of the entire claim. On June 29, 1920, the trustees in liquidation filed with the court an application for a restraining order against the collector, asking that the collector be restrained 270 APPLICATION AND ADMINISTRATION from interfering with their possession of the company's property, not- withstanding the fact that there was pending in this office a claim in abatement covering the taxes in question, during the pendency of which no distraint proceedings would have been carried out by the collector. It was alleged that the trustees were officers of the court and that an interference by the collector with their possession would be a contempt of the court. Upon the hearing of this application, the Superior Court of New Haven County refused to grant the restraining order. Thereafter, on September 20, 1920, the trustees filed another application for a restraining order and for instructions from the court as to the duty of the trustees in relation to such claims of the United States, and for a hearing by the court to determine what taxes, if any, were due the United States. This application was made upon the theory that the trustees in liquidition were officers of the court, in view of the fact that in winding up the affairs of the corporation they were subject to the orders of the court, and that, in order that proper instructions might be issued to them in con- nection with the Government's claim for taxes, the court should hear and determine the proper amount due and that the collector should be restrained from taking any steps to distrain upon the company's property in the satisfaction of any sum in excess of the amount the court should allow. On October 15, T920, upon hearing such appli- cation, the Superior Court was of the opinion that it had no juris- diction to hear and determine the claim of the United States for taxes and that the assessment of the Commissioner of Internal Revenue was conclusive upon it. The court directed the trustees to pay the Government's claim for taxes, authorizing them to take steps to pro- tect the estate of the corporation by way of claim for refund and suit to recover back the taxes paid. Judgment was therefore entered in favor of the United States. From this order and judgment, and from the order denying the application of the trustees dated June 29, 1920, an appeal was taken to the Supreme Court of Errors for the State of Connecticut as above indicated. (T. D. 3166, dated May 19, 1921.) The higher court affirmed the lower court's decision in each case. In commenting upon the second case, the higher court said i*^ Decision. The facts found disclose that the federal taxes in- volved in these proceedings have not been paid, and that a claim for the abatement of said taxes is pending before the Commissioner of Internal Revenue, under Section 5949 (Sec. 3226, R. S., U. S.) of the Compilation of United States Statutes, 1916. Under such facts, in accord with the terms of Section 5949 (Sec. 3226, R. S., U. S.) *'Ib{d. APPEALS, REFUNDS, ABATEMENT 271 no suit, formal, or as here, informal, can be maintained to recover back or to abate such federal taxes in any court, state or federal. Under Section 5947 of such Compilation no suit, formal or informal, can be maintained to restrain the collection of federal taxes. Therefore the superior court had no jurisdiction to pass upon the legality of the assessment of the internal revenue taxes in question, or to issue a restraining order relating thereto, because of the provisions of the United States Statutes quoted above. Suit to recover may include penalties improperly collected. — If an illegal tax is paid, the fact that it was not paid within the time allowed by law will not prevent any taxpayer from recovering the penalty of i per cent a month paid by him for non-payment; for if the tax was illegal it was never due and therefore the penalty was as much unauthorized as the tax itself.*' Interest allowable on refunds, whether granted by the Commissioner or the courts. — Contrary to all previous laws, the 1 92 1 law provides that interest must be paid upon all claims for refund or credit allowed. The section seems to apply to refunds arising under all previous laws and covers all internal revenue taxes. Interest when allowed is allowable on all claims, whether voluntarily allowed by the Commissioner or by the courts. Law. Section 1324. (a) That upon the allowance of a claim for the refund of or credit for internal revenue taxes paid, interest shall be allowed and paid upon the total amount of such refund or credit at the rate of one-half of i per centum per month to the date of such allowance, as follows: (i) if such amount was paid under a specific protest setting forth in detail the basis of and reasons for such protest, from the time when such tax was paid, or (2) if such amount was not paid under protest but pursuant to an additional assessment, from the time such additional assessment was paid, or (3) if no protest was made and the tax was not paid pursuant to an additional assessment, from six months after the date of filing of such claim for refund or credit. The term "ad- ditional assessment" as used in this section means a further assess- ment for a tax of the same character previously paid in part. "Camp Bird v. lioivbrrt, 262 Fed. 114. Certiorari denied March 8, 1920, 252 U. S. 579- 272 APPLICATION AND ADMINISTRATION (b) Section 177 of the Judicial Code is amended to read as fol- lows: "Section 177. No interest shall be allowed on any claim up to the time of the rendition of judgment by the Court of Claims, unless upon a contract expressly stipulating for the payment of interest, ex- cept that interest may- be allowed in any judgment of any court ren- dered after the passage of the Revenue Act of 1921 against the United States for any internal-revenue tax erroneously or illegally assessed or collected, or for any penalty collected without authority or any sum which was excessive or in any manner wrongfully collected, under the internal-revenue laws." It is important to note that the date when interest begins to run varies with certain conditions. (See article 1040.) The JncHcial ("ode was also amended so that interest can he paid on all internal revenue claims allowed by the Court of Claims. I'rior to the passage of the 1921 law, the courts had held tJiat in suits against collectors interest was payable from the date of payment of an illegal tax."" Decision. The defendant's contention that interest was not allowable we cannot uphold. We liave very lately been told that — "Xo one could contend that technically a judgment of a Dis- trict Court in a suit against the collector was a judgment against or in favor of the United States." (Sage z'. U. S.^ 250 U. S. 33, 39, S. Ct. 415, 63 L. Ed. 83S, May 19, 1919). Consequently no question of allowance of interest or costs as against the sovereign arises and the suit is to be regarded .... as against a private person It is also urged that interest should not have been allowed as complained of, because the Commissioner signified his willingness to return that amount to plaintiff. Whether plaintiff would have preju- diced this suit by taking what it could get and suing for the rest is a matter not before us. It is enough to repeat that in this action the defendant, even though he has the United States behind him, is to be treated as a private person The important point to be noted is that the Treasury, after long delay, decided that the taxpayer was right and offered to ^ Neiv York Life Insurance Co. v. Anderson, decided January 14, 1920, 263 Fed. 527; affirmed 2.6g Fed. 1021. A writ of certiorari was granted March 28, 1921 (advance opinions, 65 L. Ed. 587; 41 S. Ct. 449). Writ was set aside on April 18, 1921 (advanced opinions, 65 L. Ed. 591 ; 41 S. Ct. 534). The application for the writ was finally denied Maj' 2, 1921 (advance opin- ions, 65 L. Ed. 699; 4 S. Ct. 536). APPEALS, REFUNDS, ABATEMENT 273 pay the claim without interest. Since the taxpayer had lost the use of his money for seven years he very properly claimed interest. Upon refusal of the Treasury to pay he brought suit and secured judgment. Any interest received, whether by suit or not, should be credited to interest. Such interest is taxable income. When taxes are erroneously assessed limitation does not apply. — It has been held by the Treasury that, whereas suits against the collector must be brought within five years after the payment of the tax, the limitation does not necessarily apply when the tax has been erroneously assessed by the United States.'' When suit is brought may the government open up the entire return? — Ruling Where an action for money had and received is brought against a collector of internal revenue for the amount of an additional tax paid on net income, the taxpayer is entitled to recover only such amount as is in reality greater than the tax which should have been assessed under the law as properly interpreted and applied. The fact that the Commissioner in assessing the tax erroneously allowed some deductions for depreciation does not operate as an estoppel against the collector or against the United States, as it is well settled that no assessment of the Commissioner is necessary for the collection of the tax, at least in a direct action by the United States ; nor does it make any difference that an assessment has been made, for in spite of the assessment and of the expiration of the period within which an amended assessment can be made, the United States may still sue for the amount actually due. It is immaterial that suit is in form against the collector, because the recovery in the end comes from the United States, so that even if the collector were per- sonally estopped, that estoppel under the circumstances does not apply against the United States. The conclusion is reached therefore that sums due the United States as determined by the court in suit against a collector of internal revenue are a valid offset as against the amount found due the taxpayer, though such sums include items which the Commissioner did not claim to be due the United States when considering the return for purposes of assessment. (C. B. i, page 258; T. D. 2882 (2).) See Income Tax Procedure, 1921, page 322. 274 APPLICATION AND ADMINISTRATION This might have been true so far as the laws prior to the 1918 act were concerned, when the government could bring suit at any time. Section 250 (d) of the 1921 act provides that no suit may be brought by the Commissioner after the expiration of a certain period. If the limitation period has run against the government before any counterclaim is made, it is doubtful if the entire return may be opened up. If a taxpayer filed a claim for refund for a certain item and also instituted suit within the limitation period, the government would certainly contend that the suit could include only the specific item claimed. In other words, after the period had expired, the claim could not be amended to include other items. The District Court for the Western Division of the Wes- tern District of Missouri"" has held that a suit may not include items which have not been presented to the Commissioner. The following statement is taken from the Treasury publications : Ruling. A taxpayer can not claim a deduction in court for the first time where, in its claim for refund filed precedent to bringing suit, it did not claim the right to such deduction or assert that it had failed to take it in computing net income in its return, or that it had failed to take credit for it, and where, consequently, a claim for the deduction was never presented to the Commissioner of Internal Revenue for his decision. (B. Digest 18-21-1611; T. D. 3164; Ct. D. II.) Claim for refund of sums recovered by suit. — The follow- ing regulation sets forth the detailed procedure necessary when a taxpayer makes claim for the refund of taxes or penalties erroneously collected by the government after suit has been brought and judgment secured. Regulation, (o) Claims by taxpayers for the amount of a judg- ment representing taxes or penalties erroneously collected should be made on form 843. The claimant should state the grounds of his claim under oath, giving the names of all the parties to the suit, the cause of action, the date of its commencement, the date of the judg- ment, the court in which it was recovered, and its amount. To this ^^ Kciiipcr Military School v. Crulclilcy, 274 Fed. 125. APPEALS, REFUNDS, ABATEMENT 275 affidavit there should he annexed a certified copy of the final judg- ment, a certificate of probable cause, and an itemized bill of the costs paid receipted by the clerk or other proper officer of the court, together with a certified copy of the docket entries of the court in the case or so much thereof as may be required by the Commissioner. When a recovery is had in any suit or proceeding against a collector or other internal revenue officer for any act done by him, or for the recovery of any money exacted by or paid to him and by him paid into the Treasury, in the performance of his official duty, and the court certifies that there was probable cause for the act done by the collector or other officer, or that he acted under the directions of the Secretary of the Treasury, or other proper officer of the Govern- ment, no execution shall issue against such collector or other officer, but the amount so recovered ^hall, upon final judgment, be provided for and paid out of the proper appropriation from the Treasury. ....(&) If the judgment debtor shall have already paid the amount recovered against him, the claim should be made in his name. There should also be a certificate of the clerk of the court in which the judgment was recovered (or other satisfactory evidence), showing that the judgment has been satisfied and specifying the exact sum paid in its satisfaction, with a detail of all items of costs which were paid by the judgment debtor or for which he is liable. (Art. 1 051; Reg. 45, Art. 1038.) Method of paying refunds. — Law. Section 131 7. That the paragraph of section 3689 of the Re- vised Statutes, as amended, reading as follows: "Refunding taxes illegally collected (internal revenue) : To refund and pay back duties erro- neously or illegally assessed or collected under the internal revenue laws," is repealed from and after June 30, 1920; and the Secretary of the Treasury shall submit for the fiscal year 1921, and annually thereafter, an estimate of appropriations to refund and pay back dudes or taxes erroneously or illegally assessed or collected under the internal-revenue laws, and to pay judgments, including interest and costs, rendered for taxes or penalties erroneously or illegally assessed or collected under the internal-revenue laws. Validity of tax may be determined by Bankruptcy Court. — In the case of In re General Film Corporation,^'^ the govern- ment filed proofs of claim against the bankrupt for additional taxes and interest. The trustee in bankruptcy objected to the claims and the court disallowed them. The government claimed U. S. V. Kellogg, 274 Fed. 903. 276 APPLICATION AND ADMINISTRATION that the only remedy open to the trustee for correcting any error was to pay the taxes and then proceed under Rev. Stat. Sec. 3226, by appeahng to the Commissioner for refund and subsequently bringing suit. It was held that under Section 64 (a) of the Bankruptcy Act the government's claims were not to be ordered paid as a matter of course and the trustee remitted to proceedings for refund,' but that the validity of the tax was a question to be passed mpon by the Bankruptcy Court in the first instance. The court said : Decision. We regard this section '(Section 64(a) of the Bank- ruptcy Act) as binding upon the government because it is named therein and, while conferring priority, as giving the bankruptcy court the power to hear and determine any question that arises as to the amount or legality of a tax assessed by it. The provision applies to taxes of all the persons mentioned, and w'e could not differentiate the government from the other persons in the absence of language justi- fying it. But section 3226, U. S. Rev. Stat., could under no circumstances apply to the case under consideration because the trustee is not seek- ing to maintain a suit for the recovery of internal revenue taxes il- legally assessed. Clinkenbeard v. United States, 21 Wall. 65, 22 L. Ed. 477; United States v. Nebraska Distilling Co., 80 Fed. 285, 25 C. C. A. 418. Refunds will not be entertained by either Commissioner or courts where a final determination has been had. — Sections 1312 and 1313 of the 1921 law provide that the taxpayer and the Commissioner may by agreement finally close a case. After this agreement has been made, neither may reopen the case. These sections are discussed in detail in Chapter \TI1, pages 210-21 1. Action to recover when government claims fraud or un- derstatement. — Law. Section 1323. That section 3225 of the Revised Statutes of the United States, as amended, is reenacted without change as fol- lows: APPEALS, REFUNDS, ABATEMENT 277 "Section 3225. When a second assessment is made in case of any list, statement, or return, which in the opinion of the collector or deputy collector was false or fraudulent, or contained any under- statement or undervaluation, such assessment shall not be remitted, nor shall taxes collected under such assessment be refunded, or paid back, or recovered by any suit, unless it is proved that such list, statement, or return was not willfully false or fraudulent and did not contain any willful understatement or undervaluation." The foregoing section contains a very material improve- ment in that understatements or undervaluations must be willfully false or fraudulent. In the 19 16 law the word "will- fully" in the next to last line and the word "willful" in the last line did not appear.^"* Credits Prior to the passage of the 1918 law, each year's taxes stood alone. A taxpayer was not allowed to offset one year's taxes against overpayment for previous years. Congress rec- ognized that this was an injustice; so the claim for credit was created. When may a claim for credit be filed? — Law. Section 252. That if, upon examination of any return of income made pursuant to this Act, the Act of August 5, 1909, en- titled "An Act to provide revenue, equalize duties, and encourage the industries of the United States, and for other purposes," the Act of October 3, 1913, entitled "An Act to reduce tariff duties and to provide revenue for the government, and for other purposes," the. Revenue Act of 1916, as amended, or the Revenue Act of 1917, or the Revenue Act of 1918, it appears that an amount of income, war-profits or excess-profits tax has been paid in excess of that properly due, then, notwithstanding the provisions of section 3228 of the Revised Statutes, the amount of the excess shall be credited against any income, war-profits or excess-profits taxes, or installment thereof, then due from the taxpayer under any other return, .... Regulation. Any amount of income, war profits or excess profits tax paid in excess of that properly due shall be credited " For text of decisions under 1916 law, see Income Tax Procedure, 1920, pages 211-212. 278 APPLICATION AND ADMINISTRATION against any such taxes due from the taxpayer under any other return. To obtain such credit the taxpayer should proceed as follows: (i) Where the credit demanded is equal to or less than any out- standing assessment of tax, a taxpayer desiring to obtain such credit shall file with the collector for the district in which his original return was filed a claim on Form 843, which shall be sworn to and shall contain the following statements: (a) business engaged in by claim- ant; (b) character of assessment; (c) amount of tax claimed as a credit; (d) unpaid assessment against which credit is asked and for what taxable year; and (c) all facts regarding the overpayment. (2) Where the amount claimed as a credit is greater than the outstanding assessment of tax, a taxpayer desiring to obtain such credit ^md the refund to which he is entitled shall file, Form 843, stat- ing thereon the respective amounts claimed as a credit or as a re- fund. All the facts regarding the total overpayment should be stated in the claim. (Art. 1034.) Claim for credit may be applied only against over-payment of "Income, War Profits, or Excess Profits Tax." — Ruling. Munitions tax overpayments for one year may not be credited against an additional assessment of munitions taxes for a subsequent or prior year. Munitions tax overpayments may not be credited against addi- tional assessments of income, excess profits and war profits taxes for the same or for any subsequent or prior taxable year. (C. B. 4— »■ Digest, page 330; A. R. M. 123.) Collector must receive clearance before accepting claim for credit. — Many taxpayers after having filed claims for refund also filed claims for credit against current taxes. The result was that the Treasury often had a claim for credit and refund covering the same item. It is understood that in many cases both claims were allowed, which, of course, means the taxpayer got more than he was entitled to. Taxpayers should notify the Commissioner to reject claim for refund before filing claims for credit with the collector for the same item. This is a reasonable recjuirement. Taxpayers should not be required to wait more than a reasonable time for the Commissioner's rejection of the claim for refund. Regul.\tiox. Upon receipt by the collector of a claim for credit on Form 843, he will make proper record thereof in his ofiice and. APPEALS, REFUNDS, ABATEMENT 279 except in the case of claims covering tax assessed on the hasis of returns on Form 1040 A, forward the claim inmiediately to the Com- missioner irrespective of whether or not a claim for refund of the tax now claimed as a credit has previously hcen filed. J^ue notice will be given the collector and the taxpayer of the action taken on the claim. If a claim is allowed against additional taxes due for other years, but such other taxes have not yet been assessed, only the amount of the excess of such taxes over the overpayment shall be assessed, or the excess of the overpayment over such taxes due shall be refunded as the case may be. The effective date of the filing of a claim for credit shall be the actual date of presentation to the collector. The filing of a claim for credit against the tax due under another return shall be subject to the same rules with respect to the addition of in- terest and penalties as if the taxpayer had filed a claim for abatement of the tax against which credit is desired. Under no circumstances will a taxpayer be entitled to credit for an alleged overpayment of tax prior to the allowance of such credit by the Commissioner. An attempt to take a credit prior to such al- lowance shall not be held to be the filing of a claim under section 252 of the Revenue Act of 192 1. (Art. 1035.) Ruling. Receipt is acknowledged of your letter of April 18, 1921, stating that your office has already filed a number of claims for credit in connection with the 1920 returns of your clients, in accord- ance with the provisions of Article 1035 of Regulations 45. As this procedure appears to be in conflict with the requirements of Treasury Decision 3154, dated April 12, 1921, however, you request to be ad- vised whether Treasury Decision 3154 was intended to be retroactive and, if so, to what extent? In reply, you are advised that Treasury Decision 3154 amending Article 1035 of Regulations 45, became effective on the date of its approval, April 12, 1921, and applies to all claims for credit filed on or after 'that date. Taxpayers, however, who had claims for refund on file with the Department, and converted these claims into claims for credit in ac- cordance with the regulations in effect prior to the issuance of Treasury Decision 3154, should request the Commissioner to reject such refund claims and consider only their claims for credit. (Letter to Klein, Llinds and Finke, New York, N. Y., signed by Acting Com- missioner M. T. West, and dated May 9, 1921.) Taxpayers wishing to substitute claims for credit in place of claims for refund should direct their requests to the Com- missioner at Washington. Such requests are generally com- plied with very promptly. 28o APPLICATION AND ADMINISTRATION Ruling. Receipt is acknowledged of your letter dated October 25, 1921, relative to submitting claims for credit to be considered in lieu of claims for refund already on file in this office. In reply you are advised that in accordance with the provisions contained in T. D. 3154, it is necessary for the claimant to request the rejection of any claims for refund covering the same period and including the same items as the credit claim which he desires to file before the latter can be accepted. This substitution may be greatly expedited, however, if the claimant's request is made direct to this office. Steps have been taken to insure the rejection of such claims in the shortest possible time and the letters notifying the claimants of the action taken are sent out immediately. A copy of the letter of rejection should be attached to the claim for credit and filed with the Collector of Internal Revenue for the taxpayer's District (Letter to The Corporation Trust Company, signed by Deputy Commissioner E. H. Batson, by C. B. Allen, Head of Division, and dated Nov. 9, 1921.) Time when credit is made or allowed. — In response to several questions submitted by the Unit, the Solicitor has issued the following opinion : Ruling. The reference, in effect, asks advice whether in a case where a claim for credit has not been filed by the taxpayer a credit for an excess of tax assessed for a prior year may be made or al- lowed if the examination of the return was made and the excess amount determined upon within the five-year period of limitation named in section 252, and the taxpayer within the limitation period was advised of the amount due on subsequent returns after the credit had been applied; but after the limitation period has expired the Department reconsiders and finds that a mistake was made in the amount of the tax due on the subsequent returns and the excess amount originally found as a credit (a) has not been changed, (b) should be increased, (c) should be decreased. It is assumed from the reference that the assessment represented by the original letter of advice to the taxpayer was not made. If it was made there would seem no room for doubt, since clearly the credit was made when the assessment list went out and any reduction or increase of tax would have to be accomplished by abatement or refund or further assessment. The question presented depends for solution upon what consti- tutes the making or allowance of a credit within the meaning of section 252. A statement contained in a letter from the Department to a taxpayer that the taxpayer is entitled to a credit is clearly not a credit actually made or allowed. Something must be done in a formal way that will amount to a direction to the collector who is charged APPEALS, REFUNDS. ABATEMENT 281 with the collection of internal taxes. Prior to such a direction lie has nothing to do with the taxpayer's account since it has not assumed that status of an accoinit stated to him. Such direction by the Com- missioner is usually made by formal assessment list signed by him. When such a formal statement or direction to the collector is signed by the Commissioner and forwarded to the collector, showing the amount of the tax to be collected over and above the credit, the Com- missioner has formally made or allowed the credit. When this is done the credit has been made or allowed, but prior thereto anything that is done in the way of stating the case by employees of the Bureau or in the way of statements to the taxpayer in letters from the Department can be nothing more than preliminary to the actual mak- ing or allowance of the credit by the Commissioner. This is true where credits are considered and passed upon formally by the Commissioner. Where, howevei*, the collector because of the provisions of the statute and regulations made pursuant thereto makes the credit without specific instructions from the Commissioner, the credit is actually made or allowed when the collector so records it, and in such a case subsequent action by the Commissioner in the way of a review of the collector's action, would not operate to fix the time when the credit was made or allowed, since in such a case the collector had before him the account of the taxpayer and is charged by law and the regulations to enter the credit. It is held that where the allowance of a credit as provided in section 252 of the Revenue Act of 191 8 is being considered by the Commissioner, the credit is made or allowed only when the Connuis- sioner signs and forwards to the collector a formal statement or direc- tion or assessment list showing the amount of the tax to be collected over and above the amount of the credit. (C. B. 4. page 339; Sol. Op. 106.) It is important that the privilege of filing claims for credit should not be abused, and the Treasury is justified in strictly interpreting the law. It is not unreasonable to require full compliance with the provisions regarding claims for refund. It should be noted, however, that the Solicitor did not answer the question : "Did the taxpayer as a matter of fact make what might reasonably be deemed to be a claim for re- fund within the limitation period?" Effect of a claim for credit. — The following memorandum by the Committee on Appeals and Review very aptly describes the function of a claim for credit : 282 APPLICATION AND ADMINISTRATION Ruling. A . . . . credit can not be made until the facts have been carefully examined and the validity of the credit approved by the Commissioner. That is not to say, however, that a claim for credit has no effect until approved. The claim for credit may have pre- cisely the same effect as a claim for abatement; that is, by forbearance of the collector it may suspend collection until it is acted upon by the Commissioner. If approved, credit is then given relieving both the collector and the taxpayer from any further liability. If rejected, interest is to be paid upon the amount suspended from the time it was due. This view of the law appears to be entirely consistent with its language and also with the purpose which it was believed Congress had in mind; that is to say, relief to the taxpayer from being re- quired to pay into the Treasury amounts, possibly large, at the same time that he is making a bona fide claim that other amounts are due him. As held in Law Opinion No. 957, it does not prevent the collector, if he so desires, from proceeding to collect at once just as he may do in the case of an abatement claim filed, but leaves it optional with him to suspend collection until such time as credit is given relieving both him and the taxpayer. (B. 19-20-924; A. R. M. 46.) Law Opinion 957" took the position that in order to credit an amount of tax against an overpayment for previous years, such overpayment must have been actually ascertained. The above ruling is in accord with the law and is observed in pres- ent procedure. Place of filing claim for credit when district is changed. — Ruling. Where a corporation filed a return for 1918 with the collector of one district and a return for 1919 with the collector of another district, and subsequently rendered an amended return for 1918, showing less tax liability, together with a claim for credit against the outstanding tax due for 1919, covering the overpayment to the extent shown by the amended return, it should file the amended return with the collector with whom the original return was filed for the year 1918. The claim for credit should be filed with the collector with whom the return for 1919 was filed, who should forward same to the col- lector with whom the return for 1918 was filed, for a notation thereon of the facts required by the certificate on the reverse side as to the assessment overpaid for 1918. When this has been done it will be returned by him to the collector with whom the 1919 return was filed, who will make a notation thereon as to the 1919 assessment to " C. B. I, page 256. APPEALS, REFUNDS, ABATEMENT 283 be credited, and forward same to the Commissioner of Internal Reve- nue for consideration. In filing the amended return the taxpayer should call attention to the fact that a claim for credit of the overpayment has been filed with the collector with whom the 1919 return was filed, and the col- lector with whom the claim for credit was filed should be notified that an amended return has been filed. (B. 48-20-1327; O. D, 740.) Claim for credit in case of affiliated companies. — Ruling. Upon the audit of the returns of several affiliated com- panies for the period 1909-1917, inclusive, it is found that certain of these companies are entitled to refund on account of excess taxes paid during that period. On the basis of the consolidated return for 1918, covering these companies, it appears that assessment of addi- tional taxes will be required. The question therefore arises whether refunds due the subsidiary companies may not be used as a credit against the additional tax to be assessed on the basis of the consoli- dated return. For the purposes of the income tax Acts each affiliated corpora- tion is considered a separate and distinct entity even though a con- solidated return is submitted on behalf of all. A claim for credit or refund of excess tax paid by one of the affiliated corporations can be made only by the corporation entitled to receive such credit or refund. Thus with respect to refunds, credits, and additional assess- ments each affiliated corporation occupies a status similar to that of an independent and unaffiliated corporation. The additional tax assessed for the year 1918, on the basis of the consolidated return for that year, must be apportioned among the affiliated corporations, and to the extent that each debtor corporation is entitled to receive back a part of the taxes paid in prior years, a claim for credit may be filed and the amount of additional tax each subsidiary is required to pay may be reduced thereby by the amount it is entitled to receive. In case the amount payable to the subsidiary exceeds its proportion- ate part of the additional tax assessed under the consolidated return, it may file a claim for refund for the difiference. A subsidiary which is required to pay additional tax and is at the same time entitled to receive back in the form of a refund a portion of the amount paid as taxes in prior years, may, however, within its option pay the entire amount of the additional tax and file a claim for refund for the entire amount it is entitled to receive. (B. 41-20-1237; O. D. 683.) Affiliated companies may apportion any tax assessed against them on any basis upon which they may agree; there- fore apportionment should be made so as to exhaust the entire amounts due from the government for prior years. 284 APPLICATION AND ADMINISTRATION May partners apply a credit against overpayment made by a partnership under the 191 7 law? — Ruling. Excess profits tax paid by partnership with respect to income received during 1918 can not be applied as credit to tax due from individual members for taxable year 1918. In such cases claim for refund on Form 46 should be filed by the partnership. (B. 7-19-310; O. D. 180.) The 191 7 law subjected all partnerships to an excess profits tax. As the 1918 act was not approved until 1919, many partnerships with fiscal years ending in 1918 made re- turns and paid such taxes for a part of 19 18. From an administrative point of view, the above ruling may be correct, but legally the partners are entitled to credit addi- tional taxes against their pro rata amount of the refund. Claim for credit when a partnership was incorporated prior to July I, 1919. — Ruling. Returns for 1918 were filed for a partnership and its members in accordance with the Revenue Act of 1917, prior to the passage of the Revenue Act of 1918, and tax paid accordingly. The partnership was incorporated prior to July i, 1919, and elected to be taxed as a corporation under the provisions of paragraph 3, sec- tion 330, Revenue Act of 1918. Amended returns for 1918 showing overpayment of tax were filed by the partners. There is no provision in the law whereby either the tax by the partnership or any excess tax paid by the partners may be credited against any tax liability of the successor corporation for any year. Remedy may be sought only by the partnership and the individual members thereof filing claiins for the refunding of any excess tax paid. (C. B. 2, page 247; O. D. 457.) There is no reason why the above credit should not have been allowed, because the stockholders in the new corporation were the partners in the partnership. (See C. R. 3, page 310; O. D. 757.) When successor corporation may file credit against over- payment of predecessor. — Ruling. In view of the fact that the statute of New Jersey under which a merger or consolidation of corporations resulting in the APPEALS, REFUNDS, ABATEMENT 285 formation of another corporation is accomplished provides, in effect, that the successor corporation shall represent predecessor corporations in the enforcement of their rights, it is held that the successor cor- poration is entitled to file claim for credit on account of the over- payment of tax by the predecessor corporation. (C. B. 4, page 335; O. D. 950.) Claim of credit may be filed by either husband or wife. — Ruling. Where claims for the refund of taxes erroneously paid for 1919 and prior years have been filed by the husband as a result of the Attorney General's ruling relative to community property under the laws of Texas (T. D. 3071), such claims for refund may be converted into claims for credit to be applied against any taxes due from the husband or wife as shown by separate returns filed by them for the taxable year 1920 and subsequent years, subject to the provisions of section 252 of the Revenue Act of 1918. Such claims for credit must be accompanied by an agreement signed by the hus- band and wife consenting to the adjustments therein demanded. A claim for refund may be filed for any excess of the amount claimed as a credit over taxes shown to be due. (C. B. 4, page 335; O. D. 854.) Claim for credit arising from joint return. — Ruling. The taxpayer's wife in 1918 filed a return showing a substantial net income upon which she paid the tax. Inasmuch as the taxpayer had a net loss for such year he filed no return. The taxpayer intends to file an amended joint return for himself and wife for 1918 and a claim for credit of the excess tax paid for that year to be applied against any tax due for the taxable year 1921. Held, that a single claim for credit may be so applied against any outstanding taxes due at the time the claim for credit is filed, pro- viding an agreement signed by the taxpayer and his wife consenting to the adjustments therein demanded accompanies such a claim. How- ever, if no outstanding taxes are due by the taxpayer or his wife, a claim of refund of the excess taxes paid for 1918 should be filed, accompanied by the agreement by the taxpayer and his wife referred to. (I-2-23; I. T. 1 162.) Claims for credit may be applied against refunds due under the undistributed profits tax of the 191 7 Act. — Ruling. The tax imposed on undistributed net income of cor- porations by section 10 (b) of the act of September 8, 1916, as amended by the act of October 3, 1917, is held to be an income tax within the meaning of section 252 of the Revenue Act of 1918 286 APPLICATION AND ADMINISTRATION and may, therefore, be credited against an additional amount of in- come tax due from the taxpayer within the limitations of that section. (B. Digest 1-20-662; O. 974.) Payment Under Protest Payment under protest unnecessary to support claim for refund. — In no event is it necessary to pay under protest to secure a legal right to demand a refund when it is believed that the tax has been erroneously assessed. Section 3220 of the Revised Statutes specifically covers this point. The in- tention of the law is that no one shall be erroneously or ex- cessively taxed. This intention is respected by the Commis- sioner of Internal Revenue. Sometimes his subordinates or persons in the offices of the collectors, acting with more or less praiseworthy zeal, treat a taxpayer's claim as if it were an attempt to extract money from the United States Treasury under false pretenses. Anyone with a legitimate claim might just as well convey the impression that the United States Treasury retains some of his money, collected under false pretenses. Both positions are wrong. The claim and its considera- tion should be as free from technicalities as possible and be made and treated as impartially as a business transaction. The whole matter should be as simple as the filing with a rail- road company of a claim for refund of an overcharge. Busi- ness men do not hesitate to make these claims against railroad companies, but heretofore they have not been so ready to go after tax overcharges. The reference to railroad claims ex- cludes the period during which the railroads were under gov- ernment control. It has been recommended by some authorities that all taxes reported, whether in any case they are more or less than the correct amount, should be paid under protest, not to acquire any right to claim a refund (that being possible without ques- tion), but to establish a perfect foundation for a suit against the collector if the claim for refund is rejected. The theory APPEAT.S, REFUNDS, ABATEMENT 287 is that if payment is made voluntarily, in full knowledge that the tax is erroneous, the taxpayer is estopped from any right to succeed in an action at law. If, as stated elsewhere, payment has been made without any knowledge of the illegality of the assessment, an action can be maintained for that reason. Furthermore, even where a claim has been made for abatement (before paying the tax) and it is refused, and notice is served by the collector that the tax must be paid or penalties will be enforced, it is evident that the payment is being made not voluntarily, but under duress, and the courts hold that collections in such circum- stances do not estop the payer from subsequent action at law. Should payment ever be made under protest? — In the case of an additional assessment after examination, where the facts upon which the government bases its claims are, in the opinion of the taxpayer, unfounded and illegal, there can be no harm, when making the payment, in attaching thereto a simple form of protest. For instance, little trouble is involved in attaching to the remittance this notice : I hereby protest against the assessment of the tax levied against me as evidenced in notice dated , on the ground that it is erroneous and illegal, and payment is hereby made solely to prevent the imposition of penalties threatened and the attachment of my property. Protest not necessary under certain conditions. — In one class of cases it certainly is not necessary to have paid under protest — that is, where a taxpayer prepared his returns in ac- cordance with Treasury regulations, believing them to be correct, and having been assessed thereon paid the tax in due course. In the cases of Greenport Basin and Construction Com- pany V. United States, and Young v. United States,^^' the court said, after quoting section 252 of the 1918 law, that: '"269 Fed. 58. 288 APPLICATION AND ADMINISTRATION Decision. Under the act, therefore, the refund is a matter of right, without proof of duress or protest. It has been so held under a similar statute. U. S. v. Hvo'slef, 237 U. S. i, 35 Sup. Ct. 459, 59 L, Ed. 813, Ann. Cas. 1916A, 286. Even if it were necessary to plead duress or protest, the petition or complaint sets forth that the defendant computed the tax under compulsion of the regulations and filed a claim for abatement of the taxes assessed before payment. This complies with every requisite of a payment under protest. Chesebrough v. U. S., 192 U. S. 253, 24 Sup. Ct. 262, 48 L. Ed. 432; City of Philadelphia v. Collector, 5 Wall. 720, 18 L. Ed. 614. The government urges that it is necessary to make a protest at the time of actual payment, but it seems to the court that this would be a useless requirement. The objects of the protest are to define the taxpayer's attitude and to notify the govern- ment thereof. These have been fully accomplished by the objection of the taxpayer when the computation was made and by the filing of his claim. When payment should be made imder protest. — While in- voluntary payment need not be made under protest in order to secure a refund in the manner provided by the act, in cases where recovery of taxes alleged to be illegally exacted is sought by an action at law, the federal courts have held that the claimant must show involuntary payment. In City of Phil- adelphia 7'. the CoUcctor,^' the United States Supreme Court said : Decision. Where the party voluntarily pays the money he is without remedy; but if he pays by compulsion of law, or under pro- test, or with notice that he intends to bring suit to test the validity of the claim, he may recover it back, if the assessment was erroneous or illegal, in an action for money had and received. In the case cited, Elliott v. Swartwout,^^ the court said : Decision. It is therefore to be considered as a voluntary pay- ment by mutual mistake of law; and in such case, no action will lie to recover back the money. The construction of the law is given to both parties, and each presumed to know it. Any instructions from the Treasury Department could not change the law or affect the rights of the plaintiff. He was not bound to take and adopt that con- struction. He was at liberty to judge for himself, and act accordingly. '"'■ 5 Wall. 720; 7J U. S. 720; 18 L. Ed. 614. °'35 U. S. 137; 12 Curtis 46; 9 L. Ed. ^Ji- APPEALS, REFUNDS, ABATEMENT 289 .... There can be no hardship in requiring the party to give notice to the collector that he considers the duty illegal, and put him on his guard, by requiring him not to pay over the money. The col- lector would then be placed in a situation to claim an indemnity from the government. But if the party is entirely silent and no intimation of an intention to seek a repayment of the money; there can be no ground upon which the collector can retain the money, or call upon the government to indemnify him against a suit. It is no sufficient answer to this that the party cannot sue the United States. The case put in the question is one where no suit would lie at all. It is the case of a voluntary payment under a mistake of law, and the money paid over is to the treasury; and if any redress is to be had it must be by application to the favor of the government, and not on the ground of a legal right. Court held that in case of mistake of law, protest was necessary to suit. In case of mistake of fact, such protest was not necessary. It should be noted that the foregoing case was decided in 1836. Arguments in favor of paying under protest. — Although the Treasury unreservedly states that a tax, if excessive, need not have been paid under protest to be recovered, there are certain cases which indicate that a taxpayer should pay under protest to protect his right to sue for refund. They are, however, not entirely clear and it will be found that the mod- ern tendency is to waive the formal protest. The following cases are illustrative of past practice: Wright v. Blakeslee, loi U. S. 174, 25 L. Ed. 1048 (1880) holds that, although no written notice or protest is required by statute of a party paying illegal taxes under the internal revenue laws, in order to recover the amount erroneously paid, he must, however, pay under protest in some form, or his payment will be deemed voluntary. As stated by Chief Justice Fuller, in Chesebrough v. United States.'" Decision. The rule is firmly established that taxes voluntarily paid cannot be recovered back, and payments with knowledge and without compulsion are voluntary. At the same time, when taxes 192 U. S. J53; 48 L. Ed. 432; 24 S. Ct. 262 (1904). 290 ArPLICATION AND ADMINISTRATION are paid under protest that they are being illegally exacted, or with notice that the payer contends that they are illegal and intends to institute suit to compel their repayment, a recovery in such suit may, on occasion, be had, although generally speaking, even a protest or notice will not avail if the payment be made voluntarily, with free knowledge of all the circumstances, and without any coercion by the actual or threatened exercise of power possessed, or supposed to be possessed, by the party exacting or receiving the payment, over the person or property of the party making the payment, from which the latter has no other means of immediate relief than such payment. In Hei'old V. Kahn,^^ the court said : Decision. The proper administration of the fiscal afifairs of the government, require that the payment of taxes should not be delayed by disputes as to their legality, but that the taxes should first be paid and all questions in regard to them be determined in suits brought for their refunding. It is a wise policy, therefore, that encourages the payment under protest of disputed taxes. Though there is some conflict in the dicta of the Supreme Court, we think that the true doctrine is that, when taxes are paid under protest that they are being illegally exacted, or with notice that the payor contends that they are illegal and intends to institute suit to compel their repay- ment, a sufficient foundation for such suit has been established.*^ Procedure of Collectors The procedure of collectors regarding claims for abate- inent and refund is not of general interest to taxpayers and is omitted from this book.®^ '"IS9 Fed. 608; 86 C. C. A. 598. ®' The mandate was recalled and amended in 163 Fed. 947 ; 90 C. C. A. 307, so as to include interest from tiie date of the judgment of the District Court. " See T. D. 3260. CHAPTER X INFORMATION AT THE SOURCE The provisions of the 1918 law requiring certain informa- tion returns have been re-enacted in the 1921 law in identical terms. The system of information at the source was introduced in the 19 17 law with a dual purpose — to obtain an effective method of check regarding certain classes of income included or which should be included in tax returns, and to remove the causes of complaint leveled at the provisions of the 19 13 and 1916 laws regarding withholding of tax at the source. "Collection before receipt," as withholding has been called, was, and still is, a salient feature of the British income tax law ; but its adoption in this country proved too technical and unsuited to American conditions. The use of information returns, now in force, provides a method of supplying the taxing authority with a vast amount of accurate information regarding taxable income which, if used intelligently, will enable the government to obtain almost as definite a hold on the income in question as if the tax had been withheld by the payor. It is important that those responsible for the filing of in- formation returns become cognizant of the requirements of the law, not only as an assistance to the government but also in order to prevent the infliction of penalties on themselves for non-compliance. The farmer paying a foreman $90 a month must be educated to obey the law just as much as a corporation which pays its president $9,000 a month. Information returns on all payments would result in the submission of an immense amount of material, a large part of which would be entirely valueless. The framers of the law made it discretionary with the Commissioner, subject to cer- 291 292 APPLICATION AND ADMINISTRATION tain limitations, as to the type of returns that may be demanded. For this reason, the regulations make ver)^ full provisions as to the information returns required. Classification of information returns. — Returns of informa- tion may be divided into the following groups: 1. Returns for all payments of fixed and determinable income, such as interest (other than bond interest), rent, wages, salaries, fees, commissions, etc., pay- able to citizens or residents and to foreign partner- ships. 2. Ownership certificates which must be used in collecting interest on foreign and domestic corporation bonds, and dividends on foreign stocks. 3. Withholding returns in the case of all payments of fixed and determinable annual or other periodical income payable to non-resident alien individuals and foreign corporations. 4. Returns of payments of domestic dividends. 5. Returns of payments of profits to clients by brokers. 6. Returns disclosing actual ownership of stock made chiefly by foreign principals. The pages immediately following deal with returns for payments of fixed or determinable income, while the subject of ownership certificates is covered in the latter part of this chap- ter. Withholding returns are discussed in Chapter XI. Payments of Fixed or Determinable Amount Who must furnish information as to payments of salaries, interest, rent, etc., of $1,000 or more. — Law. Section 256. That all individuals, corporations, and part- nerships, in whatever capacity acting, including lessees or mortgagors of real or personal property, fiduciaries, and employers. The classes to which paid. — making payment to another individual, corporation,^ or partnership, * Payments to corporations need not be reported (Art. 1074). INFORMATION AT THE SOURCE 293 Description of payments. — of interest, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income (other than payments described in sections 254 and 255), [The exceptions are dividends and transactions by brokers (see page 302)]. The amount to be reported. — of $1,000 or more in any taxable year. Employees of United States government must make re- turn. — or, in the case of such payments made by the United States, the officers or employees of the United States having information as to such payments and required to make returns in regard thereto by the regulations hereinafter provided for, Form of returns.- — shall render a true and accurate return to the Commissioner, under such regulations and in such form and manner and to such extent as may be prescribed by him with the approval of the Secretary, setting forth the amount of such gains, profits, and income, and the name and address of the recipient of such payment The regulation dealing with this matter follows : Regulation. All persons making payment^ to another person of fixed or determinable income of $i,ooo'' or more in a taxable year must render a return thereof to the Commissioner for the preceding calendar year on or before March 15 of each year, except as specified in articles 1073, 1074, 1075, 1076, and 1079. The return shall be made in each case on Form 1099, accompanied by a letter of transmittal on Form 1096 showing the number of returns filed. The street and ' [Former Procedure] Under the 1913 and 1916 laws there were pro- visions for withholding at the source for all classes of fixed and determin- able annual or periodical income. These withholding returns constituted a source of information, but "information at the source" in the strict sense was first provided for in 1917 law. This system was substituted where withholding at the source was abolished. The provisions of the 1918 law regarding information are substantially the same as those of the 1917 law. * These returns are required for actual amounts paid or credited and made available during the calendar year equal to or exceeding $1,000. (C. B. 2, page 249; O. D. 428.) * [Former Procedure] Under the 1917 law the amount to be reported was an annual aggregate of $800. 294 APPLICATION AND ADMINISTRATION number where the recipient of tlic payment lives should be stated, if possible. Where no present address is available, the last known post-office address must be given. Although to make necessary a return of information the income must be fixed or determinable, it need not be annual or periodical. '^ (Art. 1071.) The new article omits the requirement of reporting on form 1096 the aggregate amottnt represented by the separate form 1099. The new form only requires a statement of the number of forms 1099 attached thereto. Ruling. A receiver in partition proceedings is required to file returns of information covering payments of commissions, attorney's fees, and other fixed or determinable income of $1,000 or more made to any person during the taxable year. (B. 52-21-1995; O. D. 1149.) Returns cover calendar year. — Law. Section 256 The provisions of this section shall apply to the calendar year 1921 and each calendar year there- after, .... The instructions on form 1099 (1920) state: One of these forms must be filled in for each person to whom in- come, as described on this form, was paid during the calendar year Fixed and determinable income defined. — The law re- quires returns of information only when the income is fixed and determinable. It is not necessary that the income be an- nual or periodical, as stipulated in the requirement for with- holding. Regulation (a) Income is fixed when it is to be paid in amounts definitely predetermined. On the other hand, it is determin- able whenever there is a basis of calculation by which the amount to be paid may be ascertained (Art. 362,) It has been held that where a lease provides for a payment of rental in crop shares, the landlord and tenant sharing pro- portionately the expenses and dividing the proceeds, such pay- ° Where withholding is required the income must be annual or periodi- cal as well as fixed and determinable. INFORMATION AT THE SOURCE 295 merits are not fixed and determinable and need not be re- ported." Commission on account of a single transaction has been held not to be fixed or determinable annual income.' Income credited but not paid is subject to the provisions of article 362.* Fees for professional services should be included in informa- tion returns.® Earnings of lawyers and doctors are not usu- ally within the purview of this provision of the law (unless they are paid a regular retainer).^" Payments to employees. — Returns of information regard- ing payments to employees, other than those against whom withholding is required, are specifically covered as follows : Regulation. The names of all employees to whom payments of $1,000 or over a year are made, whether such total sum is made up of wages, salaries, commissions, or compensation in any other form, must be reported. Heads of branch offices and subcontractors employing labor, who keep the only complete record of payments therefor, should file returns of information in regard to such pay- ments directly with the Commissioner. When both main office and branch office have adequate records, the return should be filed by the main office. In case an employer has a large number of employees and the computation of exact amounts paid during the calendar year will result in an undue hardship, careful estimates may be made on the basis of any representative month, and unless the yearly payment based on this estimate in the case of any employee amounts to $1,000 or more, no return of payments to such employee is required. (Art. 1072.) The new regulation permits employers who have a large number of employees to make returns on estimated payments. The old regulation extended this privilege only to employers having a large number of employees who were being moved from job to job. To report accurately the payments made to individual employees occasions a great amount of unnecessary expense •Treasury Bulletin "B," page 38; also C. B. i, page 261; O. D. 115. 'C. B. 4, page 232; O. D. 907. ' C. B. 2, page 249 ; O. D. 428. * C. B. 2, page 248; O. D. 416. "Treasury Bulletin "B," page 11. 296 APPLICATION AND ADMINISTRATION to many large corporations. It has been ascertained that the production of $1 tax to the government has cost corporations in some cases as much as $10. The new regulation will reduce the labor involved to some extent, but the author is still of the opinion that the requirements of the government, in so far as this particular form of information is concerned, would be amply met if corporations were to report merely the name and address of any employee paid at the rate of $1,000 per annum or over without specifying the exact sum paid. If an employer is required under a state law to withhold a tax on an employee's salary, the gross payment before de- duction should be reported. Ruling, In executing Form 1099, ^" employer who is required to withhold tax from an employee under a State income-tax law, should report on such form the amount of the salary paid to the em- ployee plus the amount of the tax withheld. The employee should report the same amount in his personal return on Form 1040 or Form 1040A as the case may be. (C. B. 2, page 249; O. D. 401.) The value of living quarters and board furnished em- ployees^^ must be considered by employers in preparing re- turns of information : Rulings A person receives cash compensation for services rendered, and in addition thereto living quarters ; when such quarters are furnished for the benefit and convenience of employees, the amount of cash compensation plus the value of living quarters must be returned. When, however, Hving quarters are furnished for the convenience of the employer only, the value thereof rreed not be returned. Board and lodging furnished seamen in addition to their cash compensation is held to be supplied for the convenience of the employer (Treasury Bulletin "B," page 38.) The value to a domestic servant of the board and lodging received as part of his compensation for services rendered is deemed to be the same amount which he would be required to pay for board and lodging elsewhere than in his employer's household. If the value of the board and lodging added to the cash compensa- tion equals or exceeds $1,000 an employer is required to report such amount on Forms 1099 and 1096. The value of the board and lodging " See Chapter XIV. The 1921 law specifically provides that the rental value of a minister's house is not taxable and should therefore not be reported. INFORMATION AT THE SOURCE 297 should be entered separately on Form 1099, as evidence of the fact that such value has been considered in computing the total amount received by the servant. (C. B. 4, page 348; O. D. 874.) In view of the foregoing, employees should be advised by employers regarding the tax to which they are subject. Return of information by partnerships, personal service corporations, and fiduciaries. — Information returns on forms 1099 and 1096 are required in all the above cases regardless of whether such income amounts to more or less than $1,000 annually.^" Salaries paid to members of partnerships or personal service corporations must also be included in the returns of information. Similarly, if a fiduciary receives a salary from an estate, an information return must be filed. All payments by partnerships, personal service corporations, and fiduciaries to employees must be reported if such payments equal or exceed the statutory mini- mum. Many taxpayers object to making information returns for members of partnerships and personal service corporations and for beneficiaries, because such information is shown on the partnership return 1065 dnd the fiduciary return 1041. This duplication of information returns Vk^as the subject of a recent conference at Washington between the Secretary of the Treas- ury and representative bankers and others. It resulted in the, elimination of forms 1096 and 1099 in these cases, as stated in the instructions on the new form 1096. Ruling. A business w^hich had been operated as a partnership was incorporated in June, 1920, and thereafter operated as a corpora- tion. There was no interruption to the business, and the employees of the partnership were retained by the corporation. '^ See Treasury Bulletin "B," page 3q; also C. B. 4, page 348; M. 2708. [Former Procedure] Ruling. "Form 1099 's required to be filed for the calendar year. A partnership which renders its return on a fiscal year basis should report on Form 1099 the distributive share of each member of the partnership for the fiscal year ending within the calendar year for which the Form 1099 is rendered." (C. B. 4, page 348; O. D. 885.) 298 APPLICATION AND ADMINISTRATION Held, that for administrative purposes it will not be considered that there was a change in employer. Since there was no inter- ruption to business, and the employees of the partnership continued to be the employees of the corporation, only one Form 1099 covering the calendar year 1920 is required to be filed in each case where the total amount of payments made equalled or exceeded $1,000. (C. B. 4, page 347; O. D. 788.) Information returns of bond interest and foreign dividends not limited to payments of $1,000. — The statutory provision as to information returns in case of bond interest and foreign dividends is as follows : Law. Section 256. . . . . Such returns may be required, regard- less of amounts, (i) in the case of payments of interest upon bonds, mortgages, deeds of trust, or other similar obligations of corpora- tions, and (2) in the case of collections^^ of items (not payable in the United States) of interest upon the bonds of foreign countries and interest upon the bonds of and dividends from foreign corporations by individuals, corporations, or partnerships, undertaking as a mat- ter of business or for profit the collection of foreign payments of such interest or dividends by means of coupons, checks, or bills of exchange Monthly and annual returns required/* — The withhold- ing agent is required to make monthly and annual returns as follows : • Regulation, (a) Every withholding agent shall make an an- nual return to the collector of the tax withheld from interest on cor- porate bonds or other obligations on or before March i on Form 1013. He shall also make a monthly return on Form 1012 on or before the 20th day of the month following that for which the return is made. The original ownership certificates, or the substitute certificates where authorized, must be forwarded to the Commissioner with the " [Former Procedure] Ruling. "The term 'collections' as used in section 256 of the Revenue Act of 1918 includes the following: "(a) The payment by the licensee of the foreign item in cash; "(b) The crediting by the licensee of the account of the person present- ing the foreign item ; "(c) The tentative crediting by the licensee of the account of the per- son presenting the foreign item until the amount of the foreign item is received bj' the licensee from abroad ; "(d) The receipt of foreign items by the licensee for the purpose of transmitting them abroad for deposit." (I-4-47; L T. 1176.) " See Chapter XI. INFORMATION AT THE SOURCE 299 montlily return .... the tax withheld must be paid on or be- fore June 15 of each year to the collector (Art. 371; Reg. 45, Art. 370.) The ownership certificates are now to be sent to the Com- missioner and not to the collector as previously. If a non-resident alien claims exemption on tax-free cove- nant bonds on or before February i by filing with the with- holding agent form looiB, the amount of tax due from the withholding agent as shown by form 1013 may be reduced b)- 2 per cent of the aggregate amount of interest payments made to such individual during the calendar year.^^ When forms looi and lOOiA are used there is no actual withholding , such returns being simply information returns}^ Monthly and annual returns are nevertheless required. ^^ Regulation. Where a debtor corporation or its duly authorized withholding agent has made payments of interest on its bonds, but in certain instances has been required to withhold no tax, the owner- ship certificates on Form looi filed in connection with such payments shall be transmitted to the Commissioner, accom- panied by a return on form 1096A showing the number of ownership certificates thus transmitted and the total amount of interest paid. This return shall be made by the 20th day of each month following that for which the return is made and need not be sworn to. An annual return shall be forwarded to the Commissioner not later than March 15 of each year on form 1096B, on which shall be given a summary of the monthly returns (Art. 373.) Return of information as to foreign items. — Regulation. In the case of collections of foreign items, re- gardless of amount, the original ownership certificates, when duly filed, shall constitute and be treated as returns of information, (o) In the case of dividends, as to which the first bank or collecting agent is the source of information, it shall detach the ownership " See Chapter XXXVI for discussion of personal exemption of non- resident aliens. " It should be noted that all withholding returns are treated as informa- tion returns and are therefore mentioned in this chapter. All information returns, however, are not withholding returns and this distinction should be noted. " The requirement as to monthly and annual returns covering payments on form lOoiA are the same as for looi. The regulation governing re- turns on form lOOiA is quoted in full on page 316. 300 APPLICATION AND ADMINISTRATION certificate and indorse on the item the words, "Certificate detached and information furnished," adding its name and address. When foreign items have been indorsed as above prescribed, the certifi- cates shall be forwarded to the Commissioner on or before the 20th day of the month following that during which the items were accepted, ac- companied by a return on form 1096A showing the number of cer- tificates. An annual return on form 1096B shall be forwarded to the Commissioner not later than IMarch 15 of each year, on which shall be given a summary of the monthly returns, (b) In the case of interest items, as to which the paying agent or the last bank or collecting agent in this country is the source of information, the own- ership certificate shall accompany the coupon to such agent or source of information, who shall forward the ownership certificate to the Commissioner in the same manner as above provided with respect to dividend items. Where ownership certificate Form 1000 is used, a monthly return shall be made on Form 1012 and an annual return on Form 1013, as provided in articles 361-375 (Art. 1079.) The name of the paying agent should be shown on forms 1012 and 1013 when they are used to make returns of owner- ship certificates covering foreign interest. The aggregate amount of foreign items is no longer reported on form 1096A. The provisions of subdivision (b) above are appHcable also to foreign registered bonds. ^^ Information regarding foreign items. — "Foreign items" and the source from which information is obtained are ex- pressly stated as follows : Definition of "foreign item." — Regulation. The term "foreign item," as here used, means any dividend upon the stock of a nonresident foreign corporation or any item of interest upon the bonds of foreign countries or nonresident foreig'n corporations, whether or not such dividend or interest is paid in the United States or by check drawn on a domestic bank. Source of information. — (a) Wherever a foreign country or nonresident foreign corporation issuing bonds^^ has appointed a paying agent in this country, charged "C. B. 3, page3i3; O. D.674; " A non-resident corporation is defined as "a foreign corporation not engaged in trade or business within the United States and not having any office or place of business therein." "A foreign corporation not engaged INFORMATION AT THE SOURCE 301 with the duty of paying the interest upon such bonds, such paying agent shall be the source of information. If such foreign country or foreign corporation has no such agent, then the last bank or col- lecting agent in this country shall be the source of information. (b) In the case of dividends on the stock of a nonresident foreign corporation, however, the first bank or collecting agent accepting such item for collection shall be the source of information. No return of information is required with respect to foreign items owned by a nonresident alien individual, a foreign partnership, or a foreign cor- poration, provided the first bank or collecting agent is satisfied as to such ownership. In such case the foreign item may be stamped "foreign owner." (Art. 1076; Reg. 45, Art. 1077.) Returns of payments to non-resident aliens.-" — Regulation. In the case of payments of annual or periodical income to nonresident alien individuals, partnerships composed in whole or in part of nonresident aliens and not having an office or place of business within the United States, or to foreign corporations not engaged in trade or business within the United States and not having any office or place of business therein, the returns filed by withholding agents on Form 1042 shall constitute" and be treated as returns of information. (Art. 1075; Reg. 45, Art. 1076.) Form 1042 is the annual list return of the withholding agent which must be filed on or before March i. Ruling. A withholding agent is not relieved from obligation to pay to the Federal Government the amount of tax correctly with- held from the income of a nonresident alien by reason of the fact that the nonresident alien has filed a return showing no tax liability. (B. 31-21-1756; O. D. 985.) Return of payments of dividends. — Law. .Section 254.-^ That every corporation subject to the tax in trade or business within the United States which has a fiscal agent in the United States, is not a resident corporation." See Treasury Bulletin "B," page 10. * There is no withholding on fixed and determinable annual or other periodical income paid to foreign partnerships, except in the case of in- terest on tax-free covenant bonds. Apparently information returns must be filed on form 1099, in the case of such payments. (Bulletin 1-19-10; O. D. 76.) If the income of non-resident aliens is not fixed or determin- able, no information return is required. (C. B. 3, page 312; O. D. 673.) '^ [Former Procedure] Reg. :i^, 1918, Art. 33, referred to special Regulations 40, governing returns to be made by brokers, but these were apparently never promulgated. 302 APPLICATION AND ADMINISTRATION imposed by this title and every personal service corporation shall, when required by the Commissioner, render a correct return duly verified imder oath, of its payments of dividends, stating the name and address of each stockholder, the number of shares owned by him, and the amount of dividends paid to him. Regulation. When directed by the Commissioner, either spe- cially or by general regulation, every domestic or resident foreign corporation and every personal service corporation shall render a return on Form 1097 of its payments of dividends and distributions to stockholders for such period as may be specified, stating the name and address of each stockholder, the number and class of shares owned by him, the date and amount of each dividend paid him, and when the surplus out of which it was paid was accumulated. (Art. 1060; Reg. 45, Art. 105 1.) Returns of brokers. — Law. Section 255. That every individual, corporation, or part- nership doing business as a broker shall, when required by the Com- missioner, render a correct return duly verified under oath, under such rules and regulations as the Commissioner, with the approval of the Secretary, may prescribe, showing the names of customers for whom such individual, corporation, or partnership has transacted any business, with such details as to the profits, losses, or other information which the Commissioner may require, as to each of such customers, as will enable the Commissioner to determine whether all income tax due on profits or gains of such customers has been paid.^^ Regulation. When directed by the Commissioner, either specially or by general regulation, every person doing business as a broker shall render a return on Form iioo, showing the names and addresses of customers to whom payments were made or for whom business was transacted during the calendar year or other specified period next preceding and giving the other information called for by the form. (Art. 1065; Reg. 45, Art. 1061.) Where no return of information on forms 1099 and 1096 is required. — As previously stated, the statute gives the Com- missioner discretionary powers as to the class of payments to be reported on information returns 1099 and 1096. The list of specific payments which require no information returns follows : *" [Former Procedure] A similar provision was in the 1917 law, but no return of dividends paid was ever required, except in the case of pay- ments to foreign corporations — these being liable to withholding of the tax. INFORMATION AT THE SOURCE 303 Regulation. Payments of the following character, although over $1,000, need not be reported in returns of information on Form 1099: (a) payments of interest on obligations of the United States; (b) dividends paid by domestic or resident foreign corporations; (c) payments by a broker to his customers; (b) payments of any type made to corporations; (c) bills paid for merchandise, telegrams, tele- phone, freight, storage, professional services, and similar charges; (/) annuities, representing the return of capital; (g) payments of rent made to real estate agents (but the agent must report pay- ments to the landlord if they amount to $1,000 or more annually; (h) payments made by branches of business houses located in for- eign countries to alien employees serving in foreign countries; and (i) payments made by the United States Government to sailors and soldiers and to its civilian employees. (Art. 1073; Reg. 45, Art. 1074.) The instructions on form 1096 state that no return on form 1099 is required in case of "Distributions to members of a part- nership, personal service corporation and beneficiaries." Ruling. An employer is not required to report on Form 1099 the amount representing compensation for personal injuries or sickness paid to an employee. (C. B. 4, page 349; O. D. 858.) Although several types of income paid by states or political subdivisions thereof are exempt from tax, there are numerous instances in vi'hich taxable income is paid. Such taxable in- come must be reported: Ruling. A department of municipal government is required to file a return of information as provided in section 256 of the Revenue Act of 1918, showing payments of fixed or determinable gains, profits, and income of $1,000 or over in any taxable year, excluding from the return, however, payments made as salary or wages to officials or employees of a State or political subdivision thereof, and payments of interest on the obligations of a State or political subdivision thereof. (C. B. 2, page 249; O. D. 470.) When extensions of time for certain returns of income^* have been granted for a period not exceeding ninety days after the proclamation of peace, such extension does not authorize any delay in filing returns of information." '^ Sec page 61. "* See article 446, page 60. 304 APPLICATION AND ADMINISTRATION H H Pi w O o o = -3 .£? - cs:e 23 23 13 13 s s o o ° i o 5.S 2j s.s 2j 23 23 o.S 2j s.s s.s 2j CO S '^ 23 -< 1 13 5"! 2j 5 ^ 23 s.s 2J 23 S.S 2j to < a. o '- < -S CO c . BO XI 1: >< o rt C o.S <^ o o5^ 23 5'" s.s o o IN s.s 13 §3 (U 23 23 s.s 2j 13 O.S l3 0) 8.5 o^ 1 CD O - 2J 23 >=: c 23 OJ 23 23 2-1 13 o.H 2hJ — . "" O ^ a o S o. E 0) i-i u c/l c u u O n (I) N o a c o a, 0) X D c cu •a (U u t- ^ 1) ■^ u a □ c a _o a a o c c o p Q "a > c .2 "5 r IS 0) V. c o D C c« Ph C "v 5 c 0) o E o b« > c ttf u o c. u o o fa a c c c cs u c a 6 c if '_S o c o O e h; '5 c .£■ : "3 • u . u • a ■ ^ : . *-» ' 3 ; •d ■ 0) • > ; '- es ...^ c — c t^ o-S 3 o C 'O •5 c „ c £ rt 5 c 2 S ©■ m •S'o ij c ■^ J3*" X O whic and d by nal e pers H M . lU o u "cTS 3 V- J5 § c « ^ J3 O 1) O. _ M M .- C J3T3 ^ .? 3 3w " and is£ St on s ent, sho ships. I, after Q H ountry iiitere cal ag artner used. I, 192 V 3 m ^* -^ '.S ■" u C a> X cg-:|-SE ^ „ X V.-0 5 agen al ta ress or shou to D 2 "5 seal orm add estic lA up m (T- C C ffi T3 1 S. a a c ^.^ OTS j3 having ithhold name nd by , form artners E u -^ "> ,„ — . *^ kT ■« 2 C ■« & ^ —•0. 2.4)^ O 11 £ v- S >« C O 3 Oi o o. - rt^EIH.SS'x; T3 Sf '►■O -^ « 2 OJ O ^~ Ul « o .2 M •2 m"^ « " r- ■" ^•nEc"S'> «" •^■> ^ Si-' O CJ tJ u 1-5 1- C"*- D « U C u, n " «rJ3 — ■.. O 4, r^ ° c ift: c 5 » c M« fl) iJ rt r *" a o m > S**- t; o tn t) S. " OJ oic o^ £ c ^ O O-i^ ^^ V o '^ P ■" m ^^ -r -c J! r . a_2.5 c X-- o> S >- ..; M k. o u INFORMATION AT THE SOURCE 305 Returns under systems of "information at source" and "payment at source." — Returns by withholding agents, treated in more detail later, are required of the various classes of withholding agents covered by the regulations. Corporations paying interest on bonds and similar forms of indebtedness are required to report the amount withheld in any month on or before the 20th day of the following month, using for this purpose form 1012. At the close of the year and on or before March i of the following year, these monthly returns are summarized on an annual return, using form 1013. The monthly returns referred to above are not required by the statute, but are demanded under regulations prescribed by the Commissioner as a convenience in reporting this tax. Their purpose is to enable the Treasury to audit and check from month to month the items therein reported, and thus avoid congestion at the close of the year. The annual re- ports, however, are required by the statute, and failure to file them subjects the withholding agent to penalties the same as those for failure to file the annual returns of net income.*^ An extension of time may be obtained for filing the list returns in the same manner and for the same reasons as those apply- ing to returns of net income. ^^ Tax withheld from income other than bond interest will be accounted for on income tax form 1042, and separate re- ports of the payments entered in form 1042 will be made on form 1098. Employers, tenants and debtors must report annually on form 1099"' amounts of $1,000 or more, paid for salaries, wages, rents, interest, premiums, etc., during the year. In the case of payments of bond interest and collection of for- eign dividends the report is not limited to amounts in excess of $1,000. As one person, firm or corporation may find it ' Sec page 132. ' See page 157. 'For classes of items lo be rcporlcd, sec page 293. 3o6 APPLICATION AND ADMINISTRATION necessary to fill out more than one form 1099, it will be neces- sary to accompany the forms with a letter of transmittal, which is known as form 1096. The form used for non-resident aliens is form 1098. Affiliated corporations do not make a consolidated report for purposes of information. Form 1099 is to be used by each corporation separately in reporting payments.^® A graphic chart published by the government (Treasury Bulletin ''B'") will be found helpful (see page 307). The chart indicates in heavy-faced type the number of the form at its point of origin. For instance, form 1000, shown in heavy-faced type opposite the caption "Individual or Owner," is made out by the individual or other owner of the securities, and by him is forwarded to the bank or collecting agent. Subsequently form 1000 is shown in light-face type, indicating its receipt and forwarding, respectively, by the bank, the payor, the collector, and finally the Commissioner. Some of the other forms do not pass through as many hands. For instance, form 1087 goes directly from the individual to the Commissioner. Ownership Certificates Use of ownership certificates. — Perhaps no feature of our revenue laws has been more confusing to taxpayers than the proper use of ownership certificates. Such certificates are re- quired "for the purpose of eft'ectuating the withholding re- quirements of the law relating to the payment of tax at the source on bonds and similar obligations, and in order to obtain information at the source."*^ The withholding requirements of the statute regarding tax-free covenant bonds have com- plicated their use.^° Regulation. The owners of bonds or other obligations, except See Appendix B. Treasury Bulletin "B," paj^c 21. ' See Cliaptcr X for discussion of this subject. INFORMATION AT THE SOURCE 307 5f2 III ° - s ?2 N OQ i cQ 0- CD - < ,9. H- ii -J ran s . sii CQ Si d 8 <^ ^ CO „ 1 1° 11 ~~" 8 '*> a cn UJ o is: z: < cQ o uJ _l < O o Q I- a: |_ < CL e _J _J o o z: ^ LlJ Ij-I ± a: LU ct: O LU 3o8 APPLICATION AND ADMINISTRATION domestic and resident corporations, whether or not such bonds or other obhgations contain a free-tax covenant, issued by domestic or resident foreign corporations, when presenting interest coupons for payment shall file a certificate of ownership for each issue of bonds, showing the name and address^^ of the debtor corporation, the name and address of the owner of the bonds, the nature of the obligations, the amount of interest and its due date,"- and the amount of any tax withheld (Art. 365; Reg. 45, Art. 364.) Domestic corporations presenting interest coupons for pay- ment need no longer attach ownership certificates. The re- quirement that ownership certificates should show the marital status of the owner is eliminated. Rulings. If banks and other collecting agents accept coupons for collection to which are attached incomplete or otherwise improperly executed ownership certificates, such banks or collecting agents be- come a party to the filing of incomplete returns of information and shall upon demand of the debtor furnish the name and address of the owner of the coupons so that such ownership certificates may, when filed, be accepted as returns of information in accordance with the provisions of the regulations issued under section 256 of the Revenue Act of 1918. (C. B. 4, page 232; Mim. 2725.) Since the debentures of the M Company are evidence of indebted- ness on the part of the M Company the payments made on the de- bentures are not dividends but payment of interest. The holders of such debentures are therefore required to file ownership certificates on Form looi when receiving payment made by the corporation un- der the terms of the debenture. (C. B. 4, page 232; O. D. 1060.) All ownership certificates should contain complete informa- tion, or payment should be refused. The interest of the tax- payers and the agents demands this. Taxpayers who fail to file the required form automatically waive the credit which they might otherwise claim for tax constructively withheld at the source. Once a form has been accepted by banks or other collecting agencies, the responsibility for its corrections lies with such banks or agents. ^^ They should always bear the ^ It is not necessary to enter the street address of the debtor corporation on the ownership certificate. (O. D. 615.) ^' Bondholders frequently enter the maturity date of the bond, instead of the due and payment date of the coupon. '^ See page 312. INFORMATION AT THE SOURCE 309 signature of the owner or his agent. Space is also provided for reporting foreign dividends. The use of ownership certificates takes the place of information returns 1099 and 1096. Regulation. In the case of payments of interest, regardless of amount, upon bonds and similar obligations of domestic or resident foreign corporations, the original ownership certificates, when duly filed, shall constitute and be treated as returns of information (Art. 1074; Reg. 45, Art. 1075.) The following Ownership certificates are now in use: Form loofj (revised)."' Ownership certificate — tax to be paid at source. Interest on bonds and other similar obligations of domestic and resident corporations. Form 1 00 1 (revised). Ownership certificate — tax not to be paid at source. Interest on bonds and other similar obligations of domestic and resident corporations. Form 1 00 1 A (revised). Ownership certificate— tax not to be paid at source. Dividends on stock of foreign corporations and interest on bonds of foreign coun- tries and foreign corporations. Form looiB.^'' Statement of income received by non- resident alien from sources within United States — per- sonal exemption claimed. Used by non-resident to claim exemption on tax-free covenant bonds. Form 1087 (revised). Ownership certificate — disclos- ing actual owner of stock. For use of foreign prin- cipal to disclose actual ownership of stock of a domestic corporation registered in name of representative in the United States. Form of certificate when witholding is required. — With- holding at the source is discussed in detail in Chapters XI and XXX VT; but, inasmuch as withholding returns are treated as "When this form is used there is actual withholding at the source. ^° Few non-resident aliens claim exemption on tax-free covenant bond interest. Hence this form is seldom used. 3IO APPLICATION AND ADMINISTRATION information returns, it is deemed advisable to state the regu- lation governing the use of ownership certificate form looo (revised).'' Regulation. For the purposes of article 365 Form 1000 shall be used (a) by citizens or residents of the United States when no personal exemption or credit is claimed against interest on bonds containing a tax-free covenant; (b) by nonresident alien in- dividuals, by partnerships composed in whole or in part of nonresident aliens and not having an ofifice or place of business within the United States, and by foreign corporations not engaged in trade or busi- ess within the United States and not having any office or place of business therein, whether or not such bonds contain a tax-free cove- nant; (c) by partnerships, resident or nonresident, and (prior to Jan- uary I, 1922) personal service corporations, in the case of bonds con- taining a tax-free covenant; and (d) where the owner is unknown to the withholding agent. (Art. 366; Reg. 45, Art. 365.) Partnerships are now included under (c) and claim (d) is entirely new. Certificates required when there is no withholding.^" — Regulation. For the purposes of article 365, Form looi shall be used (a) by citizens or residents of the United States when personal exemption is claimed against interest on bonds contain- ing a tax-free covenant and when presenting coupons from bonds not containing a tax-free covenant; (b) by domestic and resident partner- ships, in the case of bonds not containing a tax-free covenant. In case a citizen or resident alien individual receives interest on bonds containing a tax-free covenant in excess of the amount of personal exemption which the individual may claim, any such excess must be reported on Form 1000. (Art. 367; Reg. 45, Art. 366.) Form 1 00 1 is no longer used by domestic corporations, non-resident partnerships, nor by foreign corporations. Use of substitute certificates.^® — Regulation. Resident collecting agents, including responsible banks and bankers receiving interest coupons for collection with ownership certificates attached, may present the coupons with the ""For monthly and annual returns rcfjuired, see pages 298-299. "For monthly and annual returns required, see page 299. " Substitute certificates are favored by persons who wish to conceal the identity of bondholders from the debtor corporation or its paying agent. INFORMATION AT THE SOURCE 311 original certificates to the debtor corporation or its duly authorized withholding agent for collection, or may detach and forward the original certificates directly to the Commissioner, provided each such collecting agent shall substitute for such original certificates its own certificates, Form 1058 or Form 1059, and shall keep a complete record of each transaction, showing (a) serial number of item re- ceived; (&) date received; (c) name and address of person from whom received; (rf) name of debtor corporation; (e) class of bonds from which coupons were cut (whether containing a tax-free cove- nant or not) ; and (/) face amount of coupons. The original cer- tificate for which the certificate of the collecting agent is substituted shall be endorsed, preferably with a rubber stamp, by the collecting agent, as follows : Owner's certificate No (Name of collecting agent.) , I9---- (Give date of certificate.) The counterpart of the within certificate bearing like number was attached to -the coupons within mentioned for delivery to the debtor or withholding agent, by whom the coupons are payable. For the purpose of identification the substitute certificates shall be numbered consecutively, reverting to the numeral i at the begin- ning of each calendar year, and corresponding numbers given the original certificates of ownership. The use of substitute certificates by collecting agents, banks, and bankers is not permitted, however, in the case of ownership certificates presented with coupons for col- lection by nonresident alien individuals, partnerships, or corporations. (Art. 368; Reg. 45- Art. 367.) Form 1059 is used instead of form 1000; form 1058, in- stead of form 1 00 1. Interest coupons presented without ownership certifi- cates. — Regulation. When interest coupons are received unaccom- panied by certificates of ownership, unless the first bank be satisfied that the owner is a domestic or resident corporation, the first bank shall require of the payee a statement showing the naine and address of the payee, the name and address of the debtor corporation, the date of the maturity of the interest, the name and address of the person from whom the coupons were received, the amount of the interest, and a statement that the owner of the bonds is unknown to the payee. Such 312 APPLICATION AND ADMINISTRATION statement shall be forwarded to the Commissioner with the monthly return on Form 1012. The first bank receiving such coupons shall also prepare a certificate on Form 1000, crossing out "ow^ner"'^^ and inserting "payee" and entering the amount of interest on line 6, and shall stamp or write across the face of the certificate '"State- ment furnished," adding the name of the bank. (Art. 369.) The affidavit form is no longer required, a mere statement only being necessary. If the first bank is satisfied that the owner of the coupon is a corporation, no statement is now required. Correction of ownership certificates by banks or other col- lecting agents. — Ruling. Banks or other collecting agents receiving coupons attached to ownership certificates executed on the wrong form, in order to expedite the collection of the interest, are permitted to transfer the necessary information from the erroneous to the proper form, the following notations being stamped in the lower left-hand corner : (Name and address of bank or collecting agent.) By (Name of official executing certificate.) The original certificate should be forwarded with the certificate executed on the proper form by the bank or collecting agent, the original certificate bearing the notation substantially as follows : "Superseded by ownership certificate Form ....," designating the form of certificate executed bv the bank or collecting agent. (C. B. 2, page 192; O. D. 562.) The Treasury places the burden on the bank or collecting agent to see that certificates are properly made out. By ac- cepting an ownership certificate the bank or agent becomes directly responsible for its being made out in accordance with the requirements of the law and regulations. Ruling. The attention of the Bureau of Internal Revenue has been invited to the fact that in many instances indifference and care- lessness has been shown by owners in executing ownership certificates ' Line 6 is provided for unknown holders. INFORMATION AT THE SOURCE 313 accompanying coupons presented to banks and other collecting agents for collection of interest on bonds and other obligations of debtors, and also that banks and other collecting agents have been accepting in- complete and improperly executed ownership certificates with such coupons deposited for collection and have been transmitting same to debtors for payment Banks and other collecting agents are not required by law or regulations to accept interest coupons for collection. If, however, as a matter of convenience to their custom- ers, they do accept interest coupons for collection, it is their duty to see that the ownership certificates which are executed by the owner of the coupons are properly filled out. These ownership certificates cannot be accepted as returns of information unless they are properly filled out and debtors receiving coupons from banks or collecting agents with incomplete or otherwise improperly executed ownership certifi- cates are, under the foregoing quoted provisions of Section 256, au- thorized to demand that the name and address of the owner of the coupons accompanied by incomplete or otherwise improperly executed ownership certificates shall be furnished before the coupons are paid. If banks and other collecting agents accept coupons for collection to which are attached incomplete or otherwise improperly executed ownership certificates, such banks or collecting agents become a party to the filing of incomplete returns of information and shall upon de- mand of the debtor furnish the name and address of the owner of the coupons so that such ownership certificates may, when filed, be ac- cepted as returns of information in accordance with the provisions of the regulations issued under Section 256 of the Revenue Act of 1918. (C. B. 4, page 232; Mim. 2725.) Ownership certificates for bonds sold between interest dates. — Ruling. Where an interest coupon is presented for payment of interest upon a bond which has been sold between interest dates, the coupon shall be accompanied by the ownership certificate of the purchaser only, and the certificate should cover the full amount of the coupon. The purchaser may, if he does not claim exemption from having the tax paid at the source, take credit in his return for the tax paid at the source on the entire amount of interest represented by the coupon. The discrepancy between the amount of bond interest reported in the purchaser's return in such cases, and the amount of interest shown by his ownership certificates to have been collected by him should be explained by a statement attached to and made a part of the return, showing the total amount of interest collected and the amount of interest accrued on the bond to the date of pur- chase. (C. B. 4, page 232; O. D. 830.) 314 APPLICATION AND ADMINISTRATION The foregoing ruling is an exact reversal of the Treasury's former procedure*" which called for certificates of ownership from both vendor and purchaser, the interest being appor- tioned between them. The change in procedure does away with a needless duplication of certificates and still supplies the required information regarding the allocation of interest. It tends, however, to impose a deprivation on the vendor, where such vendor is an individual and not a corporation. Under the ruling the vendee is entitled to take credit for the tax paid at source on the entire amount of interest represented on the coupon. The value of the coupons is $ioo, the amount thereof accrued to the vendee is only $20, yet the vendee has credit for the whole of the tax paid at source and the vendor with $80 interest has credit for no portion of that tax. In view of that fact, the vendor, when disposing of bonds, where tax on the interest is paid at source, must have this feature of the situation in mind. In arriving at the figure for which he would dispose of them, he should recognize the value of (i) the principal, (2) the interest, and (3) the loss arising from inability to take credit for the proportionate share of the tax paid at source. Ruling. Certain bonds contain the privilege of being converted into the stock of the corporation which issued the bonds. If the owner of the bonds exercises his privilege of conversion between interest dates and is allowed accrued interest, he is required to file an ownership certificate covering such accrued interest when it is paid. (C. B. 4, page 234; O. D. 949.) Ownership certificates to be used by fiduciaries and joint owners. — Regulation. When fiduciaries have the control and custody of more than one estate or trust, and such estates and trusts have as assets bonds of corporations and other securities, a certificate of ownership shall be executed for each estate or trust, regardless of the fact that the bonds are of the same issue. ViHien bonds are owned jointly by two or more persons, a separate ownership certificate must be executed in behalf of each of the owners. (Art. 374.) "See Incovic Tax Procedure, njzi, page 250. INFORMATION AT THE SOURCE 315 Use of ownership certificates for tax-free covenant bond interest by personal service corporations. — Ruling. Personal service corporations are to be treated, so far as practicable, on the same basis as partnerships for the purposes of withholding under section 221 (b) of the Revenue Act of 1918. Cor- porations which have received notice from the Income Tax Unit that their returns as personal service corporations have been approved may thereafter and not before issue Form 1000 in collecting interest from bonds or other obligations of a corporation containing a so- called tax free covenant clause in the same manner and to the same extent that partnerships are authorized to use that form. The form should bear the stamped or written notation "approved by the Treas- ury Department as Personal Service Corporation on (date)." (C. B. I, page 186; O. D. 339.) Ownership certificates for payments of registered in- terest. — Regulation. Ownership certificates, are required in connection with interest upon registered bonds the same as interest upon any other class of bonds. If ownership certificates are not furnished by the owner of the bonds, such certificates must be prepared by the debtor corporation or its withholding agent, (a) If the bonds contain a tax-free covenant clause, ownership certificates must be prepared on Form 1000 for the following classes of bondholders : Citizens or residents of the United States, nonresident alien individuals, part- nerships, whether foreign or domestic, foreign corporations having no office or place of business within the United States, (b) If the bonds do not contain a tax-free covenant clause. Form 1000 shall be prepared in the case of nonresident alien individuals, partnerships composed in whole or in part of nonresident aliens and not having an office or place of business within the United States, or in case the owner is a foreign corporation not engaged in trade or business within the United States and not having an office or place of business therein. If ownership certificates are not filed by a citizen or resi- dent of the United States or a resident partnership in connection with interest payments upon registered bonds not containing a tax- free covenant clause, Form looi should be prepared by the debtor corporation or its withholding agent. Regardless of whether the registered bonds do or do not contain a tax-free covenant clause, no ownership certificate is required in con- nection with such bonds owned by domestic or resident corporations. (Art. 370; Reg. 45, Art. 369.) 3i6 APPLICATION AND ADMINISTRATION Ownership certificates for foreign items. — Regulation. When bonds of foreign countries, or bonds or stocks of nonresident foreign corporations, are owned by citizens or residents of the United States, individual or fiduciary, or by resident partnerships, ownership certificate Form looiA shall be executed by the actual owner or by his duly authorized agent when presenting the item for collection, whether such item is a dividend or an interest payment, except in the case of a foreign country or a foreign corpora- tion having a fiscal agent or a paying agent in this country and issuing bonds which contain a tax-free covenant clause. In such excepted case the fiscal agent or paying agent is required to withhold a tax of 2 per cent from the interest on such bonds and ownership certificate Form 1000, modified to show the name and address of the fiscal agent or the paying agent, should be used, unless the owner (if so entitled) desires to claim exemption, in which case Form lOOiA should be filed.-*! (Art. 1077; Reg. 45, Art. 1078.) Domestic corporations are no longer required to execute form 1 00 1 A. Income payable to a foreign government is not subject to federal income tax, but it is held*^ that it should be reported on hne 6 of form looiA by crossing out the word "corpora- tion" and substituting therefor "foreign government." Ap- parently this conflicts with article 365.^^ Rulings. Non-resident alien individuals, partnerships, and corpo- rations not engaged in trade or business within the United States and having no ofiice or place of business therein, should file Form looi-A properly modified, in connection with interest coupons on bonds of a corporation organized in the United States but which transacts no business in the United States and owns no property therein. In cases where Form 1000 has been filed by non-resident alien bondholders, the certificate should be stamped as follows before be- ing forwarded to the Commissioner of Internal Revenue, Sorting Division : Exempt — debtor corporation owns no property and does no busi- ness in the United States. (C. B. i, page 262; O. D. 354.) Ownership certificates representing interest on bonds owned by nonresident aliens, bearing addresses of domestic liankers in lieu of " No attempt is made to tax non-resident aliens on income which simply passes through American banks for collection and is not income derived from sources within the United States. See Chapter XXXVI. ^' C. B. 2, page 191 ; O. D. 520. " See page 306. INFORMATION AT THE SOURCE 317 the residences of the aliens, will be accepted. (C. B. 4, page 233; O. D. 908.) No ownership certificates required for certain foreign divi- dends. — Following the principle in force under the 1918 law, it is presumed that ownership certificates will not be required in collecting dividends from foreign corporations which are free from normal tax/* Ownership certificates will be nec- essary in the case of dividends from other foreign corpora- tions." Foreign items presented for collection unaccompanied by ownership certificates. — Regulation. If the foreign item is an interest coupon de- tached from bonds containing a tax-free covenant clause, issued by a foreign country or corporation having a paying agent in the United States, a statement and ownership certificate. Form 1000, shall be furnished as provided in article 369. In the case of other foreign items which are received unaccom- panied by an ownership certificate and the owner is unknown, a statement shall be required of the payee, showing the name and ad- dress of the payee, the name and address of the debtor organization, the date of the dividend check or the maturity of the interest coupon, the name and address of the person from whom the dividend check or interest coupon was received, and a statement that the owner of the securities is unknown to the payee. The first bank receiving such foreign item shall prepare a certificate of ownership, Form looiA, crossing out the word "owner" and substituting therefor the word "payee." The first bank shall stamp or write across the face of the certificate "statement furnished," adding the name of the bank. Thereupon the statement and certificate shall be forwarded to the Commissioner as provided in article 1079. (Art. 1078.) Information as to actual owner. — Regulation. When the person receiving a payment falling within the provisions of the statute for information at the source is not the actual owner of the income received, the name and address of the actual owner shall be furnished upon demand of the indi- vidual, corporation or partnership paying the income, and in de- See sections 216 ^(a) and 234 (a-6). For former procedure see Income Tax Procedure, 1921, page 253. 3i8 APPLICATION AND ADMINISTRATION fault of a compliance with such demand the payee becomes Hable to the penalties provided ^^ (Art. 1080.) Use of form 1087 (revised) to disclose ownership. — The proper use of this ownership certificate is most conveniently summarized as follows : Ruling. This ownership certificate [form 1087 (revised)], is designed primarily for the use of a foreign principal to disclose the actual ownership of stock of a domestic corporation registered in the name of his representative in the United States. Unless the dis- closure is made to the commissioner on this form, the record owner will be liable for any additional tax on dividends on stock of domestic corporations or resident foreign corporations. In all cases where the actual owner is a nonresident alien individual, and the record owner a person in the United States, the record owner will be considered for tax purposes to have the receipt, custody, control, and disposal of the dividend income, and must make return for the actual owner, regardless of the amount of income, and pay any surtax found by such return to be due. When a foreign corporation is the registered owner of stock of a domestic corporation and the actual owner is a nonresident alien, individual or partnership, disclosure of actual ownership should be made on Form 1087 (Revised). This form should be adapted to make disclosure in order that a domestic corporation required to render a return of information as to dividends in accordance with section 254 of the act, may have at its disposal information as to the actual ownership of the stock (Treasury Bulletin "B", page 27.) Ownership certificates not required for interest on obliga- tions of the United States and political subdivisions thereof. — Law. Section 256 The provisions of this section .... shall not apply to the payment of interest on obligations of the United States. Regulation No ownership certificates need be filed in the case of interest payments on bonds the income from which is not required to be included in gross income, nor in the case of any obligations of the United States (Art. 365; Reg. 45, Art. 365.) Bonds of the War Finance Corporation are not obligations of the United States.^' Hence an ownership certificate is re- ' Sec page 3J1. C. B. I, page 185; O. D. 26 INFORMATION AT THE SOURCE 319 quired in collecting' interest on such securities. Ownership certificates arc not required in case of municipal bonds and such other bonds the interest from which is exempt from tax. General Miscellaneous rulings regarding duties of banks. — Ruling. Where a debtor corporation fails to withhold the 2 per cent tax on tax-free-covenant bonds, and the owner has filed Form 1000, there is no obligation on the bank receiving the coupons to with- hold the tax, as assessment will be made against the debtor or its withholding agent, based on the tax liability as disclosed by the ownership certificates, Form 1000. A bank purchasing abroad coupons of bonds issued by domestic corporations will be held prima facie to be the recipient of income. Ownership certificates should therefore be secured from original owners of bonds in order that tax may be withheld as provided by law. Where a promissory note, signed by a corporation, is left with a bank or trust company for collection, such bank or trust com- pany should not require an ownership certificate to be attached. Ownership certificates are required to be filed with respect to interest payments upon first-mortgage participation bonds issued by a trust company and secured by a real estate mortgage deposited with the trustee. In cases where coupons of the bonds are not ac- companied by ownership certificates, the first bank is required to fur- nish a certificate. Where no ownership certificates are filed in con- nection with interest upon such registered bonds, the withholding agent will be required to prepare certificates. (Treasury Bulletin "B," page 31.) It has been held that in the case of interest payments on overdue coupon bonds, the interest coupons of which have been exhausted, ownership certificates must be filed when collecting interest, in the same manner as if interest coupons were pre- sented for collection.*® Use of stamps and facsimile signatures by banks and trust companies. — If proper authorization is obtained from the Com- missioner of Internal Revenue, banks and trust companies C. B. 2, page 191 ; O. D. 392. 320 APPLICATION AND AD^IINISTRATION may use facsimile signatures in executing income tax certi- ficates (substitute or otherwise) issued under their names. '*^ License required for the collection of foreign items. — Law. Section 259. That all individuals, corporations, or part- nerships undertaking as a matter of business or for profit the collec- tion of foreign payments of interest or dividends by means of cou- pons, checks, or bills of exchange shall obtain a license from the Commissioner and shall be subject to such regulations enabling the Government to obtain the information required under this title as the Commissioner, with the approval of the Secretary, shall pre- scribe; and whoever knowingly undertakes to collect such payments without having obtained a license therefor, or without complying with such regulations, shall be guilty of a misdemeanor and shall be fined not more than $5,000, or imprisoned for not more than one year, or both. Regulation. Banks or agents collecting foreign items, as de- fined in article 1076, and required by article 1079 to make returns of information with respect thereto, must obtain a license from the Commissioner to engage in such business. Application Form 1017 for such license may be procured from collectors. The license is issued without cost on Form loio. Foreign items shall not be accepted for collection by any bank or collecting agent so licensed unless properly indorsed or accompanied by proper ownership certifi- cates giving all the information called for by such certificate. (Art. nil.) Payer has right to demand name and address of recipient of income. — Law. .Sectiiin 256 When necessary to make effective the provisions of this section the name and address of the recipient of income shall be furnished upon demand of the individual, corpora- tion, or partnership paying the income Ruling. Official position of person authorized to sign ownership certificates in behalf of corporation and identity of person signing ownership certificates in behalf of partnership required to be dis- closed on certificates. (Telegram to the Southern Pacific Company, New York, N. Y., signed by Deputy Commissioner E. H. Batson, and dated June 16, 1921.) " Either rubber stamps or printed signatures may be used. This con- cession was made to facilitate collection uf coupons by banks. It avoids much delay and inconvenience. INFORMATION AT THE SOURCE 321 Heavy penalties for failure to furnish information. — The specific penalties for failure or refusal to furnish information were increased in the 1918 law.^° Regulation. A penalty of not more than $1,000 attaches for failure punctually to make a required return, whether of income, withholding or information, or to pay or collect a required tax. If the failure is willful, however, or an attempt is made to defeat or evade the tax, the offender is liable to imprisonment and to a fine of not more than $10,000 and costs. See also the act of July 5, 1884. In addition to these specific penalties ad valorem penalties are im- posed in various cases. An ad valorem penalty is assessed and col- lected as a part of the tax, while a specific penalty is enforceable only by suit. (Art. 1055; Reg. 45, Art. 1041.) Section 253. _The 1921 law re-enacted this section without any change. CHAPTER XI PAYMENT OF TAX AT SOURCE^ The framers of the income tax laws of 1913 and 1916 adopted the principle of collection at the source^ largely on the strength of its success as a feature of British income tax administration. No attempt was made first to test the operation of an income tax in this country by direct collection from the taxpayer. The withholding provisions of these two laws proved burdensome and difficult of efficient administration. Consequently the 191 7 law substituted a system of "informa- tion at the source" and withholding was completely abolished, excepting only the cases of non-resident aliens and interest on bonds containing a so-called tax-free^ covenant clause. The withholding provisions of the 192 1 law are substantial!}' the same as those of the two laws preceding it. The suljject of withholding of tax at source in connection with non-resident aliens is fully discussed in Chapter XXXVI. So far as citizens or residents of the United States are concerned there is now no withholding or payment of tax at the source, except in the case of tax-free covenant bonds. Nev- ' As the subject of "Information at the Source" has been treated in Chapter X. "Non-Resident Aliens" in Chapter XXXVI, "Monthly and Annual Returns" in Chapter III, all questions as to forms of owner- ship and information certificates required in the various cases and the withholding of income paid to non-resident aliens and monthly and annual returns required have been omitted from this chapter. " This is variously called "collection at the source," "deduction at the source," "withholding at the source," and "stoppage at the source." Col- lection at the source was early instituted in British income tax administra- tion to prevent evasion of the law. In the 1920 Report of the Royal Com- mission on the Income Tax, the opinion has been emphatically expressed that retention of deduction at the source is necessary to the efficient admin- istration of the revenue. At least 70 per cent of the present British income tax is collected at the source. The Commission has also concluded : "We are not satisfied that any system of 'information at the source' would be a practical and efficient substitute for the present system, and it would be a source of trouble and irritation to the community in general." ^This term should not be confused with "tax-exempt," which means freedom from taxation — state, local or federal, or all three. 322 PAYMENT OF TAX AT SOURCE 323 ertheless, there has been considerable agitation for its com- plete abolition and this withholding feature of the law would doubtless have been abolished if it had not been for the opposi- tion of bond owners and investment banking houses. After the enactment of the 1913 law many bonds were issued which contained tax-free covenants whereby the debtor corporations agreed to pay interest in full without deducting the amount of tax required to be withheld at the source. Bonds having such covenants commanded a somewhat higher price than those not having such agreements. Those who had purchased bonds for this privilege were naturally opposed to any modification of the law which would abolish it. To meet these objections the 1917, 1918. and 1921 laws provided for restricted with- holding in the case of tax-free covenant bond interest. What is a "tax-free covenant"?' — The law defines a tax- free covenant as follows : Law. Section 221."' .... (b) In any case where bonds, mort- gages, or deeds of trust, or other similar obligations of a corporation contain a contract or provision by which the obligor agrees to pay any portion of the title imposed by this title upon the obligor, or to reim- burse the obligee for any portion of the tax, or to pay the interest with- out deduction for any tax which the obligor may be required or per- mitted to pay thereon or to retain therefrom under any law of the United States." , , . , * Tax-free covenants are frequently not limited to federal taxes, but include any state, county or local taxes or impositions which the obligor may be required or permitted to deduct or retain under present or future laws. ° Subsection (a) refers only to non-resident alien individuals or part- nerships. (See Chapter XXXVI.) " [Former Procedure] Under the 1913 law withholding was re- quired in the case of interest on domestic and foreign bonds and dividends of foreign corporations regardless of amount, and on pay- ments of interest, rent, salaries, wages, premiums, annuities, compen- sations, remuneration, emoluments or other fixed or determinable gains, profits and income amounting to $3,000 or over in any taxable year. Exemption from the withholding provisions of the act could be obtained to the amount of the personal exemption, by filing a cer- tificate with the withholding agent, and a further exemption was per- mitted by filing a statement of the deductions to which the taxpayer was entitled. Under the 191G act the withholding provisions were similar except that the rate was increased from 1 to 2 per cent. However, under 324 APPLICATION AND ADMINISTRATION By Treasury interpretation Ijonds issued under a trust deed containing a tax-free covenant arc treated as if they themselves contained such a covenant. It is also held : Ruling. Where neither bonds nor the trust deeds given by the obligor to secure them contain a tax-free covenant, supplemental agreements executed by the obligor corporation and the trustee con- taining a tax-free covenant and which modify the original trust deeds to that extent are of the same effect from the date of their proper execution as if they had been part of the original deeds of trust, and the bonds from such date are subject to the provisions of section 221(b) of the Revenue Act of 1918, provided proper authority exists for the modification of the trust deeds in this manner. The authority must be contained in the original trust deeds or actually secured from the bondholders. (C. B. 2, page 187; O. D. 414.) Amount of tax to be withheld by obligor corporation. — Law. Section 221. .... (b) .... the obligee shall deduct and withhold a tax equal to 2 per centum of the interest upon such bonds, mortgages, deeds of trust, or other obligations, v/hether such interest is payable annually or at shorter or longer periods "Withholding agent" defined. — Law. Section 200 (3) The term "withholding agent" means any person required to deduct and withhold any tax under the provisions of section 221 or section 237; .... The sections referred to in the foregoing relate to non- resident alien individuals or partnerships and foreign corpora- tions, as well as to domestic corporations paying interest on bonds having a tax-free covenant. The legal theory of "deduction." — The tax-free covenant clause in bonds has long been a prolific source of misunder- the 1917 law withholding was abolished except in the case of non- resident aliens and interest on tax-free bonds, and section 1212 of that act provided for refunding all tax that had been withheld dur- ing 1917 except such as had been withheld on. tax-free bonds. Withholding agents did not in all cases promptly release the amounts in their hands, although the law was so clear that no time should have been lost after October 3, 1917, in returning the funds. If withholding agents did not have in their possession the informa- tion regarding the legal owner of the bonds to whom repayment was due, they were directed to communicate with the bank through which collection was made, secure the name of the pa}-ees and promptly refund the amounts due. (T. D. 2635, January 24, 1918.) PAYMENT OF TAX AT SOURCE 325 standing" and confusion to the average bondholder, notwith- standing the effort of investment houses to clarify its meaning. Perhaps such covenants should be omitted from future issues to avoid the inherent difficulties which attend their use. Confusion arises chiefly from the necessarily involved legal phraseology of such covenants and the legal fiction of "deduc- tion." The legal fiction is that a tax-free covenant requires the debtor corporation actually to deduct 2 per cent from the amount of the coupon, pay this sum to the government, and then pay the bondholder 98 per cent of his coupon plus an additional 2 per cent, if the corporation has agreed to reim- burse to that extent. Such is the legal fiction of deduction. In practice the corporation pays the coupon in full and in addi- tion pays on behalf of the bondholder to the government a tax equivalent to 2 per cent of the amount of the coupon. (See discussion of Massey v. Lcdcrcr in Chapter XIX.) Under some tax-free covenants the debtor corporation only agrees to reimburse the bondholder up to i per cent of the amount of the coupon. In this case the theory is that 2 per cent is deducted from the coupon and the bondholder is paid 98 per cent of the coupon plus a reimbursement of i per cent. Practically, the bondholder gets 99 per cent of his coupon and the corporation pays 2 per cent to the government for him. Limitation of the debtor corporation's liability. — The con- tention that corporations having tax-free covenants in their bonds contracted to pay the full normal income tax is now mainly of academic interest. When a corporation has specifically agreed to pay the normal income taxes assessed against the owners of its bonds on the income accruing therefrom, it should be held strictly to such agreement; but obviously such an agreement must be reasonably, if not strictly, construed. If federal income taxes are the only ones mentioned, it cannot be contended that state income taxes are to be paid. If the normal tax rate 326 APPLICATION AND ADMINISTRATION in furce when the lionds were issued was i per cent and if the rate is raised to 2 per cent or 12 per cent, the corporation must pay the increased rate. But if 2 per cent is the "normal" rate and a law specifies that in addition to the "normal" tax of 2 per cent an "additional" tax of 4 per cent is imposed, the cor- poration should not pay more than the 2 per cent normal tax/ If a corporation has -not agreed to pay the bondholder's income tax, but has agreed merely to pay such taxes as it is required to witJiJwld, there is no obligation on its part, moral or legal, to pay any tax, normal or surtax, income or property, federal or state, which may be legally assessed against the recipients of the income, iinless the corporation is required by the government to withhold the tax. Corporations are ordinarily obligated to rciinburse bond- holders only for tJic amount zvhicJi they arc required to deduct, and in some cases this reimbursement is expressly limited by contract to a sum less than the amount theoretically deducted (e. g., I per cent). Even though the present normal tax is 8 per cent, it is lawful to zvithJiold only to the extent of 2 per cent. Since the imposition of a high normal tax there has been a tendency to state the actual percentage of tax for which the corporation will make reimbursement. Among such provisions are : "Both ])rinci])al and interest payable in full without de- duction for any federal normal income tax .... not in ex- cess of 2 per cent" and "both principal and interest payable in 'full without deduction for any federal normal income tax .... up to 4 per cent." The first clause limits the present and future liabilit}- to reimburse to 2 per cent. The second clause limits such future liability to 4 per cent. In other words, if under a future law 6 per cent were the lawful de- duction, reimburseiuent would be made to the extent of 2 per ' [Former Procedure] Normal taxes imposed by the Act of October 3. 1917, were in addition to those imposed bj- the Act of September 8. 1916. The Revenue Act of 1918 contained no provision of this kind, prior laws being there1)y repealed. This, however, apparently does not constitute an argument for full payment of normal tax. PAYMENT OF TAX AT SOURCE 327 cent under the first clause or 4 per cent under the second. This 4 per cent hmitation should not be construed to render corporations liable to 4 per cent under the present law, because 2 per cent is the maximum possible lawful deduction in the case of a bond containing a tax-free covenant clause. From whom tax is withheld. — The law provides that in making payments of interest on tax-free covenant bonds, the obligor shall deduct and withhold a tax equivalent to 2 per cent of the coupon. Law. Section 221 (b) .... whether payable to a nonresident alien individual or to an individual citizen or resident of the United States or to a partnership: Froi-idcd, That the Commissioner may authorize such tax to be deducted and withheld in the case of in- terest upon any such bonds, mortgages, deeds of trust or other obliga- tions, the owners of which are not known to the withholding agent Law. .Section 237. That in the case of foreign corporations sub- ject to taxation under this title not engaged in trade or business within the United States and not having any office or place of business therein, there shall be deducted and withheld at the source in the same manner and upon the same items of income as is provided in section 221 a tax equal to 12^/2 per centum thereof (but during the calendar year 1921 only 10 per centum), and such tax shall be returned and paid in the same manner and subject to the same conditions as provided in that section: Provided, That in the case of interest described in subdivision (b) of that section the deduction and withholding shall be at the rate of 2 per centum. The Treasury's interpretation follows : Regulation (c) of a tax of 2 per cent in the case of interest payable to an individual or a partnership, whether resident or nonresident, or to a foreign corporation not engaged in trade or business within the United States and not having any office or place of business therein, upon bonds or other obligations of domestic or resident foreign corporations containing a so-called tax-free covenant clause A foreign corporation having a fiscal agent or paying agent in this country is required to withhold a tax of 2 per cent upon the interest on its tax-free covenant bonds (Art. 361.) Ruling. "Withholding at the liighest applicable rate" as providefl in article 361 of Regulations 45, in the case of interest on bonds or other securities where the owner is unknown to the withholding 328 APPLICATION AND ADMINISTRATION agent is interpreted to mean the highest rate of tax applicable under section 221 of the Revenue Act of 1918, viz., 2 per cent in the case of tax-free bonds and 8 per cent in the case of other fixed or de- terminable annual or periodical income.^ (C. B. 2, page 188; O. D. 518.) When tax withheld is paid by withholding agent. — Law. Section 221 (c) Every individual, corporation, or partnership required to deduct and withhold any tax under this section shall make return thereof on or before March i of each year and shall on or before June 15 pay the tax to the official of the United States government authorized to receive it. Every such individual, corpora- tion, or partnership is hereby made liable for such tax and is hereby indemnified against the claims and demands of any individual, cor- poration, or partnership for the amount of any payments made in accordance with the provisions of this section When no liability of withholding agent for collecting of tax at source. — Law. Section 221 (c) If any tax required under this section to be deducted and withheld is paid by the recipient of the in- come, it shall not be recollected from the withholding agent; nor in cases in which the tax is so paid shall any penalty be imposed upon or collected from the recipient of the income or the withholding agent for failure to return or pay the same, unless such failure was fraudulent and for the purpose of evading payment. No withholding against domestic and resident foreign corporations. — The law does not require withholding from interest on tax-free covenant bonds paid to a domestic corpora- tion or to a foreign corporation having an office or place of business in the United States and engaged in a trade or busi- ness 'therein. Under the 19 18 law personal service corporations were taxed like partnerships, as far as was practicable. Conse- quently, under that law it was proper for debtors constructively * It appears that the highest applicable rate of tax in the case of in- terest on bonds which do not contain the tax-free covenant clause would be 12I/2 per cent after 1921, or the rate of withholding on non-resident alien corporations. It seems that for its own protection the governrnent would desire an additional withholding of loK; per cent in case of interest on tax-free obligations. PAYMENT OF TAX AT SOURCE 329 to withhold tax in making payment of tax-free covenant bond interest.^ This is the only exception to the rule that there is no withholding against a domestic corporation. If the taxation of the stockholders of personal service corporations is held to be invalid, it is not probable that any readjustments for tax-free covenant interest under the pro- visions of section 1332 will follow. Personal service cor- porations disappear as taxable entities after December 31, 1 92 1. Hence, after that date, debtors will not withhold against such corporations. The tax-free covenant no longer has any advantage for personal service corporations. As a rule, in the case of payments of tax-free covenant bond interest to domestic or resident corporations,^" no pay- ment is made to the government on their behalf ; hence the tax- free covenant is of no value to such holders. This feature of the law makes the tax-free covenant less costly to the issu- ing corporation, since large blocks of bonds are sold to banks, insurance companies, and other corporations. Apparently, in a few isolated cases, debtor corporations have, inadvertently or othervv'ise, paid tax on behalf of cor- porations owning their bonds. Under the 1918 regulations, such payment was allowed as a credit against an owner's nor- mal tax, upon proof of payment. ^^ Section 221 (b) of the 1921 law provides that the Com- missioner may authorize the tax of 2 per cent to be deducted from the interest on tax-free covenant bonds the owners of which are not known to the withholding agent. Under the regulation issued on this point, ^" it would appear to be possible for domestic corporations to obtain the benefit of having the tax paid for them by concealing their identity. This, how- ever, would be a palpable evasion of the law, and is neither recommended nor suggested. Under the law there is no •Art. 365. '"Excepting personal service corporations during years 1918 to 1921, inclusive. " See Income Tax Procedure, 1920, page 246. " See page 327. 330 APPLICATION AND ADMINISTRATION other way in which domestic corporations can get the benefit of tax-free covenants in bonds owned by them. Withholding obligation on bond interest paid in years after the interest became due. — Ruling Bond interest represents income to taxpayer when due and payable in accordance with article 54, Regulations 45. No tax required to be withheld from interest upon bonds due prior to March i, 1913, but paid subsequent to that date. Interest due on and after March i, 1913, subject to withholding at rates in force at time of payment but in case excess tax is withheld and paid to gov- ernment claim for refund on form 46 will be considered. (Telegram to A. Iselin & Co., New York, N. Y., signed by P. S. Talbert, Acting Assistant to the Commissioner, and dated September 8, 1919.) From the above it would appear that no withholding is necessary by a debtor corporation in the case of coupons from bonds containing a tax-free covenant clause now presented but due prior to Marcli i, 1913; but on any coupons matur- ing subsequent to that date, withholding must be made at the rate in existence at the time of payment. The date of ma- turity does not determine the rate of withholding. Of course, if an excessive tax is withheld and paid, the bondholder may secure relief by filing a claim for refund. Withholding at the source of interest on bonds having no tax-free covenant. — The government has taken the position that corporations whose securities do not contain a tax-free covenant shall not be permitted to pay the tax except under supplemental agree- ments. Ruling. Your telegram May 29. Bonds without tax-free cove- nant not permitted to be considered tax-free bonds at option of issu- ing corporations. Corporation only allowed to withhold tax at rate of 8 and 10 per cent from non-resident alien individuals and non resident alien corporations respectively. Corporation prohibited from paying tax on interest derived from such bonds when owned by citizens or residents of United States. (Telegram to the Farmers' Loan & Trust Company, New York, N. Y., signed by Commissioner Daniel C. Roper, and dated June 2, 1919.) PAYMENT OF TAX AT SOURCE 331 Exemption from withholding. — Under the law the debtor corporation or its paying agent is required to withhold a tax of 2 per cent on tax-free covenant bond interest paid to indi- vidual citizens or residents who do not claun exemption, and in the case of resident partnerships. (Withholding on account of non-resident alien individuals, foreign partnerships and corporations is discussed in Chapter XXXVI.) The statute provides that exemption from withholding may be claimed in the following manner: Law. Section 221 (b) .... Such deduction and with- holding shall not be required in the case of a citizen or resident entitled to receive such interest, if he files with the withholding agent on or be- fore February i a signed notice in writing claiming the benefit of the credits provided in subdivisions (c) and (d) of section 216; nor in the case of a nonresident alien individual if so provided for in regulations prescribed by the Commissioner under subdivision (g), section 217. .... [.Section 217 gives the Commissioner discretion in allowing non-resident alien individuals to claim exemption by means of certifi- cates of ownership.] This provision of the law and the use of ownership cer- tificates in its administration are responsible for much of the bondholder's confusion regarding tax-free covenants. In the case of tax-free covenant bonds interest is paid in full regard- less of whether exemption is or is not claimed. If exemption is claimed on such coupons, the taxpayer merely serves notice on the debtor corporation that his income is too small to be subject to tax and therefore nothing should be paid to the gov- ernment on his behalf. If exemption is not claimed, a tax of 2 per cent of the amount of the coupon is paid to the govern- ment by the obligor. Who should claim exemption from withholding? — Individ- ual citizens or residents are privileged to claim exemption from withholding, but partners may not claim such exemption. A resident alien is required, in claiming such exemption, to file in addition a certificate of residence (form 1078, revised) with the withholding agent. 332 APPLICATION AND ADMINISTRATION Individual citizens or residents should claim exemption, if the total amount of net taxable income does not exceed their personal exemptions, i.e., $i,ooo for a single person, $2,000 or $2,500 for a married person, plus $400 for each dependent. ^^ By filing such a claim the individual relieves the debtor cor- poration from paying a tax not lawfully due. The debtor corporation's liability under a tax-free covenant covers only the portion of normal tax deductible at the source. If, therefore, a taxpayer is subject only to surtax, because his lawful deductions exceed the amount of income, if any, subject to normal tax, he should relieve the debtor corporation from making payment to the government in his behalf by filing a claim for exemption in collecting tax-free covenant bond interest. The situation is analogous to the case mentioned in the preceding paragraph. If an individual who has not claimed exemption at the time of collecting the interest afterwards desires to claim exemption, he may file in writing with the paying agent, at any time prior to February i of the succeeding year, his notice claiming ex- emption. Form 1 00 1 may be used for such notice. Similarly, an individual who has claimed exemption and subsequently desires not to claim exemption must file notice in writing (form 1000) with the paying agent on or before February i. Tax paid on tax-free covenant bond interest considered income.^* — The Treasury Department, in 1919, ruled that any tax paid pursuant to a tax-free covenant clause on behalf of a taxpayer should be considered in the nature of additional interest and should be reported by the taxpayer in his return. This ruling was a source of great irritation to the investing public and aroused many protests. The 192 1 law, under sec- tion 234 (a-3), specifically provides that taxes paid under See page 31 et seq for discussion of personal exemption. For discussion, see Chapter XIX. PAYMENT OF TAX AT SOURCE 333 tax-free covenants shall not be included in the gross income of the taxpayer. Tax paid on tax-free covenant bond interest not deductible by corporation.^^ — Under section 234 (a-3) of the law, the debtor corporation is not allowed to make deduction for federal taxes so paid under the heading of either interest or taxes. Credit for taxes paid on tax-free covenant bond interest. — Taxpayers are allowed to credit their total normal and surtaxes with the amount of any tax paid for them at the source by a debtor corporation pursuant to a tax-free covenant clause.^*' '^ For discussion, see Chapter XIX. '* Section 221 (d). PART II INCOME CHAPTER XII CREDITS AND EXEMPT INCOME 111 addition to the deductions from gross income which are fully discussed in Chapters XXV to XXXIV, the tax laws have provided other means of reducing tax liability. Tax- payers in receipt of large incomes are chiefly interested in the various classes of wholly exempt income ; taxpayers whose incomes are less than $5,000 are chiefly interested in the spe- cific exemptions. There is a vast difference between deduc- tions and credits; the former affect surtaxes as well as the normal tax; credits for specific exemptions, dividends and the like reduce only the normal tax. Credits and exempt in- come are discussed at this point because the net effect of each is to reduce the amount of taxes which would be due if taxpayers merely reported their gross income. It is less confusing to dispose of these possibilities in one chapter. Income Exempt from Normal Tax Only — "Credits" The law imposes a normal tax of 8 per cent^ on the total net income of individuals, and graduated surtaxes upon the larger incomes. It imposes a flat 10 per cent rate (no sur- taxes") upon the income of corporations, which is raised to 12I per cent after December 31, 1921. Partnerships are not taxed as independent units, the partners instead being taxed upon their respective shares of the profits whether or not dis- tributed.^ Certain individual income* is exempt from the normal tax, but is nevertheless subject to the surtax rates, the ' Reduced to 4 per cent on the first $4,000. See Chapter VTI. "Up to December 31, 1921, there was the excess profits tax in addition. See Excess Profits Tax Procedure, 1921. 'For a fnll statement, including a discussion of personal scrvii-e cor- porations, sec Chapter XXIV. * Certain dividends, certain interest, and the personal exemptions. ZZ7 338 INCOME adjustment being made by "crediting" (section 216) these items of income for purposes of the normal tax only. Even in the case of corporations, where no surtax rates apply, there are certain items" which, in accordance with the practice in the case of individuals, are entered as "credits" (section 236) rather than as deductions, the effect being to make the term "net income" include these items for excess profits tax pur- poses. In this chapter the exemptions and credits alluded to are discussed. The personal exemptions : wife and dependents. — Law. Section 216 (c) In the case of a single person, a personal exemption of $1,000; or in the case of the head of a family or a married person living with husband or wife, a personal exemption of $2,500, unless the net income is in excess of $5,000, in which case the personal exemption shall be $2,000. A husband and wife living together shall receive but one personal exemption. The amount of such personal exemption shall be $2,500, unless the aggregate net in- come of such husband and wife is in excess of $5,000, in which case the amount of such personal exemption shall be $2,000. If such hus- band and wife make separate returns, the personal exemption may be taken by either or divided between them. In no case shall the reduc- tion of the personal exemption from $2,500 to $2,000 operate to in- crease the tax, which would be payable if the exemption were $2,500, by more than the amount of the net income in excess of $5,000;" (d) $400" for each person (other than husband or wife) dependent upon and receiving his chief support from the taxpayer if such de- pendent person is under eighteen years of age or is incapable of self- support because mentally or physically defective ° The specific exemption of $2,000, on incomes of $25,000 or less, and of certain interest, excess and war profits taxes. "[Former Procedure] Tlic 1013 law [section II (C)] and the 1916 law [section 7 (a)] permitted the deduction "for the purpose of the normal tax only" and made the exemption $3,000, plus $1,000 additional if the person making the return were married with husband or wife liv- ing with her or him. The normal tax, v.'hich was i per cent under the 1913 law, was made 2 per cent in 1916. The 1917 law allowed this arrangement to remain in force, but added what in effect was a second and distinct income tax with an additional normal rate of 2 per cent. For the purpose of this new 2 per cent tax the exemptions of $3,000 and $4,000 provided in the 1916 law were changed to $1,000 and $2,000 (1917 law, Title I. sec- tion 3). Consequently there were two sets of exemptions in 1017. one for each normal tax of 2 per cent. The 1918 law provided for one set of exemp- tions of $1,000 and $2,000 [1918 law, section 216 (c)]. ' This is an increase of $200 in the e.xemption allowed for each depend- ent under the 1918 law. CREDITS AND EXEMPT INCOME 339 The addition in the igji law of $500 to the personal exemption for the head of a family or a married person living with a spouse, is extended only to those whose incomes do not exceed $5,000. The limitation of the higher exemption is explained in the following example : Example Two taxpayers, A and B, married, no children, with net taxable incomes of $5,010 and $5,030 respectively. The computation of A's tax is made in the following manner : ( 1 ) Net income $5,010.00 Personal exemption 2,500.00 Amount subject to tax $2,510.00 Tax at 4% $100.40 (2) Net income $5,010.00 Personal exemption 2.000.00 Amount subject to tax $3,010.00 Tax at 4% 120.40 Excess of computation (2) over ( i ) $20.00 Since this amount of $20 is greater than the excess of the net income over $5,000, viz., $10, and since the tax under (2) must not be greater than the tax under (T) by more than the excess of $5,010 over $5,000, i. e., $10, the total tax due by .A. is, therefore, $100.40 plus $io=$i 10.40, instead of $120.40. In the case of B the computations are: ( 1 ) Net income $5,030.00 Personal exemption 2.500.00 Amount subject to tax $2,530.00 Tax at 4% $101 .20 (2) Net income $5,030.00 Personal exemption 2,000.00 Amount subject to tax $3,030.00 Tax at 4% 121.20 Excess of computation (2) over ( i ) $ 20.00 In this instance the reduced exemption does not increase the tax beyond the amount of income over $5,000, viz., $30. The total tax due by B is, therefore, $121.20. 340 INCOME It will bo found that the benefit of the provision ceases in case of taxable net incomes over $5,020. The tax on net incomes, of other than single individuals, at and below that figure, but in excess of $5,000, will be computed on the same basis as A above. Test of dependency. — Regulation. A taxpayer receives a credit of $400^ for each per- son (other than husband or wife), whether related to him or not and whether living with him or not, dependent upon and receiving his chief support from the taxpayer, provided the dependent is either (a) under eighteen or (b) incapable of self-support because defective. The credit is based upon actual financial dependency and not mere legal dependency. It may accrue to a taxpayer who is not the head of a family. But a father whose children receive half or more of their support from a trust fund or other separate source is not entitled to the credit. (Art. 304.) "Head of a family" defined. — Regulation. A head of a family is an individual who actually supports and maintains in one household 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 con- trol and provide for these dependent individuals is based upon some moral or legal obligation. In the absence of continuous actual resi- dence together, whether or not a person with dependent relatives is a head of a family within the meaning of the statute must depend on the character of the separation. If a father is absent on business or at war, or a child or other dependent is away at school or on a visit, the common home being still maintained, the additional exemption applies. If, moreover, through force of circumstances a parent is obliged to maintain his dependent children with relatives or in a boarding house while he lives elsewhere, the additional exemption may still apply. If, however, without necessity the dependent con- tinuously makes his home elsewhere, his benefactor is not the head of a family, irrespective of the question of support. A resident alien with children abroad is not thereby entitled to credit as the head of a family. (Art. 302.) There are slight verbal changes in this article, as com- pared with article 302, "Regulations 45. The foregoing regulation does not impair the right of a parent to claim the $400 for each dependent irrespective of The credit for dependents under the 1916, 1917 and 1918 laws was $200. CREDITS AND EXEMPT INCOME 341 the nationality or place of residence of the dependents. The requirement of residence in "one household" has been aban- doned.^ It had no justification under the law/" When "without necessity the dependent continuously makes his home elsewhere," it may be reasonable to hold that the taxpayer is not to be considered the head of a family. If, however, a resident alien has children abroad "with" neces- sity, it would seem that, in addition to the credit of $400 for each dependent, the resident alien should be classed as the head of a family because every resident alien individual is subject to the income tax, even though his income is derived wholly from sources outside the United States. ^^ If a taxpayer can qualify as the head of a family under the definition formulated above, he can claim as personal exemption the full $2,500, or $2,000, as the case may be, even though he be not married. On the other hand, it is no longer necessary that he be the head of a family to claim the $400 for each dependent, provided he supplies the "chief support" of such dependent. Practically every unmarried person who is the chief supporter of a dependent should be able to qualify as a head of a family and avail himself of the additional per- sonal exemption as well as the $400 deduction. A widow or a widower supporting minor children is clearly a "head of a family." A child acting as the main support of a dependent parent or a minor brother or sister is entitled to the additional exemption, plus the $400 exemption for each minor child or dependent person mentally or physically defective. An uncle upon whom nephews and nieces are dependent is en- titled to the full exemption for those under eighteen years of age.^" It has been held that a child over eighteen years of age, away at school, with an income in excess of $1,000 a year (who filed an income tax return claiming exemption of $1,000), but whose income was insufficient to pay half the cost 'C. B. 3, page 194; O. D. 665. '" Income Tax Procedure, 1920, pages 31 and },2. " Section 210. "C. B, 4, page 215; A. R. R. 551. 342 INCOME of its support, is "dependent" on its mother (a widow), who is therefore entitled to exemption as the head of a family. ^^ A widower with a daughter over eighteen years of age who re- ceives nominal income from other sources and is neither physically nor mentally incapable of self-support, is head of a family." In cases where several persons combine to contribute to the joint support of several dependents, it may be desirable to allocate their contributions to particular persons in the group of dependents to the extent of making the taxpayers clearly the main supporters of certain individuals. By so doing they provide a basis for exemption claims which other- wise could not be allowed. This principle has been maintained in a ruling to the effect that, where a husband and wife both contribute to the support of a dependent, the credit must be taken by the one contributing the chief support and may not be divided between them." Where, in a family group, one claims the exemption ap- plicable to the head of the family, the income of minors who are dependent upon him should be included in his return, be- cause the law to this extent contemplates the computation of the tax upon the family as a unit. The following ruling un- der the 19 1 8 law bears on this point. Ruling. A father has two sons, seventeen and twenty years of age, respectively. During 1919, each son earned in excess of $1,000, but both were dependent upon the father since he appropriated their entire earnings. In view of the fact that both sons were minors, and had not been emancipated, and their earnings were appropriated by the father, the entire amount of such earnings, together with the father's income from all other sources, must be reported in the father's return for 1919. The credit of $200 for dependents is applicable only to the son under iS years of age. ( C. B. 4, page 214; O. D. 797.) ''C. B. 2. page 159; O. D. 474; also Bulletin C. B. 4, page 214; O. D. 775. " C. B. 2. page 159; O. D. 422. "C. B. 4, page 214; O. D. 776, CREDITS AND EXEMPT INCOME 343 The father was not well advised. He should emancipate the sons, charge them lioard and have them make tax returns. Minors not exempt. — A minor as such is not exempt. If he has a substantial income a separate return should be made for him and the $1,000 exemption should be claimed.^* Ruling. Where a father has made a bona fide and absolute gift of property to his minor child, the income therefrom need not be included in the father's return of gross income for the purpose of normal tax and surtax, even though the father administers the prop- erty and collects the income for the child. In such a transaction there is no presumption that the gift is or is not bona fide, but the burden should be upon the father in each case to show that it is an absolute gift to the child. (C. B. 3, page 116; Sol. Op. 14.) Status at end of year determines exemption. — The status of the taxpayer on the last day of his taxable year is the significant factor in establishing his right to the personal exemption. Law. Section 216 (f) The credits allowed by subdivi- sions (c), (d), and (e),^" of this section shall be determined by the status of the taxpayer on the last day of the period for which the re- turn of income is made; but in the case of an individual who dies during the taxable year, such credits shall be determined by his status at the time of his death, and in such case full credits shall be allov/ed to the surviving spouse, if any, according to his or her status at the close of the period for which such survivor makes re- turn of income. The inclusion of the above section is new in the ])resent law\ It is, however, based on a regulation issued under the Revenue Act of 1918.^^ What constitutes "living with husband or wife"? — Regulation. In the case of a married man or married woman the joint exemption replaces the individual exemption only if the man lives with his wife or the woman lives with her husband. In the absence of continuous actual residence together, whether or not a man or woman has a wife or husband living with him or her within '" See page 84. "See Chapter VII, page 155. " Reg. 45, Art. 305. 344 INCOME the meaning of the statute must depend on the character of the separation. If merely occasionally and temporarily a wife is away on a visit or a husband is away on business, the joint home being main- tained, the additional exemption applies. The unavoidable absence of a wife or husband at a sanatorium or asylum on account of illness does not preclude claiming the exemption. If, however, the husband voluntarily and continuously makes his home at one place and the wife hers at another, they are not living together for the purpose of the statute, irrespective of their personal relations. A resident alien with a wife residing abroad is not entitled to the joint exemption. (Art. 303.) Ruling. The taxpayer's wife was granted an annulment of the marriage with him by a court composed of three workmen, known as the People's Commission, under the Soviet regime. She later mar- ried a Russian subject. This marriage was under Soviet auspices. On or about August — , 1920, her marriage with the Russian was resolemnized by a clergyman. Irrespective of their personal relations the above facts do not indicate that the separation was of a temporary character or that it was unavoidable. It is held that the taxpayer did not have on De- cember 31, 1920, the status of a married man living with his wife. (B Digest 49-21-1960; O. D. 1 124.) The fact that a husband has been declared mentally in- competent and that his consequent confinement in an institu- tion may be indefinite has no effect on the joint personal exemption. ^^ Personal exemption valid for normal tax only. — In computing the surtax, the personal exemption may not be deducted from the net income. ^° Therefore, if a head of a family has more than seven dependents for 1921 and more than nine for subsequent years, or if all of a taxpayer's income is from dividends or from a large amount of Liberty bonds, it is possible for him to be subject to a surtax while exempt from the normal tax. Personal exemptions of resident aliens.^^ — An alien resident in the United States is in almost all respects treated C. B. 3, page 130; O. D. 603. ' See section 216. "For purposes of normal tax only " For exemptions of non-resident aliens, see Chapter XXXVI. CREDITS AND EXEMPT INCOME 345 exactly as a citizen. He is permitted to take advantage of the personal exemptions in the usual manner. Ruling. An alien residing in the United States permanently, with wife and children residing abroad, is entitled to a personal exemption of only one thousand dollars since he is not living with his wife, but is entitled to a two hundred dollar credit for each child, provided such child is dependent upon and receives its chief support from him and is under eighteen or incapable of self-support because defective. (C. B. 3, page 195; O. D. 640.) Personal exemptions of wards, beneficiaries and ESTATES. — Wards and other beneficiaries receiving their in- come from estates are entitled to claim exemption according to their status, and the guardian or trustee when making re- turns is allowed to deduct this personal exemption from the amount of income derived from the property of which he has charge in favoY of each ward or beneficiary who has not claimed a personal exemption independently or through an- other trustee [section 219 (d)]. Where the estate is sub- ject to a tax by reason of income received by it but not dis- tributed during the year, a deduction of $1,000 only (no deductions for dependents) is allowed in computing the tax upon the estate [section 219 (c)]. This is the only instance in which the personal exemption may be claimed by anyone other than the individual taxpayer." Regulation, (a) An estate or trust taxed to the fiduciary is allowed the same credits against net income as a single person, in- cluding a personal exemption of $1,000, but no credit for dependents. .... (b) .... Each beneficiary is entitled to but one personal exemption, no matter from how many trusts he may receive income. . . . . (Art. 346.) For a detailed discussion of the subject of fiduciaries, see Chapter XXXVII. ^ [Former Procedure] Prior to the enactment of the 1917 law this exemption (but $3,000 in amount) applied to all estates [section 7 (a)], but as amended by that law the exemption was limited to citizens or resi- dents of the United States, excluding non-resident aliens. The 1918 law again permitted the exemptions in the case of all estates, domestic and foreign. 346 INCOME Specific Credit to Corporations Corporations whose net income does not exceed $25,000 are entitled to a specific credit of $2,000. This provision is effective from January i, 1921. Law. Section 236. That for the purpose only of the tax imposed by section 230 [income tax] there shall be allowed the following credits: .... (b) In the case of a domestic corporation the net income of which is $25,000 or less, a specific credit of $2,000; but if the net income is more than $25,000 the tax imposed by section 230 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000;-- .... This provision, which corresponds closely to the specific exemption from normal tax extended to individuals, has as one of its effects the entire elimination of the payment of any tax b}' a domestic corporation whose net income is less than $2,000. In case a consolidated return is filed for several corporations, only one $2,000 specific credit is allowed, and that only if the consolidated net income does not exceed $25,000."* A further analogy to the specific exemption allowed individuals appears in the limitation of the credit. Only cor- porations with net incomes of $25,000 or less reap the benefit of this provision. The application of the credit to corporations whose net income is but little in excess of the $25,000 is illus- trated by the following computations : Example I Corporation A with net income in 1921 (after deducting the CREDIT FOR EXCESS PROFITS TAXES) OF $25,100 (a) The tax, without the specific credit, at io% $2,510.00 (b) Net income of $25,100 Less : Credit 2,000 Tax at 10% on $23,100 2.310.00 Excess of (a) over (b) $ 200.00 ^ [Former Procedure] Under the igog law corporations received a $5,000 exemption. Under tiie 1913. 1916 and 1917 laws corporations did not receive any specific exemption. The 1918 law reinstated a specific exemp- tion (for income tax purposes only) to the extent of $2,000. "-* For a discussion of the credit allowed corporations for excess profits taxes imposed, see Chapter V, Excess Profits Tax Procedure, 1921, and Appendix A in this book. CREDITS AND EXEMPT INCOME 347 As the liinitation inipused by the section prcckides the tax cum- puted under (a), $2,510, exceeding tlie tax computed under (b), $2,310 (an excess of $200), by more than the income in excess of $25,000 ($100), the actual tax in the case of corporation A would be: $2,3io+$ioo=$2,4io. Example II Corporation B with net income in 1921 (after deducting the CREDIT for excess PROFITS TAX) OF $25,300 (a) The tax, without the specific credit, at 10% $2,530.00 (b) Net income of $25,300.00 Less : Credit 2,000.00 Tax at 10% on $23,300.00 2,330.00 Excess of (a) over (b) $ 200.00 In this example the excess of (a) over (b), $200, is not more than the excess of the net income over $25,000, $300; the actual tax, therefore, of corporation B remains as computed without the specific credit, i. e., $2,530. The same examples would hold good for the taxable year 1922, except that the rate of taxation is raised to 12^/2 per cent. The re- peal of the excess profits tax will also mean that the whole of the taxable net income will be subject to the income tax, i. e., there will be no credit for excess profits tax. The dividing line below and above which the specific credit of $2,000 is effective, or otherwise, is $25,200 for 1921 and $25,250 for 1922. Dividends Which Are Exempt from Normal Tax Dividends of the classes referred to in section 216 below are exempt from normal tax in the hands of recipients. Law. Section 216. That for the purpose of the normal tax only there shall be allowed the following credits: (a) The amount received as dividends (i) from a domestic corporation other than a corporation entitled to the benefits of sec- tion 262, -'■ or (2) from a foreign corporation when it is shown to the satisfaction of the Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such part of such period as the corporation has "° Refers to limitation of gross income of certain corporations to that derived from sources within the United States. See Chapter XXXVI. 348 INCOME been in existence) was derived from sources within the United States as determined under the provision of section 217;-'^ .... The above credit applies to individuals and its effect is to exempt dividends from the normal tax even though the pay- ing corporations are exempt from tax."' In the case of corpor- ations substantially the same language is used in a clause"^ included among the deductions, which makes dividends re- ceived from other corporations non-taxable. The passage of the corresponding section of the 1918 act eliminated com- pletely the long-standing discrimination against corporations which own stocks in other corporations.^^ Prior to 1921 the situation regarding dividends received by citizens or residents from foreign corporations was anomal- ous. As long as the distributing corporation was "subject to tax" in the United States, quite independent of the fact that it might actually pay no tax in this country, dividends from such corporations were exempt from normal taxes. The position is now clarified to the extent that more than one-half of the in- =^ See Chapter XXXVI. ^ [Former Procedure] Under the 1918 law the exemption was limited to dividends received from corporations taxable under that law. Dividends received by the holders of the preferred stock of a corpora- tion, all of the common stock being owned by a town, the corporation fur- nishing water, power, light and heat to the town, are not exempt from normal tax. (C. B. i, page 93; O. D. 328.) ■^Section 234 (a-6). ■■* [Former Procedure] Under the 1913 and 1916 laws corporations were not permitted to deduct dividends received from other corporations. The 1917 law, which levied an additional 4 per cent tax on corporations, exempted dividends received by corporations from this rate, but not from the 2 per cent rate of the 1916 law, which continued in force, except as to dividends out of earnings realized during 1913, 1914 and 1915, which were taxable at i per cent (see Chapter VII). The exemption was granted in the form of a "credit" (1917 law, war income tax, section 4). The permission given corporations by the 1918 law to deduct dividends has the effect of automatically relieving such dividends from the exce3s profits tax. This was accomplished by special provision in 1917. A consoli- dated return in 1917 was permitted only for the purpose of the_ excess profits tax. For income tax purposes separate returns were required for each corporation, imposing upon each corporation the 2 per cent rate on dividends under the 1916 law which was still in effect. In making a con- solidated return for a fiscal year beginning in 1917 and ending in 1918, when the computation was made to determine the tax applicable to the portion of the year falling in 1918, all dividends were deducted in de- termining net income. CREDITS AND EXEMPT INCOME 349 come of the foreign corporation must have accrued from sources within the United States. Foreign corporations doing sufficient business in the United States should notify their stockholders regarding the right of credit. When stockholders do not receive a notice the credit should not be claimed. If stockholders have reason to think that they should receive the credit, but have received no notice concerning it from the corporation, they should, of course, ask the corporation for information regarding it. It should be noted that Porto Rico and the Philippine Islands are not included in the term "United States" for the purposes of the statute. Dividends received from corporations taxed in those countries, but having no income from sources within the United States, are not allowed as credits against net income of individuals or gross income of corporations (article 1131). Dividends from personal service corporations which were specifically alluded to in this section of the 1918 law are not included in the present section.^" The status of these corpora- tions is that of ordinary domestic corporations, after Decem- ber 31, 192 1. A full discussion of the situation created by the 1921 law in connection with dividends and distributive profits of per- sonal service corporations, is given in Chapter XXIV. Dividends of a personal service corporation paid on or after January i, 19 18, out of earnings accumulated prior to January i, 19 18, are exempt from the normal tax and return- able the same as dividends paid by ordinary corporations. Dividends of a personal service corporation paid on or after January i, 19 18, and prior to January i, 1922, out of earnings '" [Former Procedurel Dividends paid by a personal service corpora- tion from earnings accumulated prior to January i, iyi8, are exempt from the normal tax. Dividends paid by a personal service corporation between January i and March i, igi8 (both inclusive), are deemed to have been paid from the earnings of 1917 [section 201 (e)], but were taxable at the rates of surtax in force in the year in which received, viz., igi8. The result is that as to the dividends received in these two months the stockholders nf a personal service corporation were on the same basis as the stockholders of any other corporation. 350 INCOME accumulated after January i, 1918, have not been subject to any tax at all in the hands of the corporation. The entire net income of the corporation has been taxed to the individual stockholders for both normal and surtaxes, whether or not distributed ; hence dividends, as such, when received are not taxable and need not be reported at all. If the distributee is not a stockholder at the end of the year, an accounting must be made to determine the tax liability for the taxable year. [See section 218 (d).] Interest which is exempt from normal tax. — Law. .Section 216. That for the purpose of the normal tax only there shall be allowed the following credits: .... (b) The amount received as interest upon obligations of the United States and bonds issued by the War Finance Corporation, which is included in gross income under section 213; .... The foregoing section applies to individuals. Corpora- tions may take credit under section 236 (a) for similar in- terest. The interest here described is that included within the definitions of gross and net income by virtue of the fact that these particular public securities do not fall within the scope of section 213 (b-4-c). In the case of all the Liberty loans since the first, and of the Victory 4^/4. per cent issue, the interest, except that on cer- tain specified amounts, has been made subject to the individual surtaxes and to the excess and war profits taxes. The sections quoted above provide the machinery for exempting the interest from the normal tax of individuals and the corporation 10 per cent (12^ per cent after December 31, 1921) tax and yet rendering it subject to the surtax and excess profits tax. For a full discussion see Chapter XX. Income Exempt from Both Normal and Surtaxes In section 213, which, it will be recalled, applies to both individuals and corporations, certain items are definitely ex- cluded from the definition of gross income and consequently CREDITS AND EXEMPT INCOME 351 need not be reported at all. These items will be considered separately in the pages which follow. War risk insurance and pensions from United States ex- empt. — Law. Section 213. That .... the term "gross income" — .... (b) Does not include the following items, which shall be ex- empt from taxation under this title: .... (g) Amounts received as compensation, family allotments and allov/ances under the provisions of the War Risk Insurance and the Vocational Rehabilitation Acts, or as pensions from the United States for service of the beneficiary or another in the military or naval forces of the United States in time of war; .... The foregoing provision is new.'^^ Accident and health insurance exempt. — Law. Section 213. That .... the term "gross income" — (b) Does not include the following items, which shall be exempt from taxation under this title: .... (6) Amounts received, through accident or health insurance or under v/orkmen's compensation acts, as compensation for personal injuries or sickness, plus the amount of any damages received whether by suit or agreement on account of such injuries or sickness;^"- .... The foregoing exemption has been extended to the estate or other beneficiaries in case the insured is deceased. Regulation (c) Whether he be alive or dead, the amounts received by an insured or his estate or other beneficiaries through accident or health insurance or under workmen's compensation acts as compensation for personal injuries or sickness are excluded from the gross income of the insured, his estate and other beneficiaries. Any damages recovered by suit or agreement on account of such injuries or sickness are similarly excluded from the gross income of the individual injured or sick, if living, or of his estate or other beneficiaries entitled to receive such damages, if dead (Art. 72.) " Payments under the War Risk Insurance Act made since June 25, 1918, were exempted by the act under which paid (Reg. 45, Art. 72). Pay- ments under the Vocational Rehabilitation Act were taxable (C. B. 4, page 79; Sol. Op. 97). Pensions were taxable under the 1918 law (Reg. 45, Art. 32). ■'"This exemption, first introduced in 1918. resulted from court inter- pretations of earlier laws. See Income Tax Troccdurc, 1920, page 40. 352 INCOME Rulings. The alienation of a wife's affections is not such a personal injury as to entitle the recipient of damages therefor to exemption from income tax as to the amount received. (C. B. 2, page 71; S. 1384.) Damages in the form of yearly payments throughout the life of the injured party, recovered through the compromise of a threatened suit for breach of promise of marriage, are not regarded as a return of capital, since the benefits of which the injured party was deprived were merely anticipatory. Such payments are within the statutory definition of income and accordingly are taxable to the recipient. (C. B. 2, page 70; O. D. 501.) Life insurance — extent to which exempt.'^ When paid to beneficiaries. — Law. Section 213. That .... the term "gross income" — (b) Does not include the following items, which shall be exempt from taxation under this title: (i) The proceeds of life insurance policies paid upon the death of the insured;'^ .... The foregoing provision definitely exempts the proceeds of all life insurance.^* Rulings. A and B, beneficiaries under life insurance policies covering the lives of their respective husbarrds, accepted the option of allowing the proceeds thereof to remain with the insurance com- pany to draw interest at the rate of 3 per cent per annum, plus the amount of any excess interest dividends; the principal sum to be paid upon the death of the beneficiary to the beneficiary's legal rep- resentatives. In one case the option accepted was provided for in the policy, and in the other it was offered by the company independently of the policy. Held, that as the beneficiary in either case had the option of re- ceiving the proceeds of the insurance or of leaving the money with ^ For exemption relating to insurance companies, see Chapter XXXVIII. "* [Former Procedure] The 1913 law exempted "the proceeds of life insurance policies paid upon the death of the person insured" [section II (B)]. The regulations under the 1918 law attempted to tax the proceeds paid to the estate of the insured, but this was reversed by T. D. 3190, July I, 1921. The 1918 law exempted insurance paid to individual bene- ficiaries or to the estate of the insured, but excluded from the exemption payments to corporations. '^ Policies payable to partnerships (except limited partnerships of the corporate type) are in effect payable to individual beneficiaries. (C. B. i, page 82; T. B. R. 22.) CREDITS AND EXEMPT INCOME 353 the company to draw interest, she in effect has loaned the money to the company, and the interest so received thereon is taxable income for the year of its receipt. In the policies covering the life of C's husband, provision was made that C should receive only an annual payment representing 3 per cent of the principal of the policy, together with any excess infferest dividends apportioned to the policy. C may not receive any part of the principal, but at her death the entire sum is to be paid to certain named beneficiaries of the insured. Held, that the annual payment received by C represents a part of the proceeds of an insurance policy, and is therefore exempt from income tax in her hands. (C. B. 3, page 120; O. D. 612.) Where under a life insurance policy there is payable to a first beneficiary named 6 per cent per annum of the face value of the policy during the life, and, upon the death of the first beneficiary, the face value of the policy is payable to a second beneficiary, the pay- ments to the first beneficiary are a part of the proceeds of the policy within the meaning of section 213 (b) i of the Revenue Act of 1918, and are not to be included in gross income for the purpose of the income tax. (C. B. 2, page 90; O. 995.) Amounts received by an individual beneficiary or by the estate of the insured under the terms of an ordinary life, continuous installment bond contract issued by a life insurance company are exempt from tax under the provisions of section 213 (b) i. Revenue Act of 1918. This applies not only to the installment payments received but also to any dividends received under the terms of the bond. (C. B. 2, page 91; O. D. 433.) According to tlie nomination of the beneficiary signed by the in- sured the principal of the policy is to be held by the insurance com- pany as trustee for the benefit of his widow during her life and upon her death for the benefit of his son until he has attained the age of 30 years. The right of withdrawal is withheld from the widow during her life and his son until he reaches the age of 30, unless the income there- from for the period of a year falls below 4^ per cent of the principal, in which case the beneficiary has the right to withdraw all that part of the principal on which the beneficiary may be entitled to draw interest income. Held, that any interest received by the widow during her life, or by the son prior to his reaching the age of 30, so long as such in- come is not less than 4I/2 per cent of the principal, is exempt from income tax. In case the income from the principal falls below 43/2 per cent, the income is taxable to the beneficiary, regardless of whether the principal is withdrawn or left in the hands of the company, and any interest received thereafter shall be taxable to the beneficiary 354 INCOME whether more or less than 4^ per cent of the principal. The yearly income from the principal will be taxable to the son upon his arriving at the age of 30 years. ( B. 35-21-1790; O. D. loio.) The law says "j^rocccds of life insurance policies'" are ex- empt. These interpretations of the Treasury are of interest, but the courts may take a different view. When paid to the insured. — Law. Section 213. That .... the term "gross income" .... (b) Does not include .... (2) The amount received by the insured as a return of premium or premiums paid by him under life insurance, endowment, or annuity contracts, either during the term or at the maturity of the term men- tioned in the contract or upon surrender of the contract; .... Dividends received 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, are not considered items of taxable income under the law and should be excluded from a return of income. The same rule applies to dividends declared on endowment and other policies until the maturity of the contracts. Dividends from paid-up policies, however, are considered ordinary dividends, and when the taxpayer's net income is sufficiently large, are subject to the surtax. Regulation (b) During his life only so much of the amount received by an insured under life, endowment, or annuity con- tracts as represents a return, without interest, of premiums paid by him therefor is excluded from his gross income (Art. 72.) The law does not specify the method of reporting the amount received by the assured under an endowment or can- celled policy in excess of premiums paid. As is apparent from the regulations quoted above, the Treasury holds that the en- tire amount received in excess of premiums paid is taxable in- coine for the year during which received. In view of the ex- pressed purpose of the law in other sections, that no income or gain which accrued prior to March i, 19 13, is to be taxed, it must be assumed that the same intention applies to this sec- CREDITS AND EXEMPT INCOME 355 tion. Even if it were not the intention, it is not likely that the courts would uphold any attempt to tax amounts accrued in excess of premiums prior to March i, 191 3. Therefore it would seem to be proper to value an endowment or similar policy as of March i, 1913, and upon any realization thereof account only for the excess cash received over the sum of the value at that date and the amounts paid by the policyholder between March i, 1913, and time of realization. It would be difficult for a policyholder to calculate the value, but the insur- ance company should furnish the necessary information. Likewise during the years prior to maturity or payment, if the individual keeps his books upon the accrual basis, there would seem to be no objection to reporting each year's accrual so that upon collection of the principal sum there will be no necessity for reporting in one year the entire excess above premiums paid. In the case of large endowment policies the question is important. Gifts and inheritances exempt."-' — Law. Section 213. That .... the term "gross income" — .... (b) Does not include the following items, Vi^hich shall be exempt from taxation under this title: .... (3) The value of property acquired by gift, bequest, devise, or descent (but the income from such property shall be included in gross income), .... Regulation. Money and real or personal property received as gifts, or received under a will or under statutes of descent and dis- tribution, are exempt from tax, although the income therefrom de- rived from investment, sale, or otherwi.se is not An amount of principal paid under a marriage settlement is a gift (Art. 7Z-) The foregoing section merely states that the value of prop- erty ac([uircd by gift need not l)e included in gross income. A lax on i)roperty acquired l)y gift would ])e a ])roperty tax and could not 1)e lield to l)c income as income has l^een defined ""The iy2i law attempts tn tax donees on gains realized by sale. See Chapter XVII. This iirovision, if valid, makes a radical change in the con- sideration of gift.s. 356 INCOME by the United States Supreme Court, nor taxed as such, In the 1 92 1 law appears for the first time an attempt to tax such part of the proceeds of gifts as represents accrued gain at the date of the gift. It is claimed that the gift itself is not taxed but only the untaxed gain contained in the gift. Against this is the contention that the imposition of a so-called income tax on donees based on a time and a base over which donees have no legal control, and usually no knowledge at all, is purely and simply a tax on the capital interest with which donees become seized at the date of gift. It should be noted that no attempt is made to tax gifts as such; the tax referred to only becomes effective when, as and if donees sell or exchange the property acc[uired by gift. This chapter deals only with exempt income. It may be said therefore that, as in all other income tax laws, property acquired by gift is exempt from the income tax. If money or other property is acquired in a manner about which there is a doubt, the transaction may be inquired into. If it is determined that legal consideration is an element, the value of the property may be wholly or in part income, de- pending on the circumstances of each case. It is apparent that in many cases the proper course of ac- tion for the recipient of a gift which might seem to be some- what in the nature of compensation for services rendered is determined by the action of the person who made the pay- ment. If the giver desires to deduct the item as an expense, the recipient can scarcely object to reporting any payment of this nature actually received as taxable income. Here, as in so many cases, good faith and a disposition to yield on really doubtful points are essential to the successful administration of the income tax law. Transactions in which the element of taxability is stronger than that of exemption are discussed in the appropriate chap- ters dealing with income from services, gains or sales, etc. CREDITS AND EXEMPT INCOME 357 Gifts which have been held to contain no element of taxable income are illustrated Ijy the following rulings. Ruling. Personal transportation passes issued by a railroad com- pany, to its employees and their families, to be used when not engaged on business for the company, and which are not provided for in the contracts of employment, are considered gifts and the value thereof does not constitute taxable income to the employees. (C. B. 4, page no; O. D. 946.) Ruling. Held, that the question as to whether a gift from hus- band to wife is bona fide must be considered in the light of the intent of the donor, from all available facts, and that where a transfer is made by unconditional endorsement of securities, failure to record the transfer on the books of the corporations and the deposit of in- come from such securities in a joint account, are not conclusive that the gift was colorable. (C. B. 4, page 107; A. R. R. 367.) Colorable gifts. — It is reasonable to insist that gifts must be irrevocable and bona fide in order that subsequent realized gains or income will be taxed to the donees instead of to the donors. Usually the element of consideration controls. Where there is no family relation (where the consideration of "love and affection" is sufficient) it should be shown that the con- sideration is reasonable. In the case of bequests the element of consideration does not enter, and no attempt has been made to tax as income property acquired by bequest. Ruling. The following rules should be followed by the Bureau of Internal Revenue in distinguishing a case of an actual gift and a case of a merely colorable gift : (a) Where it appears that the owner of property has purported to transfer it without consideration to a member of his own family, or to any other person with whom he is in confidential relations, and that shortly thereafter a profitable sale of the security or property so transferred has occurred, such facts constitute prima facie evi- dence that the purported gift was not an actual gift and that the transfer was, in fact, merely colorable. In such case the so-called gift should be ignored in calculating tax, and the case should be investigated for evidence on which a charge of fraud could be sup- ported in a contest. 358 INCOME (b) The prima facie case made out by the facts mentioned in the preceding paragraph may be rebutted by proof which establishes that it was not a transaction primarily for the advantage of the donor, and that there was no agreement or understanding, tacit or other- wise, that the donor was to receive back the proceeds or at any time control their disposition. Mere statements by the parties to the effect that the gift was genuine are regarded as of little weight; the best proof that a gift was a real gift would consist of facts showing that the position or relationship of the parties is such as to show a rea- sonable occasion for such a gift being made, and such as to explain the sale by the donee. Inquiry should be made as to the disposition of the proceeds. (c) Where a taxpayer purports to make a gift to a member of his family or to a person in a confidential relation to himself, but no sale occurs, the question whether such gift was real or merely color- able is one to be decided on all of the facts. The mere fact that such conveyance is made may not lawfully be regarded as proof of fraud; but if the effect of the gift is to diminish tax liability, and it appears, either at the time of the gift or at any time thereafter, that the donor is deriving advantage from the property which he purported to give away, such facts constitute prima facie evidence that the gift was only colorable and the transaction should be treated as a nullity unless other facts are developed which show that it was a true gift. If such a gift is colorable only and made for the purpose of escaping tax, the donor is guilty of fraud and subject to penalty and punishment therefor. ( C. B. i, page 83; S. 1022.) The foregoing is clear and reasonable. There is no indica- tion of an intention to tax the proceeds of sales by donees when the gifts are bona fide. An attempt was made in January, 1921,^' to obviate the tax evasion made possible because of the ''colorable gifts" referred to above. The bill in question was not passed at the time but has been enacted in substance into the 192 1 law.''^ The same difficulty was faced by New York State under its personal income tax law. An attempt was made to tax to the donor the appreciation in value at the time of gift, but the attempt was held to be unconstitutional.^^ '' H. R. 14198. '""Section 202 (a-2). see Chapter X\"II. "'People c.v rel. Wilson v. iVcndcU. 188 N. Y. Snpp. 272^ People ex rel. Brewster v. Wendell, 188 N. Y. Supp. 510. CREDITS AND EXEMPT INCOME 359 When a so-called pension*" is a gift. — Rulings. The terms "pension" and "gift" are not nnitually ex- clusive. A payment may be both a pension and a gift. When a pension is given by one for whom services are per- formed in consideration of such services, even though it be granted after the services have been rendered, the pension is not a gift but in the nature of additional compensation. When, however, so-called pensions are awarded by one to whom no services have been rendered, such payments become mere gifts or gratuities and do not constitute taxable income. Payments by the Carnegie Foundation for the Advancement of Teaching, made to teachers and the widows of teachers, fall into the latter class. Law opinion 560 is modified to conform hereto. (C. B. 2, page Jt,; O. D. 361, overruled.) (C. B. 3, page 120; L. O. 1040.) A corporation paid to the widow of a deceased officer a certain amount equal to the salary he would have earned in two months. The payment was without consideration, a gratuity voted as a com- pliment to the deceased. It is held that the payment does not con- stitute taxable income. (B. 36-21-1798; O. D. 10 17.) Interest which is exempt from both normal and surtaxes. — Law. Section 213. That .... the term "gross income" — .... (b) Does not include the following items, which shall be exempt from taxation under this title: .... (4) Interest upon (a) the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia ;^i or (b) securities issued under the provisions of the Federal Farm Loan Act of July 17, 1916,^- or (c) the obligations of the United States or its possessions; or (d) bonds issued by the War Finance Corpora- tion. In the case of obligations of the United States issued after Sep- tember I, 1917 (other than postal savings certificates of deposit), and in the case of bonds issued by the War Finance Corporation, the in- terest shall be exempt only if and to the extent provided in the respec- tive Acts authorizing the issue thereof as amended and supplemented, and shall be excluded from gross income only if and to the extent it is wholly exempt from taxation to the taxpayer from income, war-profits and excess-profits taxes; .... *" Military and naval pensions from the United States are now exempt [section 213 (9).] See page 351. " [Former Procedure] The words "Territory" and "District of Columbia" were specifically included for the first time in the 1918 law. Under the igi6 law the word "State" was defined to "include any Terri- tory, the District of Columbia," etc., "when such construction is necessary to carry out its provisions." (1Q16 law, section 15.) " [Former Procedure] This clause was introduced i)y the 1916 law (section 4). 360 INCOME Regulation. Among income exempt from tax is interest upon the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia. Obligations issued for a public purpose by or on behalf of the State or Territory or a duly organized political subdivision acting by constituted authorities duly empowered to issue such obligations, are the obligations of a State or Territory or a political subdivision thereof. The term "political subdivision" denotes any division of the State or Territory made by the proper authorities thereof acting within their constitutional powers for the purpose of carrying out a portion of those functions of the State or Territory which by long usage and the inherent necessities of gov- ernment have always been regarded as public. Political subdivisions of a State or Territory, within the meaning of the exemption, include special assessment districts so created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee, school, harbor, port improvement, and similar districts and divisions of a State or Territory. The purchase by a State of property subject to a mort- gage executed to secure an issue of bonds does not render the bonds obligations of the State, and the interest upon them does not become exempt from taxation, whether or not the State assumes the payment of the bonds. (Art. 74.) The precise degree to whidi the interest on the various issues of United States bonds is exempt from taxation is fully treated in Chapter XIX. "Income from Interest." Suffice it here to say that the only totally exempt securities are state and municipal bonds of any date, farm loan bonds, United States securities issued prior to September i, 1917, the 3f per cent securities of the Victory Loan, and obligations of possessions of the United States. Totally tax-exempt interest need not be included in "gross income"' at all. The 1918 law for the first time required, purely for information purposes, a statement concerning the taxpayer's holdings of such se- curities. The present law omits this requirement. Rulings. Interest received on certificates of indebtedness known as "Fire relief certificates" issued in the State of Minnesota, is con- sidered interest upon the obligations of a State and therefore not taxable. (C. B. i, page 83; O. D. 30.) Certificates of sale issued by a county or other political subdivision of a State in connection with the sale of property for nonpayment of taxes do not fall within that class of obligations of a State, county, or municipality, the income from which is exempt from Federal in- come tax. (C. B. I, page 83; O. D. 327.) CREDITS AND EXEMPT INCOME 361 Interest on promissory notes of a political subdivision of a State or Territory is exempt from tax under section 213 (b) 4 of the Reve- nue Act of 1918. (C. B. 4, page no; O. D. 817.) A municipality borrows money from a bank, issuing to the bank its promissory notes at a discount. It is provided that if the notes are not paid when due, they will also draw interest from maturity until paid. Held, that both the discount and the interest on the notes after maturity are exempt from income and profits taxes in the hands of the bank. (C. B. 4, page no; O. D. 856.) Interest paid by the contractor on funds advanced by a bank on certificates of indebtedness of a municipality, and discount charged by the bank for cashing such certificates, are deductible from gross income.*^ Rulings. The interest received upon Philippine 4 per cent bonds of 1914-34 is exempt from the taxes imposed by the Revenue Act of 1918. (C. B. 4, page in; O. D. 922.) Where the executors under a will hold property specifically be- queathed to a governmental agency of a State, and other assets of the decedent's estate are sufficient to pay all debts, income received by the executors during the period of administration from such property is not taxable in the hands of the executors under section 2 (b) of the Act of 1916. (C. B. 2, page 96; S. 1374.) In the ruHng last quoted the question at issue was the taxa- bility of income from property specifically bequeathed to a state university, but still held by the executors during the period of administration. Certain dividends exempt from both normal and sur- taxes. — Federal land bank and farm loan association divi- dends EXEMPT. Regulation. As section 26 of the Federal Farm Loan Act of July 17, 1916, provides that every federal land bank and every na- tional farm loan association, including the capital and reserve or sur- plus therein and the income derived therefrom, shall be exempt from taxation, except taxes upon real estate, and that farm loan bonds, with the income therefrom, shall be exempt from taxation, the in- come derived from dividends on stock of federal land banks and '■'B. Digest 34-21-1778; O. D. 999. 362 INCOME national farm loan associations and from interest on such farm loan bonds is not subject to the income tax (Art. 75.) Federal reserve bank dividends. — Regulation. As section 7 of the Federal Reserve Act of Decem- ber 23, 1913, provides that federal reserve banks, including the capital stock and surplus therein and the income derived therefrom, shall be exempt from taxation, except taxes upon real estate, such exemption attaches to and follows the income derived from dividends on stock of .federal reserve banks in the hands of the stockholders, so that the divi- dends received on the stock of federal reserve banks are not subject to the income tax. Dividends paid by member banks, however, are treated like dividends of ordinary corporations. (Art. 76.) Compensation for active war service exempt.** — No exemp- tion for war service is allowed under the 192 1 law. The exemption allowed under the 1918 law expired automatically with the Joint Resolution of Congress dated March 3, 192 1. The period of its effectiveness extended from January i, 19 18, to March 3, 1921.*^ Dividends and interest from domestic building and loan associations. — The exemption, under the 192 1 law, of dividends and interest from domestic building and loan associations to a maximum of $300 per annum, is entirely new. Law. Section 213. That .... the term "gross income" — .... (b) Does not include the following items, which shall be exempt from taxation under this title: .... (10) So much of the amount received by an individual after De- cember 31, 1921, and before January i, 1927, as dividends or interest from domestic building and loan associations, operated exclusively for the purpose of making loans to members, as does not exceed $300; .... The ambiguity in the amount of the exemption is discussed in Chapter XIX. Rental value of minister's house not taxable. — Law. Section 213. That .... the term "gross income" — .... ^* Income Tax Procedure, 1921, page 51 ct seq. The exemption did not apply to the Public Heahh Service (B. 47-21-1932; T. D. 3242). " C. B. 4. page 112; O. D. 900. CREDITS .AND EXEMPT INCOME 363 (b) Does not include the following items, which shall be exempt from taxation under this title:. . . . (11) The rental value of a dwelling house and appurtenances thereof furnished to a minister of the gospel as part of his compen- sa'ion; .... This provision removes an anomaly that existed in the 1918 law under which compensation received in this form was taxable. Under the latter circumstances the property of an exempt body, a corporation operated exclusively for re- ligious purposes, was indirectly taxed. Shipowners' mutual protection and indemnity associa- tions. — Law. Section 213. That .... the term "gross income" — .... (b) Does not include the following items, which shall be exempt from taxation under this title: .... (12) The receipts of shipowners, mutual protection and indemnity associations, not organized for profit, and no part of the net earnings of which inures to the benefit of any private stockholder or member, but such corporations shall be subject as other persons to the tax upon their net income from interest, dividends, and rents The exemption of premiums collected and received by ship- owners' mutual protection and indemnity associations is in- cluded for the first time in the 1921 law. Mutual marine in- surance companies, as such, receive certain exemptions.*'' The above specific provision brings shipowners into line with farmers and other purely local organizations wherein protec- tion is sought without any design to secure other monetary benefits to the members. Bonus from state not taxable. — Ruling. A bonus paid by a State to its residents who served in the military or naval forces during the war with Germany does not constitute taxable income to the recipient. (C. B. i, page 83; O. D. 286. ) The exemption is based on the ground that the bonus is a gift. "Sec Chapter XXXVIII. 364 INCOME Income of foreign governments exempt. — Law. Section J 13. That .... the term "gross income"— .... (b) Does not include the following items, which shall be exempt from taxation under this title: .... (5) The income of foreign governments received from investments in the United States in stocks, bonds, or other domestic securities, owned by such foreign governments, or from interest on deposits in banks in the United States of moneys belonging to such foreign governments, or from any other source within the United States; .... Regulation. The exemption of income of foreign governments applies also to their political subdivisions. Any income collected by foreign governments from investments in the United States in stocks, bonds, or other domestic securities, which are not actually owned by but are loaned to such foreign governments, is subject to tax (Art. 86.) This article was heretofore niinil)ered 83. Ruling. Income derived by a foreign corporation from sources within the United States is subject to Federal tax, regardless of the fact that 51 per cent of its stock is owned by a foreign Government. If such income comes within the classes contemplated by sections 221 and 237, it is subject to withholding. (C. B. 4, page iii; O. D, 958.) The term "foreign government" as defined in article 382 (see ChapterXXVIII) excludes cities such as Montreal and Paris, and it would follow that any income derived in the United States by such cities would be subject to tax. The au- thor believes that the Treasury's definition, in this case, is not in accord with the law. Income of foreign ambassadors and ministers. — Regulation The income from investments in the United States in bonds and stocks and from interest on bank balances received by ambassadors and ministers accredited to the United States and the fees of foreign consuls, are exempt from tax, but income of such foreign officials from any business carried on by thein in the United States would be taxable. As under international law the benefits and immunities of ambassadors and ministers of foreign countries extend to the members of their households, including at- taches, secretaries, and servants, the foregoing provision is likewise applicable to the wives and minor children of foreign ambassadors and ministers and the members of tlieir households. The compensation CREDITS AND EXEMPT INCOME 365 of citizens of the United States who are officers or employees of a foreign government is, however, not exempt from tax. (Art. 86; Reg. 45. Art. 83.) The authority for this exemption is not found in the \a.w. If the ambassadors, ministers and consuls were abroad, their income from the United States from the sources mentioned would be subject to withholding. It is not clear why the usual "courtesy" exemption from personal taxes, such as cus- toms duties, should be extended to withholding on account of income taxes. As an embassy is deemed to be foreign soil, those who reside in it should be taxed as if they were actually on foreign soil. If Great Britain followed our practice an ambassador from the United States to Great Britain would be exempt from British income tax on his investments in that country. Ruling. Only foreign diplomats, ambassadors, and other diplo- matic representatives in charge who are accredited to the United States to represent their sovereign or country and who reside here, and the members of their staff are entitled to exemption from tax on income from investments in bonds and stocks and from interest on bank balances. Foreign consuls resident in the United States are not entitled to the exemption. (C. B. i, page 91; O. D. 336.) Although formerly ruled to the contrary,'*^ the privileges afforded foreign diplomatic officers have been extended to emijrace their wives and minor children.''® Compensation of the President and United States judges no longer exempt. — The exemptions specifically provided in the law are all covered by the foregoing sections. It should be particularly noted, however, that the exemption formerly extended to the compensation of the President of the United States and United States judges is no longer contained in the law. On the contrary, the salaries of the President and United States judges are definitely declared to be taxable. Other federal employees continue to be taxable as formerly. ^'C. B. I, page 90; O. D. 153. "Bulletin 48-21-1945; O. D. 11 15. 366 INCOME Article 32 of the regulations provides that the President and federal judges are not suljject to a new tax or an increased tax if elected or appointed to office prior to the passage of the law. \\ hile the Supreme Court has decided"'''' that the salaries of federal judges and the President of the United States could not be taxed because the federal constitution prohibited any diminution of such salaries during continuance in office, the Attorney General in an opinion dated June 21, 1920,^° stated he was "unable to see, .... that there is anything in the recent opinion of the Supreme Court which relieves a judge appointed since the enactment of tJie income tax law from paying the tax imposed by that law." This is further discussed in ( hapter XI\". Compensation of state and municipal employees exempt. — Regula'iiox. Compensation paid its officers and employees by a State or political subdivision thereof, including fees received by notaries public commissioned by States and the commissions of re- ceivers appointed by State courts, is not taxable. Compensation re- ceived for services rendered to a State or political subdivision thereof is included in gross income unless the person receives such compen- sation as an officer or employee of a State or political subdivision. An officer is a person who occupies a position in the service of the State or political subdivision, the tenure of which is continuous and not temporary and the duties of which are established by law or regulations and not by agreement. An employee is one whose duties consist in the rendition of prescribed services and not the accom- plishment of specific objects, and whose services are continuous, not occasional or temporary. Employees of universities receiving salaries paid in part or in whole from funds available under the Smith-Lever Act of May 8, 1914, who are officers or employees of a State, are not required to return as taxable incomes the salaries so received. This is also true with respect to the act of August 30, 1890, relating to colleges for the benefit of agriculture and the mechanic arts, and to the act of ]\Iarch 2, 1887, relating to agricultural experiment sta- tions in such colleges (Art. 88.) This article was heretofore numbered 85. The new article '" Ez'ans 7'. Gore, 253 U. S. 245; 64 L. Ed. 887; 40 Sup. Ct. 550. '"'32 Op. Att. Gen. 248. CREDITS AND EXEMPT INCOME 367 contains a definition of a state officer which did not appear in Regulations 45. On May 6, 19 19. tlie .Attorney General rendered an ojjinion that "salaries of state officials and salaries and wages of em- ployees of a state are not subject to the income tax imposed by the said Revenue Act of 1918."^^ The author's understanding of the intention of the fram- ers of the 1918 law is that state employees were to be taxed. But in view of the foregoing ruling there will, of course, be no judicial interpretation of the law. Rulings. The compensation received by the employees of a cer- tain public library, a corporation, is not exempt from taxation, al- though the salaries and other principal expenses of the corporation are paid out of money appropriated by the State or city and the power of appointment and removal of the employees is exercised by the board of directors, three of whom are officials of the city and two of the remaining directors are appointed by the mayor. (B. Digest 28-21-1725; O. D. 973.) Salaries paid to teachers are exempt from income tax only where the educational institution is maintained wholly by the State, and the relation of employer and employee exists between the State and the teacher. They are not exempt merely because engaged in educational work, nor because thev are pensioned bv the State. (C. B. i, page 93; O. 826.) This subject is further discussed in Chapter XIV. Alimony not taxable. — Although not one of the specified exemptions, it is important to note here that a person receiv- ing alimony need not take it into account at all in making an income tax return. Reversing former procedure,'^" the Su- preme Court of the United States'^^" in 191 7 held that alimony is not to be considered income to the recipient, nor an item of deductible expense to the payer. This, of course, is tlie final word on the subject. "'' T. D. 2843, May 17, 1919. '" [Former Procedurel T. D. 2090 (December 14, 1914) held that alimony was a personal expense, not deductible by the ])erson paying but taxable to the iicrson receiving, (he tax being subject to withholding at the source. ™ GomW v. Gould, 245 U. S. 151 : 62 L. L-id. 211 ; 38 Sup. Ct. 33 (Reg. ^3. 1918, Art. 4). 368 INCOME Regulation Neither alimony nor an allowance based on a separation agreement is taxable income (Art. y2)-) Territorial Exemptions The 1918 income tax applies, first, to individual citizens and residents of the United States and to domestic corporations (those created or organized within the United States) and, second, to non-resident alien individuals and to foreign cor- porations so far as their income arises from sources within the United States. A person whose stay in the United States is only temporary is not considered a resident. The law states that "the term 'United States' when used in a geographical sense includes only the States, the Territories of Alaska and Hawaii, and the District of Columbia" (sec- tion I ) . This definition, it will be noted, does not include Porto Rico or the Philippine Islands,^* where the 1916 revenue law is still in force (1921 law, section 261). Regulation, (o) A citizen of the United States who resides in Porto Rico, and a citizen of Porto Rico who resides in the United States, are taxable in both places, but the income tax in the United States is credited with the amount of any income, war profits, and excess profits taxes paid in Porto Rico (&) A resident of the United States, who is not a citizen of Porto Rico, is taxable in Porto Rico as a nonresident alien individual on any income derived from sources within Porto Rico, but the income tax in the United States is credited with the tax paid in Porto Rico, (c) A resident of Porto Rico, who is not a citizen of the United States, is taxable in the United States as a nonresident alien individual on any income derived from sources within the United States, and receives no such credit The same principles apply in the case of the Philip- pine Islands. (Art. 1132.) " [Former Procedure] The 1916 law states "that the word 'state' or 'United States' when used in this title shall be construed to include any territory, the District of Columbia, Porto Rico, and the Philippine Islands, when such construction is necessary to carry out its provisions" (section 15). The 1917 law imposing the war income tax did not extend to Porto Rico and the Philippines, as is shown by the following section : "That the provisions of this title shall not extend to Porto Rico or the Philippine Islands, and the Porto Rican or Philippine Legislature shall have power by due enactment to amend, alter, modify or repeal the income tax laws in force in Porto Rico or the Philippine Islands respectively." The 1918 law continued this provision. CREDITS AND EXEMPT INCOME 369 The same principle applies in the case of corporations similarly situated (article 1133). It is to be noted that under the provisions of an Act of Congress, known as "An Act making appropriations for the naval service for the fiscal year ended June 30, 1922, and for other purposes,"^^ it was "Provided further, That the income tax laws now in force in the United States of America and those w'hich may hereafter be enacted shall be held to be like- wise in force in the Virgin Islands of the United States, ex- cept that the proceeds of such taxes shall be paid into the treasuries of said islands." This act has been ratified and confirmed from and including July i, 1921. Exemption of profits from sales of vessels. — The pro- vision in the Merchant Marine Act of 1920''" exempting for ten years from tax the gains arising from the proceeds of certain vessels referred specifically to the taxes im- posed by the Revenue Act of 1918. Of course, the "Revenue Act of 1921" is not the "Revenue Act of 1918," but as the Merchant Marine Act is still in force and -as the exemption was to be for ten years, it should be held that the gains to be exempted are the same as those imposed by the Act of 1918 and that full exemption should be granted for the ten-year period. In any event, the exemption is applicable for the year 1921. The Treasury has held that the sale of the entire capital '"' Public Law, No. 35, 67th Congress. ^ [Former Procedure] Law. "That during the period of ten years from the enactment of this Act any person a citizen of the United States who may sell a vessel docu- mented under the laws of the United States and built prior to January i, 1914, shall be exempt from all income taxes that would be payable upon any of the proceeds of such sale under Title I, Title II and Title III of the Revenue Act of 1918 if the entire proceeds thereof shall be invested in the building of new ships in American shipyards, such ships to be documented under the laws of the United States and to be of a type approved by the board [i. e., the United States Shipping Board provided for by Section 3 of the Act.] " 'Merchant Marine Act, 1920,' of which the above is the second para- graph of Section 23, approved by the President, June 5, 1920. (Merchant Marine Act, 1920, section 23, paragraph 2.)" 370 INCOME Stock of a company owning ships, even though the proceeds of such sale were reinvested in American ships, could not be brought within the privileges of the act on the ground that the law specifically provides that the exemption applies only to the sale of ships. CHAPTER XIII INCOME IN GENERAL Plan of treatment. — 'The following chapters discuss in detail the various types of income subject to the income tax. Income from personal services, business, property, interest, rents, dividends, etc., are taken up in regular order and the procedure peculiar to them is explained. However, in addi- tion to these particular subjects there are many questions which are general in their nature and application. These are brought together for treatment in this introductory chapter. Variations according to class of taxpayer. — It should be observed that, in the absence of an indication to the contrary, statements made in the text are to be accepted as applicable to corporations and individuals alike. So much of the pro- cedure applies to all classes of taxpayers that it has been deemed desirable to isolate only the exceptional points, indicat- ing plainly in such cases the limitations upon the application. It is almost impossible to frame a revenue law which will distribute the tax burden with exact equality over various classes of taxpayers. There are fundamental points of differ- ence between businesses operated by corporations and by in- dividuals, which cannot easily be equalized. Partnerships are held to be nothing more than tVk^o or more individuals acting together for convenience. Attempts have been made to regard partnerships as entities, but thus far the courts have not de- parted from the common-law principle that partnerships enjoy no privileges and need bear no burdens other than those inci- dent to individuals. This principle, however, is an ancient one and it is within the range of possibilities that in the near future some court will hold that common-law partnerships are in- dependent legal entities, taxable as such, and possessing 371 %1^ INCOME privileges and burdens which differentiate them from individ- uals or corporations/ The repeal of the inequitable and imsatisfactory excess profits tax will require some adjustment of taxes upon busi- ness, as distinguished from taxes upon income from other sources. It may be that the best solution will be to impose the same rate of tax upon business enterprises, no matter how conducted. This in turn will require an adjustment of the unduly high surtax rates. "Catch-all" provision.— The law states (section 213) that "gains or profits and income derived from any source what- ever" are subject to the tax. To provide for possible lapses in the law and regulations the following "catch-all" provision was included in a previous edition of the regulations. The statements made are still pertinent. Regulation. The intent and purpose of the income tax law is that all gains, profits, and income of a taxable class shall be charged and assessed with the corresponding income tax, normal and addi- tional, and such tax shall be paid by the owner of such income or the proper representative thereof having the receipt, custody, control, or disposal of the same. In any case where the conditions which obtain do not appear to fall within the law and regulations for the assessment and collection of the income tax, the proper tax shall be assessed in the particular case by the Commissioner of Internal Rev- enue upon his findings concerning the same. Ownership of income and liability for tax thereon shall be determined as of the year for which the return is required to be rendered. (Reg. 'i'^, 1918, Art. 49.) Ruling. A, upon becoming an officer of the M Company, in- vested in the capital stock of the company at par and later purchased additional shares. It appears that at the time of purchase of this stock ' See Massachusetts Income Tax Law, General Acts of 1916, Chapter 269, section 10, which reads in part as follows : "The tax shall be assessed on such a partnership by the name under which it does business, and the partners shall not be taxed with respect to the income derived by them from such a partnership." Oliver V. Lynn (130 Mass. 143), holds that the tax on partnership property is a separate tax against the partnership, and that an individual partner cannot sue for the recovery of such a tax unless it is proved to be wholly illegal. INCOME IN GENERAL 373 it was agreed, and so provided by the by-laws of the company, that should any employee holding common stock sever connection with the company, such employee should sell to the company all the common stock so held, receiving therefor its book value. In 1918 A severed his connection with the M Company, and under the terms of his agree- ment surrendered his stock, receiving book value therefor, such book value being x dollars in excess of the amount paid therefor. A pro- tests against taxation of this profit on the ground that the sale was not voluntary. This Committee is of the opinion that this protest is without merit, since there is no warrant of law for exempting profits actually realized from tax because such realization is involuntary (C. B. i, page 66; A. R. M. i.) Nature of taxable income, — The concept of income adopted in the law is not an entirely clear and logical one. In general it imposes the tax only when the income is reduced to money, but in certain cases this rule is not followed, the law taxing some income in forms other than money." In some respects the 192 1 law is an improvement over past laws. Capital gains and profits are still subject to the tax (as they should be) but at a reduced rate for large incomes. What is needed is an authoritative definition of "income." This cannot be found in the decisions of the Supreme Court, because there are too many differentiations and limitations to make it clear what a decision will be in any future case. The following definition of income is of interest. It should, however, include the world "realized" when applied to taxable income : Income is the money value of the net accretion to one's economic power between two points of time^ It appears from some court decisions that doubt exists as to the taxabih'tv of certain transactions which involve so-called "The 1917 and former laws pur])orted to tax only realized income but the Treasury assessed taxes on many exchanges in which there was no realized income. The 1918 law contains a formula for computing income in the case of exchanges which depends more on par or face value of securities than on actual values. "Robert Murray Haig. "The Concept of Income — Economic and Legal Aspects," The Federal Income Tax, Colinnbia University, 1921. 374 INCOME capital. In a recent case* the Circuit Court of Appeals, Second Circuit, held that a gift to a corporation is not taxable income. In defining the word "income"^ the court said: ". . . .it (income) should not include such wealth as is honestly appro- priated to what would customarily be regarded as the capital of the corporation." One judge, dissenting, said: "I find no difficulty in calling it (the gift to the corporation) income." Under the circumstances, no apology is needed to justify a careful inquiry into the right of Congress or of the Treasury to extend the taxation of income — which is permitted under the sixteenth amendment — to the taxation of capital — which is not permitted. Such an inquiry naturally should cover the right to tax any transaction unless there is an actual realiza- tion of income, as distinguished from the apparent income which may be and often is the result of temporary fluctuations in values. Income in cash or equivalent.''— The use one enjoys of his own property — as, for example, the house in which the owner lives — is not considered taxable income. Ordinarily income, to be taxable, must be in the form of money. Thus, the farmer's crop is not taxable until it has been reduced to cash (if the inventory method is not used)' and one piece of property exchanged for another when neither has a "readily * U. S. V. Orcgon-Washingion R. & Nav. Co., 251 Fed. 211. " "However, the tax, though it includes income 'from all sources.' nevertheless includes 'income' only, and the meaning of that word is not to be found in its bare etymological derivation. Its meaning is rather to be gathered from the implicit assumptions of its- use in common speech. The implied distinction, it seems to us, is between permanent sources of wealth and more or less periodic earnings. Of course, the term is not limited to earnings from economic capital ; i.e., wealth industrially employed in permanent form. It includes the earnings from a calling, as well as interest, royalties, or dividends, though in the case of corporations this may be of slight importance. Yet the word unquestionably imports, at least so it seems to us, the current distinction between what is commonly treated as the increase or increment from the exercise of some economically productive power of one sort or another, and the power itself, and it should not include such wealth as is honestly appropriated to what would cus- tomarily be regarded as the capital of the corporation taxed." " See Arts. 33 and 34, pages 438 and 437- ' See Chapter XXXIX. INCOME IN GENERAL 375 realizable market value, "^ gives rise to no immediate taxable income. However, income from personal services is taxable "in whatever form paid."^ This is true apparently on the theory that in these cases there is some basis for the determina- tion of the cash value of the income even though the income itself is in a form other than money, such as accounts receiv- aljle and mortgages. Regulation Items of income and of expenditures which as gross income and deductions are elements in the computation of net income need not be in the form of cash. It is sufficient that such items, if otherwise properly included in the computation, can be valued in terms of money (Art. 22.) Sales proceeds in escrow. — Ruling. Where a sale is made and because of claimants for com- missions the seller is required by the purchaser to put a certain part of the purchase price in escrow, and thereafter certain claimants are paid directly out of said funds in escrow, the seller is not liable for income tax upon any part of the purchase price in escrow until actu- ally received by him. (C. B. 2, page 82; S. 1315.) A lease of oil lands contained a clause that the lease could not be assigned without the approval of the Secretary of the Interior. The lease was assigned in December, 19 16, and the consideration therefor deposited in a bank in escrow pending the approval of the assignment, which was obtained in January, 19 17. The Treasury held that title to the money deposited in escrow did not vest in the assignor until the ap- proval of the assignment of the lease by the Secretary of the Interior, and therefore was income to the assignor in 191 7. (I-3-3i;L. O. 1082.) Closed transactions in property. — The attempt to tax accretions of property values has raised an interesting series of problems turning upon the question. What constitutes a closed transaction or a realization definite enough to serve as Section 202 (b). Section 213 (a). 376 INCOME the basis for the imposition of a tax? This topic is discussed in detail in Chapter XVI. "Gross" and "net" income. — The 1921 law devotes in the case of individuals, one section to the enumeration of the items included and not included in the term "gross income" (section 213) and another to "deductions" (section 214) and by de- claring "net income" to be the remainder obtained by deducting the second from the first. The items, such as dividends, per- sonal exemptions and interest on certain government securi- ties, which are subject to the surtaxes but not to the normal tax, are provided for by a series of "credits" described in an- other section (section 216). As a result "gross" income is a special term which excludes certain items such as proceeds of insurance policies and gifts which are exempt from taxation. "Net" income is also a special term which, in the case of in- dividuals, includes personal exemptions, dividends, etc. The same general plan is followed in defining the "gross" and "net" income of corporations (sections 232-236). The explanation of the concepts of gross and net income provided in the regulations is as follows: Regulation. The tax imposed by the statute is upon income. In the computation of the tax various classes of income must be con- sidered: (a) Income (in the broad sense), meaning all wealth which flows in to the taxpayer other than as a mere return of capital. It includes the forms of income specifically described as gains and profits, including gains derived from the sale or other disposition of capital assets. Income can not be determined merely by reckoning cash receipts, for the statute recognizes as income-determining factors other items, among which are inventories, accounts receivable, prop- erty exhaustion, and accounts payable for expenses incurred (b) Gross income, meaning income (in the broad sense) less. income which is by statutory provision or otherwise exempt from the tax imposed by the statute.^" . . . . (c) Net income, meaning gross income less statutory deductions. The statutory deductions are in general, though not exclusively, expenditures, other than capital ex- penditures, connected with the production of income.^^ . . . . (d) '" See page 350 ct seq. " See Chapter XXV. INCOME IN GENERAL 377 Net income less credits.^- .... The surtax is imposed upon net income; the normal tax upon net income less credits. Though tax- able net income is a statutory conception it follows, subject to certain modifications as to exemptions and as to deductions for partial losses in some cases, the lines of commercial usage. Subject to these modifications statutory "net income" is commercial "net income." This appears from the fact that ordinarily it is to be computed in accordance with the method of accounting regularly employed in keeping the books of the taxpayer (Art. 21.) Export sales. — Ordinarily there is little difficulty in deter- mining "gross income" ; but the question has arisen in case of exporting firms, as to whether or not they should include in income the profit from sales of goods shipped to customers against open drafts before the collecting banks in the foreign country report payment of the drafts. When it has been the practice in the past not to include the profit on such sales until the draft is met, it seems proper to continue the practice. In other cases when definite advices are received before March 15 of the succeeding year as to the disposition of drafts against shipments made prior to December 31 of the pre- ceding year, and when it is then known that the drafts have not been met, it is proper not to include the profit on these sales, but to include the goods in the inventory. Ruling. A corporation ships goods to foreign countries with the understanding that legal title docs not vest in the purchaser prior to his acceptance of the draft which accompanies each bill of lading. Held, that the profits from the sale should not be included in the gross income of the corporation until the draft has actually been ac- cepted and notice of that fact has been received by the corporation. Any goods shipped, the sale of which was not actually consummated as indicated above prior to the close of the corporation's taxable year, should be included in the closing inventory for that year. (C. B. 4, page 94; O. D. 824.) Income accruing prior to March i, 1913, not taxable. — Regulation. Any claim existing unconditionally on March i, I9i3> whether presently payable or not and held by a taxpayer prior See page 2i2>7 cl scq. 378 INCOME to March i, 1913, whether evidenced by writing or not, and all in- terest which had accrued thereon before that date, do not constitute taxable income, although actually recovered or received subsequent to such date. Interest accruing on or after that date is taxable income. Where an interest-bearing claim held on February 28, 1913, is paid in whole or in part after that date, any gain derived from the pay- ment of the claim is taxable. The amount of such gain is the excess of the proceeds of the claim (both principal and interest) exclusive of any interest accrued since February 28, 1913, already returned as income, over the cost thereof (both principal and interest then ac- crued). However, the gain to be included in gross income where the fair market value of the claim as of March i, I9i3> is greater than the cost thereof, is the excess of the amount re- ceived over such value. No gain results where the amount received from the claim is more than the cost thereof but less than its fair mar- ket value as of March i, 1913. In the case of an insurance policy its surrender value as of March i, 1913, may be used as a basis for the purpose of ascertaining the gain derived from the sale or other dispo- sition of such property. Where services were rendered prior to March i, 1913, but paid for thereafter, the amount received is taxable income to the extent of the excess of such amount over the fair mar- ket value on March i, 1913, of the principal of the claim and any in- terest which had then accrued (Art. 90.) When a valid and valuable claim existed, it wotild not seem to make mtich difference whether the right was conditional or unconditional. Investment in non-taxable securities. — Many taxpayers are considering the relative advantages of investments in gov- ernment and other non-taxable or partly taxable bonds as compared with investments in wholly taxable securities. The question arises both as to investment of income and as to change of investments held. Tables have been prepared by investment bankers and others which show the relative net return from taxable and non-taxable securities to recipients of income of different amotints. It is often possible for a taxpayer to reduce his tax burden by investing in non-taxable securities, but it must be borne in mind that tables which show comparative returns can be prepared onh^ with reference to assumed conditions of investments and income. Each indi- vidual's tax, however, depends on the sources of his particular INCOME IN GENERAL 379 income, whether from Inisiiiess activities, dividends, interest on bonds or other sonrces. Moreover, if changes in invest- ments are made, there may be losses upon sales which mate- rially affect the advantage of the changes. Consequently, a taxpayer who considers whether to invest in government bonds or other non-taxables should realize that not general information, but a study of his particular conditions of in- vestments and income, is needed to determine what he would gain, as to taxes, by any investment. Particularly is this true in view of the contemplated further reduction in the upper brackets of the surtax. Accounting procedure. — The 1921 law specifically pro- vides that for income tax purposes the same methods of ac- counting shall be used as are "regularly employed in keeping the books, "^'^ unless this "does not clearly reflect the income." Law. Section 212. .... (b) The net income shall be computed .... in accordance with the method of accounting regularly em- ployed in keeping the books of such taxpayer ;i^ but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income Regulations, (i) Approved standard methods of accounting will ordinarily be regarded as clearly reflecting income. A method of accounting will not, however, be regarded as clearly reflecting income unless all items of gross income and all deductions are treated with reasonable consistency. See section 200 of the statute for defi- nitions of "paid," "paid or accrued," and "paid or incurred."'^ All items of gross income shall be included in the gross income for the taxable year in which they are received by the taxpayer, and deduc- tions taken accordingly, unless in order clearly to reflect income such amounts are to be properly accounted for as of a different period. For instance, in any case in which it is necessary to use an inven- tory, no accounting in regard to purchases and sales will correctly reflect income except an accrual method A taxpayer is deemed " Section 232 makes section 212 applicable to corporations. "The provision was the same in the 1918 law. For summary of the provisions of former laws regarding the "accrual" and "cash" bases, see Income Tax Procedure, 1918, pages 67-70. " See page 383. 380 INCOME to have received items of gross income which have been credited to or set apart for him without restriction On the other hand, appreciation in value of property is not even an accrual of income to a taxpayer prior to the realization of such appreciation through sale or conversion of the property (Art. 23.) It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. Each taxpayer is required by law to make a return of his true income. He must, therefore, maintain such accounting records as will enable him to do so Among the essentials are the following: (i) In all cases in which the production, purchase, or sale of merchandise of any kind is an income-producing factor inventories of the merchandise on hand (including finished goods, work in proc- ess, raw materials, and supplies) should be taken at the beginning and end of the year and used in computing the net income of the year ; (2) Expenditures made during the year should be properly classified as between capital and income, that is to say, that expendi- tures for items of plant, equipment, etc., which have a useful life extending substantially beyond the year should be charged to a capital account and not to an expense account; and (3) In any case in which the cost of capital assets is being re- covered through deductions for wear and tear, depletion, or obso- lescence any expenditure (other than ordinary repairs) made to re- store the property or prolong its useful life should be added to the property account or charged against the appropriate reserve and not to current expenses. (Art. 24.) Period for which net income is computed. — Regulation. Net income must be computed with respect to a fixed period. Usually that period is twelve months and is known as the taxable year.^'^ .... The time as of which any item of gross income or any deduction is to be accounted for must be determined in the light of the fundamental rule that the computation shall be made in such a manner as clearly reflects the taxpayer's income. If the method of accounting regularly employed by him in keeping his books clearly reflects his income, it is to be followed with respect to the time as of which items of gross income and deductions are to be accounted for If the taxpayer does not regularly employ a method of accounting which clearly reflects his income, the com- putation shall be made in such manner as in the opinion of the Commissioner clearly reflects it. (Art. 22.) Defined in section 200 (i). INCOA'IE IN GENERAL 381 Ruling. Adjustments made in accordance with instructions from the Interstate Commerce Commission, increasing the income of a railroad corporation from transactions in prior years and taken up on the books of the corporation during the taxable year because neces- sary information was not available prior to that time, represent in- come for the years during which the transactions took place instead of the taxable year. Corrections should be made by means of amended returns. (C. B. i, page 58; O. D. 9.) Regulation. Each year's return, so far as practicable, both as to gross income and deductions therefrom, should be complete in itself, and taxpayers are expected to make every reasonable effort to as- certain the facts necessai"y to make a correct return The expenses, liabilities, or deficit of one year can not be used to reduce the income of a subsequent year -A taxpayer has the right to deduct all authorized allowances, and it follows that if he does not within any year deduct certain of his expenses, losses, interest, taxes, or other charges, he can not deduct them from the income of the next or any succeeding year. It is recognized, however, that particularly in a going business of any magnitude there are certain overlapping items both of income and deduction, and so long as these overlapping items do not materially distort the income they may be included in the year in which the taxpayer, pursuant to a consistent policy, takes them into his accounts. Judgments or other binding adjudication, such as decisions of referees and boards of review under workmen's compensation laws, on account of damages for patent infringement, personal injuries, or other cause, are deductible from gross income when the claim is so adjudicated or paid, unless taken under other methods of accounting which clearly reflect the correct deduction, less any amount of such damages as may have been compensated for by insurance or otherwise. If subsequently to its occurrence, however, a taxpayer first ascertains the amount of a loss sustained during a prior taxable year which has not been deducted from gross income, he may render an amended return for such preceding taxable year including such amount of loss in the deductions from gross income and may file a claim for refund of the excess tax paid by reason of the failure to deduct such loss in the original return. A loss from theft or embezzlement occurring in one year and discovered in an- other is ordinarily deductible for the year in which sustained (Art. III.) The foregoing article sets forth good accounting practice. It recognizes that the best test of an adjustment is its relation to the business as a whole. It also describes the proper method of procedure when a loss is discovered in a fiscal year succeed- ing the year in which it should have appeared as a deduction. 382 INCOME Ruling. A restraining order of a court required that a part of the commissions received by the petitioners should be deposited with the Clerk of the Court, pending a determination of the ownership thereof, upon which determination the amounts deposited were to be refunded to the petitioners or distributed to their patrons from whom they were collected. Held, that the commissions deposited need not be included in gross income until the taxable year of the judicial determination. (B. Digest 30-21-1743; O. D. 980.) Amended returns required in certain cases. — The following indicates that the Treasury is ready to accept ad- justments of returns of prior years, if such adjustments are necessary to reflect the true net income. Ruling. Reference is made to your letter of June 2, 1920, in which you state that during the years 1915, 1916 and 1917 .... Com- pany paid customs duties on imported merchandise on the basis of an exchange rate of a franc at 19.3 cents instead of the lower rate prevailing at the time of importation. It appears that the amount so paid as duties were included in the income and profits tax returns as part of the cost of goods sold during the years 1915, 1916 and 1917 and the surplus reduced each year to the extent of the duties paid. During the year 1919 the company received a refund of the amount so paid as customs duties which was in excess of the amount due on the basis of the exchange rate prevailing at the time of importation of the French merchandise. You submit for consideration the following inquiries relative to the treatment of the transaction for income tax purposes : (a) How should the transaction be treated in computing the annual net income for the years involved? (b) Is not the amount allowed as a refund for duties overpaid in each year a credit to surplus for that year? (c) Is not the attorney's fee and expense of collection an item of necessary business expense incurred in 1919 when the liability accrued and was paid? In reply you are advised that the law contemplates that each year's return both as to gross income and deductions therefrom shall be complete in itself. The effect of the Treasury Decision under which the claim for refund of excess duties paid was allowed is to indicate that the excess revenue, which was paid during the years 191 5, 191 6 and 1917 and for which the company received a refund during the year 1919, is an amount which has been erroneously deducted in com- puting net income for the years 1915, 1916 and 1917 respectively rather than an amount which represents income for the year 1919. INCOME IN GENERAL 383 Accordingly the company should amend its returns t'or the years 1915, 1916 and 1917, respectively, excluding from the cost of goods sold during each year the excess duties paid during such year. The surplus account for those years should also be adjusted by restoring to such account the amount paid as revenue in excess of the true liability for those years. The attorney's fees and cost of collection of the refund are a necessary business expense for the year in which the liability accrued and was paid, which appears to be the year 1919. (Letter to S. D. Leidesdorf & Company, New York, N. Y., signed by Paul F. Myers, Acting Commissioner, and dated June 26, 1920.) Cash or accrual method of computing net income. — LTnder ''definitions" the law contains the fohowing:" Law. Section 200. .... The term "paid," for the purposes of the deductions and credits under this title, means "paid or accrued" or "paid or incurred," and the terms "paid or incurred" and "paid or accrued" shall be construed according to the method of accounting upon the basis of which the net income is computed under section 212 The foregoing provisions are much more positive in tone than the permissive clauses included in the 191 6 law and have heen interpreted by the regulations to require the accrual basis for tax purposes when that method is used in the accounts. Regulation "Paid" is to be construed in each instance in the light of the method used in computing net income, whether on an accrual or a receipts basis (Art. 1533.) All well-conducted business concerns attempt to make their books reflect actual net income for their accounting periods. When this is done in good faith the income tax return should exactly agree with the books, subject to statutory provisions. Individuals do not, as a rule, keep books, and when they do their so-called accounts consist usually of cash records. But when reasonably accurate accounts are kept the taxpayer is more than repaid for the trouble involved. They assist economy and encourage thrift. Without accurate accounts an income tax cannot be satisfactorily assessed. The Com- " Same in 1918 law. 384 INCOME missioner will be justified in directing that every taxpayer be required to keep a clear record of gross income as it accrues and of expenses as they are incurred. Nothing can be more obvious than the proposition that true "net income" cannot be determined by looking over one's cash account. Even day-laborers, many of whom now re- ceive taxable incomes, often do not receive their wages in the period in which they are earned. It is not intended to suggest that taxpayers of this class should be required to prepare a return on the accrual basis ; but if the wage-earner, whose wages for December, 1921, amounting to $200, where not received by him until January, 1922, desires to include the $200 in his 192 1 returns, he should be encouraged to do so. Ruling. Under the income tax statutes taxpayers are required to render true and accurate returns of annual net income in manner and form prescribed by the Commissioner with the approval of the Secretary of the Treasury. Any return which in the judgment of the Commissioner does not reflect the true net income of a corpora- tion may be rejected by him and the taxpayer required to render a return on such basis as he may prescribe. Therefore, the action of the Unit in requiring a corporation engaged in the mercantile busi- ness, which made its returns for 1917 and 1918, on the basis of re- ceipts and disbursements, to file amended returns on the accrual basis was proper and is approved. The general plan which has been adopted with respect to mercan- tile corporations of requiring that both inventories and accounts receivable shall enter into the computation of net income is proper and in accord with the law and regulations. (C. B. 3, page 76; A. R. R. 217.) Profit on consignment sales. — Ruling. Profit on goods sold by a consignee is income to the consignor for the year in which the sales are made, even though the consignor received no notification of sale until a subsequent year. If reported otherwise, amended returns should be filed. (C. B. i, page 66; O. D. 13.) Changing from cash to accrual method. — If a tax- payer who has kept his books on a cash basis desires to change to an accrual basis, he must first secure the consent of the INCOME IN GENERAL 385 Commissioner. It is most improper to change more than once unless the reasons are extremely cogent/^ In the long" run the government is not likely to gain or lose anything by permitting one change, but if shifting back and forth were freely permitted it might easily develop into a scheme of wholesale evasion. It is desirable for the taxpayer who contemplates a change in his method of reporting, to restate his accounts as of the beginning of the taxable year as well as at the end, and thus put all the current year's earnings and expenses on an accrual basis. Regulation (3) A taxpayer who changes the method of accounting employed in keeping his books for the taxable year 1921 or thereafter should, before computing his income upon such new basis for purposes of taxation, secure the consent of the commissioner. Application for permission to change the basis of the return shall be made at least 30 days before the close of the period to be covered by the return and shall be accompanied by a statement specifying the classes of items differently treated under the two systems and specify- ing all amounts which would be duplicated or entirely omitted as a result of the proposed change. . . ." . (Art. 23.) Rulings. Office Decision 481, ruling 18-20-893, modified by Of- fice Decision 636, ruling 34-20-1144, is further modified so as to pro- vide that where a farmer keeping his accounts on the cash receipts and disbursements basis desires to change to the accrual basis, and actual records or definite proofs are submitted which establish to the satis- faction of the Commissioner of Internal Revenue the existence of an animal or other production asset on a date previous to any date on which the farmer has paid income tax, inventory adjustments may be made in accordance with the instructions contained on page 4 of Form 1040-F. (C. B. 3, page 81; O. D. 685.) A taxpayer, having reported his income prior to 1920 on the basis of cash receipts and disbursements, is not permitted to change from that basis because the books in his publishing business are now kept on an accrual basis, his accounts showing his income from. a part- nership being still kept on the cash basis and no formal books of ac- count, being kept to show his income from miscellaneous sources. (B. Digest 29-2T-1731; O. D. 1731.) A taxpayer who had heretofore computed his income and filed his returns on the accrual basis changed bis method of accounting I). 24.^3 (January 8, 1917). 386 INCOME to the cash receipts and disbursements basis on June 30, 1921, the close of his taxable year, and applied to the Commissioner for per- mission to compute his income in his return for the 1921 fiscal year on the cash basis. Held, that inasmuch as the change in his method of accounting was not made until the close of the taxable year, permission to com- pute income in his return for 1921 on the cash receipts and disburse- ments basis is denied. (B. 48-21-1941 ; O. D. 1113.) A taxpayer who has properly filed his return on the cash receipts and disbursements basis can not be granted permission to amend it by stating that it is filed on an accrual basis, even though his cash receipts and disbursements were the same as his accrued income and deductions except as to the item taxes accrued to a foreign country. (B. 50-21-1971; O. D. 1133.) Inventories.- — The provision of the 1918 law regarding inventories marked a great advance over the earlier laws. Under the 1909 and 191 3 laws the tise of inventories was permitted in certain cases without the authority of any spe- cific permission in the law and in spite of some doubt as to its legality. The 19 18 law gave the Commissioner power to require inventories "whenever necessary clearly to determine the income of any taxpayer" and specified that the basis should "conform as nearly as may be to the best accounting practice in the trade or business." The 1921 law continues this re- C|uirement. Fortunately, the determination of the "best accounting practice" is not difficult. Briefly defined, the term means ac- counts and methods which correctly reflect the true financial position of a concern as to net worth and earnings and which make it possible to secure advice which will prevent the pro- prietors or executives from deceiving themselves. The eft"ect of federal income tax legislation upon accounting practice is interesting. Prior to 1909, conservative business men usually understated rather than overstated their net earnings, while ignorant and dishonest business men overstated them. After the enactment of the 1909 law, which imposed a tax on net earnings, the dishonest men began to understate their earnings and the honest and conservative men were inclined to overstate INCOME IN GENERAL 387 their earnings in their desire to comply fully with the tax re- quirements. Men cannot be made honest through legislation, but in- come tax legislation should contain ample penalties for false returns. Those who are honest can be depended upon to remain honest. The earlier income tax laws and regulations, in almost entirely ignoring the accrual system of accounting and in forbidding conservative methods of valuing inventories, actually reduced the revenue receipts of the government'^ and at the same time attempted to impose upon taxpayers impos- sible methods of accounting and valuation. These regulations bore most heavily upon honest and conservative business con- cerns but in no way worried the dishonest ones. It is very gratifying to note the recognition now given to good accounting practice. It does not diminish the govern- ment's revenue and it enables taxpayers readily to prepare returns from accounts which accurately reflect true net in- come. The subject of inventories is fully discussed in Chapter XV, "Income from Business." Also see Chapter XXV. There are some businesses, it seems, in which the use of inventories does not reflect true net income. Ruling. The net income of a person engaged in the business of propagation and culture of oysters can not be properly computed upon the basis of inventories. Amended returns will be required for those years for which returns have been based upon inventories. The net income is the gross receipts for the year less the necessary busi- ness expense and other allowable deductions. (C. B. 3, page 80; O. D. 684.) The Commissioner, however, has no authority to refuse permission to use the inventory method when its use (rather than the cash basis) more clearly reflects the annual income of the taxpayer. "Constructive" receipt. — Even when the cash basis is used, the regulations provide that income must l)e reported See Income Tax Procedure, 1918, pages 32-37, for concrete example. 388 INCOME when it is made available irrespective of whether or not it is actually reduced to possession. If an item is a "constructive" receipt it is taxable. The following regulations cover this matter fully. Regulations. Income which is credited to the account of or set apart for a taxpayer and whicli may be drawn upon by him at any time is subject to tax for the year during which so credited or set apart, although not then actually reduced to possession. To constitute receipt in such a case the income must be credited to the taxpayer without any substantial limitation or restriction as to the time or manner of payment or condition upon which payment is to be made. A book entry, if made, should indicate an absolute transfer from one account to another. If the income is not credited, but is set apart, such income must be unqualifiedly subject to the demand of the taxpayer. Where a corporation contingently credits its em- ployees with bonus stock, but the stock is not available to such employees until some future date, the mere crediting on the books of the corporation does not constitute receipt. (Art. 52; Reg. 45, Art. 53.) Where interest coupons have matured and are payable, but have not been cashed, such interest payment, though not collected when due and payable, is nevertheless available to the taxpayer and should therefore be included in his gross income for the year during which the coupons matured. This is true if the coupons are exchanged for other property instead of eventually being cashed. Defaulted coupons are interest for the year in which paid. Dividends on corporate stock are subject to tax when unqualifiedly made subject to the de- mand of the stockholder,-'^ .... The distributive share of the profits of a partner in a partnership is regarded as received-^ by him although not distributed Interest credited on savings bank deposits, even though the bank nominally have a rule, seldom or never enforced, that it may require so many days" notice in advance of cashing depositors' checks, is income to the depositor when credited (Art. 53; Reg. 45, Art. 54.) The phrase "unqualifiedly made subject to the demand of the stockholder" has been substituted for "set apart for," and the reference to constructive receipt of the distributive shares of personal service corporations is omitted. Rulings. Under the by-laws of a cooperative bank the profits credited to a shareholder may not be withdrawn in their entirety See Chapter XXII. See Chapter XXIV. INCOME IN GENERAL 389 until five years have elapsed, but three-fourths of such profits may be withdrawn at any time upon 30 days notice, in which case the other fourth is forfeited. The question presented is wliether the profits credited to a share- holder of the bank are credited to or set apart for him without re- striction, and, if so, whether the net amount which he might imme- diately withdraw or the whole amount credited to him should be reported as income. Held, that three-fourths of the profits credited to the shareholder are credited to or set apart for him without restriction, and as such should be included in gross income for the year in which so credited or set apart. The remaining one-fourth becomes income, construc- tively received, at the end of the five-year period, provided he has not previously withdrawn his shares. (B. 44-21-1892; O. D. 1081.) The donation by assignment of partnership profits to be earned in the future does not exempt such profits, when determined, from taxation as a part of the individual income of the donor. (C. B. i, page 80; O. 912.) Where an individual is employed as an agent for a firm and under his contract is to receive as compensation 50 per cent of the profits of the agency which may be appropriated by him monthly as earned, the amount actually appropriated constitutes income of the agent for the year in which appropriated. ( C. B. 2, page 64; S. 1312. ) A distinction was drawn in this case between profits "credited or set apart" and profits "appropriated" by the individual who was entitled to draw against his share of profits. On this point the detailed opinion states : Ruling. Attorneys for the claimant make the contention that the claimant's portion of the monthly profits of the agency constitute in- come of the claimant each month ; that is to say, the claimant's share of the profits are received by him during the month in which earned. This contention is based upon the ruling of this ofiice contained in article 53 of regulations 45, the wording of which is "income which may be drawn at any time is subject to the tax for the year during which so credited or set apart, although not then actually reduced to possession." This contention is not valid for the reason that the profits of the agency are not credited to him or set apart month by month. The contract of employment provides that such profits "shall be and are the property of M." This ruling is not convincing. Tt seems that an agent who is entitled to 50 per cent of the profits of a Inisiness should be required to report all of the earnings which accrued to him 390 INCOME during each period rather than the amount "appropriated." If he had not "appropriated" any part of the earnings it is hardly Hkely that the Treasury will permit him to say that he had no taxable income. Rulings. Held, that commissions duly authorized and credited as compensation for services, when under control of the creditor and subject to his draft, should be treated as taxable income for the year in which credited, even though not reduced to possession in that taxable year. (C. B. 4, page 100; A. R. R. 366.) Stockholders of a corporation were advised of the decision of the board of directors to distribute a portion of the assets, the distribu- tion to be made as of December — , 191 5) a-nd they were given until January — , 1916, to elect whether they would receive stock or cash. Held, that there could be no constructive receipt until the option was exercised by the stockholders and communicated 'to the corpora- tion. (C. B. 4, page 102; A. R. R. 375.) An amount received by the lessee from the lessor of a living apartment, upon the termination of the lease, before its expiration for the purpose of defraying storage charges upon the lessee's household goods, should be included in gross income. (B. 37-21-1812; A. R. R. 617.) The foregoing ruling is not sound. If the tenant had remained until the expiration of his lease there would have been no storage charges. The tenant was merely reimbursed for an expense incurred for the account of another. There is no legal or accounting precedent for calling such a receipt con- structive income. The payment was authorized by the lessor and the amount of the expense, whether large or small, was of no more interest to the lessee than is the purpose of a cheque to the bank on which it is drawn. The major element of constructive income is that it must be actual income; when it is taxable is another and far different question. Assume that two tenants were affected, neither of whom derived any advantage in the way of income or reduced expenses. If the storage charges paid by the lessor amounted to $500 for one tenant and $100 for another, with neither having the slightest interest in the cost, could constructive income of $500 be imputed to one and $100 to another? Since INCOME IN GENERAL 391 neither derived any advantage the residt to each must be the same. The lessor's expenses varied, but that concerns him — not the lessees. If 'the lessor had paid the moving expenses in consideration of moving ahead of time, the element of con- structive income would arise. In a case dealing with a law partnership, where an attempt had been made to accrue fees from professional services, it was held : Ruling. Numerous court decisions have been cited by the ap- pellant in support of its contention that the rendition of a bill by a lawyer does not constitute a binding account receivable until the amount has been assented to by a client. It was further argued that the charges for legal services entered on its books were not determin- able, and did not constitute income in the sense contemplated by the income tax laws. Further, that the charges were not "accounts re- ceivable" as usually understood for the reason that no agreement existed between the principals fixing the amount of compensation for the services rendered. • In view of the foregoing facts the Committee is of the opinion that the method used by the appellant in determining its net income for the taxable year 1920 is not sufficiently definite to be construed as clearly reflecting the income of the firm, that the method used is not an accrual method in its acknowledged sense, and that the com- putation of net income for the year 1920 is more correctly determin- able on the basis of cash receipts and disbursements. Further, that this conclusion is fully warranted under the provisions of section 212, Revenue Act of 1918, which empowers the Commissioner to make the computation on the basis and in such manner as in his opinion does clearly reflect the income. • It is therefore recommended, in the appeal of the M partnership that the action of the Income Tax Unit in denying permission to change from an accrual to a cash receipts basis in computing the net income of the firm for the taxable year 1920 be reversed and the appeal accordingly sustained. (I-3-29; A. R. R. 702.) Book entries.- — -It is desirable, from many points of view, that income tax returns should agree with the books of the tax- payer; but the entries made on the books are not of funda- mental importance when compared with the actual facts in a given situation."" The facts, not the l)ook entries, control."^ '■"See Reg. 45, Art. 23, and T. D. 2873. "Book entries, however, were required by the 1918 and carlit-r laws if deductions were claimed for bad debts. In the cases of both individuals and corporations, debts to be deductible must have been "ascertained to be worthless and charged off." (1918 law, section 214 (a-7).) 392 INCOME Foreign exchange. — Rate of exchange on income accruing abroad. — Ruling. Income returnable for the purpose of Federal taxes should be expressed in terms of United States money. The rate of exchange at the time of receipt governs in making the computa.tion. (C. B. 2, page 60; O. D. 419.)-* RuLiNc. The Committee has reached the conclusion that under the abnormal conditions characterizing foreign exchange during the European war, the taxpayer may convert current assets less current liabilities payable in the foreign currency at the current rate of ex- change or at any rate less favorable to him. The Commissioner should consider in any case applications to adopt a rate more favor- able to the taxpayer or may on his own motion apply such a rate where the facts in the particular case warrant such departure. This ruling should apply primarily to taxpayers trading or manu- facturing in foreign countries and should not be held to apply to isolated or collateral investments in foreign credits or securities. (C. B. 2, f)age 60; A. R. R. 15.) .... In the case of a domestic corporation engaged in business in a foreign country, its assets and liabilities (other than capital assets) recorded on its books in terms of the foreign currency, should be appraised in dollars (whether actually converted or not) at the close of each taxable year in which it is engaged in active business at the current or market rate of exchange, if any, then prevailing. (C. B. 2, pages 60-61 ; O. D. 489.) A domestic corporation has a branch office in London which keeps a separate set of books in English currency and renders a report at {^e end of the year as to the profits. During the year, whenever the branch office has on hand more money than is needed for regular expenses, a remittance is made to the home office. Held, that the net profits of the London branch for the year should i)e computed in English currency. From the total profits for the year should be subtracted the total amount remitted to the home office during the year, all expressed in English currency. To determine the equivalent of the profits in terms of United States money, the amounts remitted should be converted into United States money at the rate of exchange in effect at the date such remittances were made. The balance of the net profits, expressed in English currency, should be converted into United States money at the rate of exchange as of the end of the taxable year, regardless of the fact that the profits may not have been remitted to the home office. (C. B. 2, page 61; O. D. 550.) '* See also B. 42-21-1870; O. D. 1066. INCOME IN GENERAL 393 Liquidation of indebtedness. — The Treasury has evolved a different procedure in cases in which liquidating lia- bilities to foreign creditors appear on the books in the United States, where remittances are made, not to cover specific in- voices, but in a running account which remains open at the end of the year. The rule laid down requires the averaging of the rate of exchange over the period, instead of applying specific rates to specific transactions or inventorying at the close of the period."^ The Treasury's position in regard to foreign items is not entirely clear but the rulings indicate that no attempt will be made to enforce arbitrary or unfair rules. Capital items. — Fluctuations in exchange do not justify corresponding changes in the book values of capital assets or liabilities. The expenditure by a corporation , of a million dollars for a building in New York is unchanged on the books, except for depreciation or obsolescence, even though the ap- parent market value declines one-half. If one million dollars is expended for a building in Paris when francs cost 8 cents and francs happen to be 6 cents at the end of the year, the apparent decline of $250,000 is not an allowable deduction. Capital profits and losses must be realized before they affect income tax computations. Current items. — The author is of the opinion that cur- rent items, such as accounts receivable and accounts payable, bank balances, etc., should be inventoried when the books are closed, as nearly as possible on the basis of cost or market, whichever is lower. Ruling. A corporation at the time of closing its books for the taxable year had an asset of x pounds sterling represented by ad- vances made in cash to its London representative for the purchase of raw material in the London market. The purchases liad not been made at the time of the closing of the books. •-■' C. B. 3, page 75 ; O. TJ. 590. 394 INCOME The rate of exchange at the time of closing the books was lower than at the date the exchange was purchased. Held, that the taxpayer did not sustain a loss as contemplated by the statute The item of "sterling owned" is a current asset. Under the ruling in C. B. 2, page 6i (see page 392), it should be inventoried at the rate of exchange in force at the end of the year. It may not be a technical loss, but if allowed as an in- ventory loss the net result is the same. When current assets abroad exceed current liabilities and exchange is lower at the end of the year than during the year, a loss will be shown. When exchange is higher, no profit or loss will be shown. When current liabilities exceed current assets and exchange is lower, no profit or loss will be shown. When exchange is higher a loss will be shown. The rule is the same in case of one item of current asset or liability as it is in the case of branch houses. The foregoing is merely conservative business practice and may or may not result in a saving of taxes. Based on market values, losses are taken, but profits are not anticipated. Official rates of exchange. — During 192 1, the Treas- ury has issued several rulings in which the rates of exchange at December 31, 1916, 191 7, 1918, 1919 and 1920 which tax- payers should use have been summarized. These rulings will be found in bulletins as under : c. B. 4, page 60 0. D. 772 c. B. 4, page 60 0. D. 803 c. B. 4, page 63 0. D. 876 c. B 4- page 63 0. D. 898 c. B. 4, page 63 0. D. 913 B 34-21-1775; 0. D. 996 B 37-21-1811; 0. D. 1027 B 38-21-1826; 0. D. 1036 B 40-21-1852; 0. D. 1052 B 42-21-1869; 0. D. 1065 B 51-21-1977; 0. D. ^^37 B 51-21-1978; 0. D. 1 138 INCOME IN GENERAL 395 Community property. — The new type of income, that from "community" property, which first came into prominence as the result of an opinion of the Attorney General dated Sep- tember 10, 1920,-'^ has been defined at considerable length in a further opinion of the Attorney Gneral dated February 26, 1921,-^ quoted below. It is held that in Washington, Arizona, Idaho, New Mexico, Louisiana and Nevada, husband and wife may each report one-half of the income arising from commun- ity property under the laws of the respective states. Texas is also a community property state. -^ This privilege is held not to be apphcable to California. Rulings. Summarizing, it appears that in all of the community- property States except California their own courts have held that the wife has, during the existence of the marriage relation, a vested in- terest in one-half of the community property. Her rights in the property of the community are perhaps most fully recognized in the State of Washington, where both spouses have testamentary disposi- tion over one-half of the community property, and where in the ab- sence of such disposition it descends to their issue, or, in the absence of issue, to the survivor; while the husband is manager of the com- munity estate in Washington he may not sell, convey, or encumber real estate unless the wife join with him in the conveyance; and as was held in Huyvaerts v. Rocdtz, ante, and Schramm v. Steele, ante, the separate debt of the husband can not be satisfied out of com- munity property where it is not incurred in connection with the community business, nor for the benefit of the community. In Idaho it is seen that the limitation upon the alienation of the community real property is the same as in Washington. But while the wife's earnings and the rents and profits of her separate estate are community property she is given the management and control of same. The Idaho rule governing the disposition of conmiunity prop- erty on the death of either spouse is, with minor variations, the same as that of Washington. In neither State is an inheritance tax pay- able on the one-half of the community that goes to the one spouse on the death of the other. In Arizona the husband only may dispose of 'community personal property, but the wife must join him in deeds or mortgages affecting real estate, except unpatented mining claims. One-half of the com- munity property is subject to the testamentary disposition of either '32 Op. Att. Gen. 298; T. D. 3071. 32 Op. Att. Gen. 435; C. B.4. page 238; T. D. 3138. '32 Op. Att. Gen. 298; T. D. 3071. 396 INCOME spouse, and in absence of such disposition goes to his or her de- scendants ; where there is neither testamentary disposition nor de- scendants, it is subject to distribution in the same manner as the separate property of the husband. On decree of divorce the court may divide the property as he sees fit, but in the absence of provision for the community property the parties from the date of the decree hold as tenants in common. The courts of Arizona hold that the wife is equal owner with her husband. In Nevada, the husband has the entire management and control of the community property, except that the wife has entire control of her earnings when living separate from her husband. Upon her death the husband takes the whole community estate, except that where he has abandoned her without good cause she may by will dis- pose of half and in absence of such disposition it goes to her heirs, exclusive of her husband. On the death of the husband the wife takes half and the husband may dispose of the other half by will, or it goes to his surviving children; if there is no will and no children survive, the whole goes to the wife without administration, subject to certain provisos. On dissolution of community by divorce for any other ground than adultery or extreme cruelty, the community prop- erty must be equally divided between the parties. The wife pays no inheritance tax under the inheritance tax law of Nevada on her in- terest in community property, the courts holding that she takes not as heir but by a right vested in her at all times during marriage. It is to be noted that the constitution of Nevada recognizes the wife's interest in community property. In New Mexico, while the husband is manager of the community estate, he may not transfer real property without a valuable con- sideration without the written consent of his wife; and under certain circumstances the wife may be substituted as manager; prior to 1915 he could not transfer community personal property except for a valuable consideration without her written consent; on dissolution of the community by the death of the wife the husband takes all except such portion as may have been set aside to the wife by judicial de- cree, which portion goes to her heirs unless she has disposed of same by will; on death of the husband one-half goes to the wife and the other half is subject to testamentary disposition by the husband. If he makes no will one-fourth of his one-half goes to the wife and the remainder to the chijdren. On separation either may petition for division of community property and after divorce continue to hold as tenants in common where no disposition has been made in the divorce decree. New Mexico has no State inheritance tax act. In Louisiana the community property comprehends all property acquired during the marriage by either husband or wife except that acquired with separate funds or by inheritance or particular dona- tion, and excepting the earnings of the wife when she is living sepa- INCOME IN GENERAL 397 rate from her husband; the husband is manager of the community but he may not convey community immovables by gratuitous title, and can not dispose of movables in fraud of the wife; either spouse may dispose of one-half the community property by will and the laws governing the descent of such property in the absence of testamentary disposition apply equally to both spouses, the survivor taking the de- ceased spouse's half by inheritance when there is no will, and neither father, mother, or descendants. As heretofore stated, the survivor pays no inheritance tax on his or her one-half of the community property but does pay on that part inherited from the deceased spouse. In California the wife has no power of testamentary disposition of community property except of such as may have been set aside to her by judicial decree; she takes one-half as heir on the death of the husband; but on the death of the wife the entire community property belongs to the husband without administration. The California courts have held that under the law as it stood prior to 1917 the wife had no vested interest in community property prior to the dissolu- tion of the marriage ; the amendment to the inheritance tax act being limited to the purposes of that act could not have had the effect of vesting an interest in her, and had the addition of Sec. 172a had that effect any amendment of the inheritance tax act would have been unnecessary to exempt her one-half from taxation thereunder. In the case of Blum v. Wardell, now pending before the Circuit Court of Appeals of the Ninth Circuit, on appeal from the District Court of the Northern District of California, the application of the Federal Estate Tax Act of 1916 is under consideration. As appears from my opinion of September 10, 1920, in Texas the control of community property is divided between the husband and wife; in that State on the death of either spouse without issue the survivor takes the whole and where there is issue, takes one-half, the other half going to said issue or their descendants. Under the State inheritance tax law the wife pays no tax on her half of the community property. In Warburton v. White. 176 U. S. 484, 496, the principle was enunciated that where State decisions have interpreted State laws governing property or controlling relations that are essentially of a domestic and State nature the United States Supreme Court will follow the State decisions, if possible to do so, in the discharge of its duties. Also in De Vaughn v. Hutchinson, 165 U. S. 566, 570, it was held that to the law of the State in which property is situated we must look for the rules which govern its descent, alienation, and transfer, and for the effect and construction of wills and other con- veyances. In United States v. Crosby, 7 Cranch 115, it was held that the title to land can be acquired and lost only in the manner pre- scribed by the law of the place where same is situated. 398 INCOME In arriving at an answer to the questions propounded by you we are called upon to determine the rules of property in the community property States ; we have, therefore, pursuant to the rules of the above cases, adopted the rules laid down by the highest courts of the various States. There remains to be determined the application thereto of the income and estate tax provisions of Federal statutes. In my previous opinion it was stated that since in Texas the owner- ship in one-half of all community property vests in each spouse, whatever is income to the community is income to both. This con- clusion applies, therefore, to all States in which community prop- erty is held to be vested equally in both spouses. Section 201 of the Revenue Act of 1916 (39 Stat. J"]"]^ and section 401 of that of 1918 (40 Stat. 1096) impose a tax "upon the transfer of the net estate of every decedent*' dying after the passage thereof, to be determined as is set forth in the sections following, which are : Revenue Act of 19 18. Sec. 402. That the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situ- ated — (a) To the extent of the interest therein of the decedent at the time of his death which after his death is subject to the payment of the charges against his estate and the expenses of its administration and is subject to distribution as part of his estate; ******* (d) To the extent of the interest therein held jointly or as tenants in the entirety by the decedent and any other person, or deposited in banks or other institutions in their joint names and payable to either or the survivor, except such part thereof as may be shown to have originally belonged to such other person and never to have belonged to the decedent. (40 Stat. 1097.) Subdivisions (a) and (c) of section 202 of the Revenue Act of 1916 are identical with subdivisions (a) and (d) of section 402 of the Revenue Act of 1918, quoted above. While the community estate of husband and wife has not in the strictest sense all the incidents of a joint estate or an estate in the entirety as they were known at common law, I am convinced that the community estate is for all practical purposes within the language of subdivision (d) of section 402, there being deductible therefrom, in arriving at the net estate of decedent, the one-half interest of the sur- viving spouse, which may be shown to have originally belonged to such person, and never to have belonged to the decedent. And even though it should be held that the community estate is not a "joint estate" or an "estate in the entirety" within the mean- ing of the Revenue Acts, the one-half interest of the deceased spouse in community property would still be subject to tax under the lan- guage of subdivision (a) above. INCOME IN GENERAL 399 My answers to your questions are therefore : (i) That in Washington, Arizona, Idaho, New Mexico, Louisiana, and Nevada the husband and wife domiciled therein, in rendering separate income tax returns, may each report as gross income one-half of the income which under the laws of the respective States becomes, simultaneously with its receipt, community property. (2) In the States mentioned, in answer to question one, there should be included in gross estate, in computing the estate tax of a de- ceased spouse, one-half only of the community property of husband and wife domiciled therein. (3) Neither of the above answers is based upon a statute enacted subsequent to March i, 1913. (4) My answers to these questions apply under income and estate tax Acts prior to the Revenue Act of 1918.-'' A wife domiciled with her husband in the State of California may not report in her separate income tax return salary and wages re- ceived by her. (B. Digest 49-21-1964; O. D. 1128.) In returns in which community income is divided between hus- band and wife domiciled in states where such income is divisible for in- come tax purposes, both husband and wife should report in detail the gross income from such community property. The deductions properly chargeable against such income should be equally divided between husband and wife. (C. B. 4, page 254; O. D. 909.) Where a husband and wife, domiciled in a State other than a com- munity property State, purchase lands located in Texas with the separate funds of one of the spouses, the rents and revenues there- from constitute the income of the spouse whose funds purchased the land, and are so returnable. Where a husband and wife, domiciled in a State other than a community property State, purchase land located in the State of Texas with funds furnished in part by the husband and in part by the wife, the rents and revenues are income of each in proportion to their interest in the land and are so returnable. (B. 28-21-1727; O. D. 975.) While domiciled in the State of Washington, husband and wife acquired real property therein with community earnings. Subse- quent thereto they moved to another State, where they have since lived. Under the laws of Washington the income from such property is community property. During coverture, as well as upon dissolution of the marriage, the wife has a vested and definite interest and title in the community property equal in all respects to that of the hus- band. Such interest is not affected by a change of domicile. There- fore, the husband and wife may file separate returns in which the -"Summary of Opinion of Attorney General, pulilished as T. D. 3138. For full decision, see C. B. 4, page 238; 32 Op. Atty. Gen. 435, 458. 400 INCOME income from community property in the State of Washington is divided between them. ( B. 47-21-1933: O. D. mo.)-''" Interest and penalties on amended returns under T. D. 3071. - Ruling. Inquiry is made with respect to the assessment of in- terest and penalties in cases where amended returns are filed in ac- cordance with the provisions of Treasury Decision 3071, relating to income from community property in the State of Texas. Held, that no penalties for the understatement of tax may be assessed against the husband when the tax reported in his original return was as large as the tax actually due from him after the allo- cation of community income to each spouse upon the basis of separate returns. The Attorney General has held "that community property, under the laws of Texas, belongs to the husband and w-ife'' and that "the income therefrom accrues to the husband and wife in equal shares." (T. D. 3071, C. B. 3, p. 221.) The husband, therefore, in reporting more than one-half of the community income in his return (not a joint return for himself and wife) was to that extent reporting income which technically was not his at all. Penalties are provided for the understatement of an individual's tax, as computed upon the total net income reported by him, and it is immaterial that the income from one or more sources is carelessly or intentionally understated in his return if by reason of an overstatement of income from other sources no understatement of his total net income is actually made. Therefore, in cases where the wife's share of community income, which was reported by the husband, was equal to or more than the amount of income received but not reported by him, there was no understatement of the amount of the husband's total net income and accordingly no negligence or fraud penalty could be assessed against him. Neither should a delinquency penalty be assessed against the wife in cases where her income, over and above her share of the connnunity income reported by her husband, was insufficient to have required her to file a return prior to the issuance of Treasury De- cision 3071, and in case she did file a return prior to the issuance of that Treasury decision, she should not be penalized for not report- ing her share of the community income which she had reason to believe was reported by her husband. (I-1-13; I. T. 1154.) '"For a similar ruling regarding a removal from Idaho to California, see B. 39-21-1845; Sol. Op. 121. CHAPTER XIV INCOME FROM PERSONAL SERVICES Following the plan of subdividing the items of income into convenient groups, adopting generally the order and classifica- tion used in the statute, this chapter is devoted to income from personal services. This term includes not only salaries and wages but also fees received from professions or vocations. Distributions by personal service corporations are dealt with elsewhere,^ because the earnings of personal service cor- porations as defined in the act are not necessarily of the na- ture of services as the word "services" is usually understood. Salaries, however, of officers or other employees of personal service corporations are dealt with here. Law. Section 213 (a) Includes gains, profits, and income derived from salaries, wages, or compensation for personal service (in- cluding in the case of the President of the United States, the judges of the Supreme and inferior courts of the United States, and all other officfers and employees, whether elected or appointed, of the United States, Alaska, Hawaii, or any political subdivision thereof, or the Dis- trict of Columbia, the compensation received as such), of whatever kind and in whatever form paid, or from professions, vocations,- .... Compensation of Certain Officers Exempt Salaries of the President and United States judges. — The omission in the 19 18 law (the 1921 law is the same) of the ' See Chapter XXIV. '[Former Procedure] The language of the 1917 law is the same as the 1913 law except for an immaterial change in the first phrase of sec- tion 4. In 191 7, those who received incomes in the form of salaries, compensation for services, including all professional fees, commissions, and income in general from an occupation, vocation, profession or from a business with no capital or only nominal capital were com- pelled to pay, in addition to their income. tax, a tax of 8 per cent upon the income from such sources. In other words, if anyone received an earned income of any kind in excess of $6,000 which had not been subject to the excess profits tax, he was subject to this 8 per cent tax. No tax of this kind appears in the 1918 or 1921 laws. 401 402 INCOME specific exemption formerly granted^ to the President and United States judges raised the interesting question as to whether or not the salaries of these officers (whose compensa- tion is not supposed to be diminished during their terms of office'*) may be subjected to a federal income tax. This question was decided in a recent case,^ the Supreme Court holding that ". . . . the fathers of the Constitution in- tended to prohibit diminution by taxation as well as other- wise — .... they regarded the independence of the judges as of far greater importance than any revenue that could come from taxing their salaries the tax was imposed con- trary to the constitional prohibition, and must be adjudged invaHd." The (acting) Attorney General in an opinion rendered on June 21, 1920 (32 Op. Att. Gen. 248) stated, in part: "I am unable to see, therefore, that there is anything in the recent opinion of the Supreme Court [E.c'aiis v. Gore, supra,'] which relieves a judge appointed since the enactment of the income tax law from paying the tax imposed by that law." Regulation The salaries of Federal officers and em- ployees are subject to tax, except that, in view of the provisions of the Constitution of the United States as construed by the Supreme Court, the salaries of the President of the United States and Federal judges are not subject to a new tax or an increased tax if elected or appointed to office prior to the passage of the taxing statute. The Revenue Act of 1921, however, imposes no new or increased tax upon such salaries; hence the salaries of all Federal judges appointed '[Former Procedure] The 191", 1916, and 1913 laws contained the following exemption : Law. Section 4. The following income shall be exempt from the provisions of this title: .... 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. * Attorney General Hoar, 13 Op. Att. Gen. 161 (1869). See also Pol- lock V. Farmers' Loan and Trust Co., 157 U. S. 429, 39 L. Ed. 759; 15 S. Ct. 718; 158 U. S. 601, 39 L- Ed. 1108, 15 S. Ct. 912. '■Evans v. Gore, 253 U. S. 245, 40 S. Ct. 550, 64 L. Ed. 887. FROM PERSONAL SERVICES 403 since February 24, 1919, are subject to the tax imposed by the Revenue Act of 1921 (Art. 2,^.) Compensation of federal officers in general not exempt. — Only those federal salaries which were specifically designated as not subject to the income tax were exempt under laws prior to 19 18. All other federal employees, except as noted below, were taxable under former laws and are taxable under the 192 1 law. Compensation of referees in bankruptcy. — Ruling. The decision of the United States Supreme Court in Evans v. Gore (T.'D. 3037), relative to the taxabiUty of salaries of judges of the Supreme Court and inferior courts of the United States, is not applicable to referees in bankruptcy as they are not judges of inferior courts. The fees received by referees in bankruptcy are sub- ject to tax under the provisions of section 213(a) of the Revenue Act of 1918. (C. B. 3, page 104; O. D. 678.) Compensation of judges of territorial courts. — Ruling. Judges of territorial courts are not such judges as are referred to in article III of the Constitution whose salaries are exempt from income tax in accordance with the decision of the Supreme Court of the United States in Evans v. Gore. (C. B. 4, page 83; O. D. 899.) Members of Board of United States General Ap- praisers. — Ruling. The Board of United States General Appraisers is not a court nor are its members Federal judges. Therefore, salaries paid the members are not exempt from tax under the Revenue Act of 1918. (C. B. 4, page 83; O. D. 902.) Salaries of state officers and employees exempt." — As a result of judicial interpretation of the scope of the federal taxing power, an implied limitation has been placed upon the power of Congress, prohibiting it from taxing the salaries of state officers.'^ But there has been no interpretation of that power since the passage of the sixteenth amendment. The "[Former Procedure] The laws of 19x3, 1916 and 1917 exempted such compensation. 'Collector V. Day, 11 Wall. 113, 78 U. S. 113, 20 L. Ed. 122. 404 INCOME idea of abandoning this doctrine has therefore found con- siderable support. If the war had continued, it is probable that the employees formerly specifically exempted would have been specifically taxed. Tlie 1918 bill as it passed the House of Representatives so provided. Senator Simmons, in report- ing to the Senate the law as it now stands, said : "The Com- mittee amended section 213 (a) so as to require that any .... salaries paid be subject to the income tax, leaving the Constitutional question as to the authority of Congress to tax certain salaries to be settled by the courts in any case in which the question may be raised."^ The attitude of the Treasury under the 1918 law, the lan- guage of which is re-enacted in the 1921 law, is based on an opinion of the Attorney General (31 Op. Att. Gen. — ) and is expressed in the following regulation and decision : Ruling In accordance with an opinion of the Attorney- General, dated May 6, 1919, and based on the well-settled rule that governmental agencies of the states are not subject to taxation by the federal government, it is held that salaries of state officials and salaries and wages of employees of a state are not subject to the in- come tax imposed by the said Revenue Act of 1918. (T. D. 2843, dated May 17, 1919.) Regulation. Compensation paid its officers and employees by a state or political subdivision thereof, including fees received by notaries public commissioned by states and the commissions of re- ceivers appointed by state courts, is not taxable (Art. 88; Reg. 45, Art. 85.) The issue is essentially constitutional — not administrative — and the matter cannot be deemed to be definitely settled un- til the courts have passed upon it. In view of the Treasury's position, however, it is difiicult to see how the question will be litigated. Since the 1918 provision has been re-enacted into the 192 1 law, the Treasury should proceed to collect taxes from state officers and employees. The question would then be settled by the United States Supreme Court. ^Report of Finance Committee to Senate, December 6, 1918, page 6. FROM PERSONAL SERVICES Definition of ''^officer" and '^'employee. 405 Ruling. An officer is a person who occupies a position in the service of the Government, the tenure of which is continuous and not temporary, and the duties of which are established by law or regula- tions and not by agreement. An employee is one whose duties consist in the rendition of pre- scribed services and not the accomplishment of specific objects, and whose services are continuous, not occasional or temporary. (Digest 45-21-1906; A. R. R. 664; Sol. Op. 122.) Compensation of referee — appointed by judge of STATE judicial DISTRICT. Ruling. A referee in drainage is appointed by the district judge of the State judicial district in which the drainage project is located. The judge is vested with authority to provide for the payment of the referee's salary, to regulate his duties, and to discharge him at pleasure. Held, that the referee is an employee of a political subdivision of the State and that his salary as such is not subject to tax under the Revenue xAct of 1918. (C. B. 2, page 100; O. D. 525.) Compensation of receiver — partly state, partly FEDERAL. Ruling. A receiver was appointed by a State court for the assets of a corporation, a part of which were located in the State appointing the receiver and the remainder in another State. The Federal district court for the latter State appointed the same person as receiver for the assets located in that State. The fees arising from the receivership are allowed in a lump sum, such compensation being fixed by the State court and approved, by the Federal court. Held, that the exemption from taxation as compensation of a State employee applies only to that portion of the fee which, is attributable to the appointment by the State court; the portion attributable to the appointment by the Federal court should be reported as taxable income by the recipient. The court fixing the compensation should be requested to allocate the portions reasonably attributable to the State and Federal appointments. (C. B. 2, page 99; O. D. 503.) Compensation of engineers having contract with state. — Ruling. A partnership of civil engineers has a contract with an irrigation district of a State for a period of two years as consulting and supervising engineers on any question it may be, called on to 4o6 INCOME consider in connection with development work of the district. At the same time it accepts business from the public generally. Compensation received by the firm from this source is not exempt from taxation as compensation paid its employees by a political subdivision of a State. (C. B. 2, page 100; O. D. 545.) The ruling was based on the following definition of em- ployee which appeared in the detailed decision: The term employee is ordinarily understood to mean one who is in the regular and continual service of his employer and who is sub- ject to the direction and control of the employer, the relation between the employer and employee (as in the relation between master and servant), implying that the employer not only prescribes to the em- ployee the end of his work, but directs or at any moment may direct the means also, or retain the power of controlling the work. This is a comprehensive definition and should enable one to determine whether he could be considered an "employee of a state" or not. In the following case, however, it is to be assumed that the engineer was an "employee" as defined above. Ruling. A chief engineer appointed by a sewerage commission created by the common council of a city under authority of a State statute, is considered to be an employee of a political subdivision of a State and the compensation paid him is not taxable. (C. B. i, page 96; O. D. 309.) Assistants to clerks of state courts — federal DUTIES. Ruling. Where clerks of State courts employ clerical assistants in connection with the administration of the Federal naturalization laws and pay the salaries of such assistants out of fees collected by them, which fees are made available for that purpose by congressional appropriation, the compensation received by the assistants is income subject to tax under the provisions of the Federal income tax laws. Clerical assistants so employed are not State employees by virtue of such employment. (C. B. 2, page 99; O. D. 484.) Employees of railway disbursing funds paid by COUNTY. • Ruling. In constructing a causeway, the salaries received by the individuals employed thereon are paid from the funds of three railway pompanies and a county, which is part owner of the project. The FROM PERSONAL SERVICES 407 county pays its pro rata share of the salaries to one of the railway companies, which by its check pays the gross amount of the salaries. Held, that as the employees constructing the causeway are not employed by and are not under the direction or control of the State or any political subdivision thereof, they do not come within the designations "State officers" or "Employees of a State" as used in article 85, of Regulations 45, and, therefore, their compensation is not exempt from income tax. (C. B. 2, page loi ; O. D. 553.) School officer— when not state employee. — Ruling. Compensation received by individuals holding the posi- tions of ''State agent of normal schools for whites," "State agent of normal schools for negroes," and "high school inspector," which positions were created by the superintendent of public instruction of a State without statutory authority, is not exempt from tax as com- pensation received from a State or a political subdivision thereof, when such compensation is paid from an endowment fund no part of which is under State control. (C. B. 2, page 98; O. D. 449.) Notary's fees exempt. — Ruling. A partner who turned over to the partnership the fees received by him as notary public under commission from the State, may in computing his distributive share of the partnership income exclude from his return an amount equal to the fees so received and turned over to the firm. The other partners are not entitled to any part of the exemption, however, and must report their entire dis- tributive shares of the partnership income regardless of the fact that a portion of it was derived from notarial fees received by one of the partners. (C. B. 3, page 125; O. D. 648.) Compensation of executors and administrators not EXEMPT. Ruling. An individual who exercises a public function under an appointment issued by a court officer for a particular transaction or purpose for a limited time, and in the exercise of such function is not invested with the character of either an officer or employee of the State or political subdivision thereof, is not considered to be such a State official or employee whose compensation is exempt from Federal income tax under the provisions of article 85 of Regulations 45 and Treasury Decision 2843. The designations "State officers" and "employees of a State" refer only to those persons who are in the regular and continual service of the State or a political subdivision thereof within the ordinary acceptance of these terms. Accordingly, administrators and execu- tors, whether or not they are considered to be officers of the court in the performance of their duties, are not exempt from Federal in- 4o8 INCOME come tax on the compensation received for their services. (C. B. 1, page 96; O. D. 256.) Compensation of liquidating trustees not exempt. — Ruling. The compensation paid trustees of a corporation, who have filed an appHcation for winding up the affairs of said corpora- tion in accordance with the laws of the State of Connecticut, is not exempt from income tax, as the trustees are not receivers in fact and do not appear to exercise a public function under an appointment of the court, nor are they invested with the character of an officer or employee of the State, although the compensation is fixed by the court. (C. B. 2, page 98; O. D. 369.) Special counsel to city is not an officer or em- ployee. — Ruling. A counsellor at law is engaged by a municipality as special counsel, to act in connection with the regular city attorney in handling a certain piece of litigation. Is he regarded as an officer or employee of a political subdivision of a state, so that his com- pensation for his services is not taxable under article 71 of Regu- lations 45, sentence 2 [now Art. 85] ? (Answer.) In reply to the first question, you are advised that under the ruling of this office, the compensation paid by a state to "special counsel," such as described above, is taxable income, and not exempt from income tax. (Part of letter from Collins & Corbin, Jersey City, N. J., and the answer thereto, signed by J. H. Callan, Assistant to the Commissioner, and dated April 15, 1919.) Special counsel for state comptroller — commissions exempt.— Ruling. The New York transfer (inheritance) tax law provides for the appointment of an attorney in each county to look after the State's interests in the collection of inheritance taxes. In 1914 A was appointed by the State comptroller as attorney in a certain county and has since then continued in that position. He receives as com- pensation a commission upon the transfer of most of the estates ; in other cases he is paid such fees and allowances as the comptroller decides are reasonable and proper. It is stated that in the service of all papers upon him reliating to transfer-tax proceedings, service is recognized as being upon the comptroller and further that all of his official acts are representative of the comptroller, being so recog- nized by the courts. Held, that the compensation received by A in the capacity of attorney for the State comptroller is not subject to Federal income tax under the provisions of article 85 of Regulations 45. (C. B. 2, page 99; O. D. 494.) FROM PERSONAL SERVICES 409 It is difficult to see any essential difference between the two cases above, the compensation the attorneys receive being in fact received from a state or poHtical suljdivision thereof. Compensation of National Guard exempt — when? — - Ruling. The compensation paid by a State to an officer of the National Guard of the State is exempt from the taxes imposed by the Revenue Act of 1918. The compensation paid by the Federal Government to an officer of the National Guard for services while engaged in field training or at instruction camps is not exempt. (C. B. 4, page 112; O. D. 942.) Confederate state pensions not exempt. — Ruling. Pensions paid by the State of Kentucky to Confederate Civil War veterans are not exempt from tax under the Revenue Act of 1918. These veterans can not be said to be "officers" or "em- ployees" of a State within the ordinary and usual meaning of those words. (C. B. 4, page 112; O. D. 903.) Attorneys employed by state exempt — when? — Ruling. The certified copy of the order of the court approving the employment of A, an attorney at law, by the collector of revenues in a certain county, states that the employment is for the term of office of the collector; that is, for a period of four years. The taxpayer states that this has been the practice for many years. A State statute provides that the collector may employ such at- torneys as he may deem necessary to file such suits as may be re- quired for the collection of delinquent taxes Since the collector is responsible for the institution and prosecu- tion of such actions and has a right to employ such attorneys for such purposes as he may deem necessary, he would have the right to discharge any attorney for failure to carry out his instructions. The employment of the attorney consists in the agreement to render personal services as directed by the collector. The relation of em- ployer and employee exists. It is therefore the opinion of this office that the taxpayer is an employee of the county and that his com- pensation received as such is exempt from the income tax. (B. 46-21-1919; O. D. 1099.) Pilots employed by a state commission held not ex- empt. — Ruling. A taxpayer is a pilot for a port in the State of Florida, appointed by the Board of Pilot Commissioners after qualifying bv required examination. This board is appointed by the Governor of 4IO INCOME the State of Florida. The taxpayer claims his compensation as pilot is exempt from tax as compensation paid an officer or employee of a State. Held, that inasmuch as the taxpayer receives his compensation as pilot from fees paid by the steamship companies to the Board of Pilot Commissioners, rather than from funds of the State, such com- pensation is not exempt from the tax imposed by the Revenue Act of 1918. (C. B. 4, page 112; O. D. 916.) District of Columbia, territories, etc., are not "states." — The 191 7 law (section 23) declares that "nothing in this title shall be held to exclude from the computation of net in- come the compensation paid any official by the governments of the District of Columbia, Porto Rico, and the Philippine Islands, or the political subdivisions thereof." No definite ruling appears to have been made regarding the status of ter- ritories, but apparently the former exemption extended to state employees did not extend to the employees of territories. Ruling. Compensation of teachers of the Territory of Hawaii is subject to income tax under section 213 (a). (C. B. i, page 66; O. D. 12.) Pay of soldiers and sailors. — The special exemption for soldiers and sailors which appeared in the 1918 law is not re-enacted in the 192 1 act.^ ° [Former Procedure] The 918 law reads as follows : Law. Section 213. ". . . . 'gross income' — .... (b) Does not in- clude the following items, which shall be exempt .... (8) So much of the amount received during the present war by a per- son in the military or naval forces of the United States as salary or com- pensation in any form from the United States for active services in such forces, as does not exceed $3,500 " Supplementing the above section of the law, the regulations pro- vided: Regulation. ". . . . this exemption does not apply to compensation received either before or after the present war. The date of the termina- tion of the war for the purpose of the statute will be fixed by proclamation of the President. The military and naval forces of the United States include, among others, army contract surgeons and the individuals named in section i of the statute. A person is in active service if he is actually serving in such forces, not necessarily in the field or in the theatre of war, and is not merely on the retired or reserve list. Accordingly, if such a person receives compensation from the United States of $3,500 or less and has no other FROM PERSONAL SERVICES 41 1 The Treasury has held (C. B. 4, page 112; O. D. 900) that for the purpose of this section of the law the war termin- ated March 3, 192 1. Ruling. The following items are to be included in the $3,500 exemption provided in section 213 (b) 8, Revenue Act of 1918, for salary or compensation received by persons in the military or naval forces of the United States during the "present war" : Bonus payable upon discharge. Mileage from point of discharge to point of enlistment. Ration money covering periods of absence from camp on fur- lough. (C. B. 2, page loi ; O. D. 370.) Pensions and all payments under war risk or vocational rehabilitational act are exempt. — Law. Section 213 (b) Does not include the following items, which shall be exempt from taxation under this title: .... (9) Amounts received as compensation, family allotments and allowances under the provisions of the War Risk Insurance and the Vocational Rehabilitation Acts,i" or as pensions from the United States for service of the beneficiary or another in the military or naval forces of the United States in time of war; .... Pensions received from a state have also been held to be exempt." Contractor for public work not a public employee. — Regulation, Any profit received from a State or political sub- division thereof by an independent contractor is taxable income. Where warrants are issued by a city, town, or other political sub- division of a State, and are accepted by the contractor in payment for public work done, the fair market value of such warrants should be returned as income. If for any reason the contractor upon conversion of the warrants into cash does not receive and can not recover the full value of the warrants so returned, he may allowably deduct from gross income for the year in which the warrants are converted into cash any loss sustained, and if lie realizes more than the value income of an amount sufficient in itself to require him to render a return of income, he need make no return. Members of draft boards are not as such entitled to this cxt'ni]>tion." (Reg. 45, Art. 86.) '" [Former Procedure] Under the iyi8 law payments under this act were taxable. Pensions were also taxable under the 1918 law. (C. B. 4, page 79; Sol. Op. 97.) " C. B. 2, page 98; O. D. 434. 412 INCOME of the warrants so returned he should include such amount in his gross income of the year in which realized. (Art. 37.) If a contractor accepts payment in warrants which are sell- ing in the market at less than par he need not account for the amount received at any value above the market. If the contractor collects the warrants at par he will be accountable for the excess when received. If sold for more or less than their market value when received, adjustment would have to be made at time of sale. Income from jury fees. — Fees paid to jurors serving in United States courts are taxable income. Fees paid by states are not taxable. Mileage paid to jurors should be applied against expenses paid. If there is a surplus it is taxable, if a deficit it should be deducted from the fees as a necessary expense incident to the earning of the income. Ruling Persons serving on the jury of a State, county, or municipal court are held to be employees of a State or a political sub- division thereof, and fees and compensation received by them are accordingly exempt from tax. (C. B. i, page 98; O. D. 434.) Fees of witnesses summoned by a state attorney are held to be taxable.^" Salaries in "land-grant" colleges. — Through acts passed in 1862, 1890 and 1914, the last known as the Smith-Lever Act, Congress deeded certain lands and granted certain funds to the states for the support of colleges. The taxability of the salaries of the professors in such colleges turns upon the point as to whether or not these teachers are employees of the state. If they are, their salaries are not taxable" even though they are received in whole or in part from Smith-Lever funds, for such funds "lose their identity as funds of the United States by being paid to the states.'"* "C. B. I, page 67; O. D. 105. " With regard to their possible tax liability under the 1918 and 1921 laws, see page 403- '*T. D. 2668, March 9, 1918. FROM PERSONAL SERVICES 413 Regulation Employees of universities receiving salaries paid in part or in whole from funds available under the Smith-Lever Act of May 8, 1914, who are officers or employees of a State, are not required to return as taxable incomes the salaries so received. This is also true with respect to the Act of August 30, 1890, relating to colleges for the benefit of agriculture and the mechanic arts, and to the Act of March 2, 1887, relating to agricultural experiment sta- tions in such colleges. (Art. 88; Reg. 45, Art. 85.) Salaries of civil service employees. — Rulings. The amounts deducted and withheld from the basic salary, pay, or compensation paid to employees in the civil service of the United States, in accordance with the provisions of the Act ap- proved May 22, 1920, should be reported by such employees for in- come tax purposes. The total compensation of the employees should be reported in gross income and no corresponding deduction can be taken for the amounts withheld, inasmuch as such amounts are pay- ments made toward the purchasQ of annuities provided for in the Act and are not allowable deductions for income tax purposes. The annuities paid to retired employees are subject to tax to the extent that the aggregate amount of the payments exceeds the amounts withheld from the compensation of the employees. (C. B. i, page 76; T. D. 3112.) If an employee leaves the civil service of the United States before he is eligible to retirement under the Act of May 22, 1920, and re- ceives the amount of salary withheld, together with interest, he should report only the amount of interest received by him as income for the year in which received. (C. B. 4, page Tj; O. D. 823.) Accounting Procedure Receipt or accrual method. — Salaries and wages need not be accounted for in the return until payment is made and re- ceived. ^^ Unquestionably this is the most convenient method of dealing with salaries and wages, because comparatively few recipients of incomes of this nature keep books, and it would require some adjustments of accounts to report the salary earned within a calendar year but partly paid prior or subsequent thereto. But anyone desiring to keep books on an accrual basis (that is, entering all income as earned and all " See Chapter XXVI as to deductions of compensation for personal services in carrying on a trade or business. 414 INCOME expenses as incurred) is permitted and encouraged to do so. For a full discussion of the accrual method, see page 383. If any part of the accrued income so reported becomes uncol- lectible, the regulations permit credit to be taken therefor as an allowable deduction. The so-called receipt method cannot be used if it serves to obscure the taxpayer's actual net income for the taxable period. Section 212 (b) defines "net income" and states that "if the method [of accounting] employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commis- sioner does clearly reflect the income." If the taxpayer prefers to prepare his income tax return from his cheque book or cash book, no fault will be found, if the result clearly reflects his actual net income. In such cases it is suggested that if the taxpayer's income arises from fees, etc., a cash book with several columns will be most useful. On the receipt side all items of receipts from fees, etc., should be entered in a column reserved for the particular purpose, so that at the end of the year the aggregate of such column will be the proper amount to include in the return. If at all feas- ible, however, the accrual system should be adopted. No other method accurately reflects net income, except in the case of wage-earners who have no investments. Regulation. Where no determination of compensation is had until the completion of the services, the amount received is ordinarily income for the taxable year of its determination, if the return is rendered on the accrual basis, or, for the taxable year in which re- ceived, if the return is rendered on a receipts and disbursements basis (Art. 32.) Many professional men, when closing their books for their taxable years, enter as accrued income an estimate of what has been earned to such date, and report such estimate as taxable income. This they have a right to do under the law. Ruling. A performed certain services in 1909 under an agree- ment that he was to receive as compensation a percentage of the net income of a business enterpri-se, the time of payment, however, FROM PERSONAL SERVICES 415 to be within the discretion of the individuals in control of the business enterprise. The amount of A's compensation was determined in 1916 but not paid until 1919. Held that as A kept his books on the cash receipts and disbursements basis, the entire amount received con- stitutes income for the year 1919. (C. B. 2, page 85; O. D. 460.) In this case the business was disposed of in 1916, and A could not have earned the compensation after that time. It might also be said that on the principle of "constructive re- ceipt" he received the coinpensation in 19 16. Certainly A could not be taxed on any income which had accrued to him at March i, 1913.^'' Ruling. A taxpayer who keeps no books of account, and to whom is paid, upon the termination of services extending over a period of years, a lump sum in amount not previously agreed upon, as compensation for such services, must return as income in the year in which received the entire amount so paid him, even when such payment is accompanied by a statement proportioning the compensa- tion over the years in which the services were rendered. (C. B. 2, page 80; T. D. 2960.)^" In the foregoing case the service did not begin until May 27, 1913. The following court decision is also of interest.^* Decision. (Syl.) Where, relying on the unofficial prom- ises of a majority of the board of directors that additional salary would be voted him for past years, the president of a corporation over- drew his account with the corporation, additional salary, subsequently voted, was income to him for the year in which the amount thereof was finally settled upon and segregated by an order of the board, al- though he had actually received and spent the money, as overdrafts, prior to that year. This procedure, as well as the principle laid down in the Jackson case, works an injustice to the taxpayer. If the Supreme Court adopts the principle that income cannot be taxed unless and until it is realized in cash, or the "See page 2,77- See also Art. 90, page 417; and C. B. 4, page 83; O. D. 956. " This statement was issued with an extract of the decision in the case of Jackson v. Smictanka, 267 Fed. 932. The Circuit Court of Appeals for the Seventh Circuit has recently affirmed this decision (272 Fed. 970). " Holbrook v. Moore, United States District Court, February 8, 1921 (not reported). See T. D. 3 161. 4i6 INCOME equivalent of cash, the Treasury wiU have to recede from its position in Regulations 45 and many rulings. Its former prin- ciples, however, regarding uncertain and undetermined claims, resulting in realizations in later years have been overruled in Regulations 62/" "Back pay" awarded by railroad board taxable in year of receipt. Ruling. A taxpayer who had been discharged from the em- ploy of a railroad company was reinstated by order of the Railroad Board and paid for all time lost during a period of over two years. It is contended that the sum received by the taxpayer, for which he rendered no service, is in reality a gift and not taxable. Held, that the payment can not be treated as a gift for the reason that it was not made voluntarily. It is income within the ordinary acceptation of the word and not being such income as is expressly exempt under the Act, should be included in the return of the tax- payer for the year in which it was received by him. (C. B. 2, page 71 ; O. D. 512.) Compensation of trustee taxable when received. — Regulation. If no determination was made as to the amount due the trustee of an estate as compensation for his services over a period of years until the trust was terminated, the amount allowed him should be returned in full, subject to allowable deductions, as income for the year in which paid ; and should not be prorated over the length of time during which he served as trustee. (T. D. 2135, January 23, 1915.) The question here arises as to what constitutes a "deter- mination." This ruling, of course, would not be applicable if it could be shown that a definite, or an approximately definite, portion of the fee had been earned and had accrued prior to March i, 1913. The trustee could not legally be taxed on in- come which accrued prior to the date when the law went into effect.^" Otherwise the ruling is fair, because the trustee could have reported the accruing income annually. If he did not "■' See page 532. '" See page },77. FROM PERSONAL SERVICES 417 do so and was compelled to return a large amount in a year when there was in force a tax rate higher than during the years when the income accrued, he had only himself to blame for not having adopted the accrual basis. Compensation for services rendered before March i, 1913 — How far taxable. — Regulation Where services were rendered prior to March i, 1913, but paid for thereafter, the amount received is tax- able income to the extent of the excess of such amount over the fair market value on March i, 1913, of the principal of the claim and any interest whicli had then accrued (Art. 90; Reg. 45, Art. 87.) This is logical. The accrual before March i, 191 3, was not taxable, because in effect it became capital at that date. If it was found to be bad after that date, it was properly an allowable deduction. If the income accrued after March i, 1 91 3, and v^as not returned for taxation, it would be improper to claim the loss as a deduction. Compensation for Services Distinguished from Gifts, Dividends, etc. The establishment of a clear distinction between compen- sation for personal services, on the one hand, and gifts, dis- tributions of profits or assets and payments for property, on the other, is one of the very difficult tasks in income tax procedure. In the case of bonuses, Christmas gifts, "profit- sharing" distributions, and other payments of a like nature, it is sometimes almost impossible to determine the exact ex- tent to which they contain other elements than that of mere remuneration for services rendered. The Treasury has faced this problem squarely'"^ and has issued regulations laying down the principles in accordance with which these distinctions "The subject was first treated in a very inadequate fashion in Reg. 33, 1918, Art. 138. In T. D. 2696 (April 10, 1918) the subject was clearly and accurately presented. 4i8 INCOME are to be made. These regulations (articles 105-107) are quoted in full in Chapter XXVI. Briefly it is held that "the test .... is whether they are reasonable and are in fact payments purely for services." Even though the payment is determined on a contingent basis and is greater than the amount which would ordinarily be paid, it may still be considered pure compensation if the basis is de- termined ''pursuant to a free bargain between the enterprise and the individual made before the services are rendered . . . . " In case of compensation determined after services have been rendered, reasonableness is ordinarily the controlling test." The Treasury held, in the following case, that the pay- ments made were for services which had been rendered and were not a gift : Ruling. A was an employee of the M Company under contract for a period of 21 years, such contract being terminable at the will of the company. The company sold its assets and discontinued business during 1920, and at the time A's employment ceased in 1921 he re- ceived 6y dollars from the M Company as an expression of its appre- ciation of his long and faithful service. A had no interest in the company, received nothing in the way of bonuses or extra commis- sion, and had no agreement with the company for anything further than his salary. This office has held that pensions and bonuses are in the nature of additional compensation to the recipient and must be included in computing net income. In a like manner, any lump sum received by an employee from a former employer upon the termination of his employment has in it a large element of compensation for services previously rendered. It is held, therefore, that the amount received by A is in the nature of additional compensation and must be included by A in computing his net income for the year in which it was received. (B. 37-21-1814; O. D. 1814.) In cases such as the above, the assumption is that the pay- ments are for services, but if intended as a gift the recipient is not taxable thereon. The facts of the foregoing case are not stated in detail, but it appears that the payment was made See Chapter XXVI. FROM PERSONAL SERVICES 419 as an expression of the company's appreciation of the em- ployee's long and faithful service. There would appear to be strong evidence to support a gift. The following arrangement was held to constitute a gift: Ruling. Subsequent to February 28, 1913, the M Company issued to A an endowment life insurance policy on his life. A made a sin- gle payment of Sx dollars in consideration of which the M Company agreed to pay as an endowment the sum of 6x dollars. The insured placed the policy on the accelerative endowment plan so that the policy became payable in 1920. It was agreed when the policy was written that the proceeds should be paid in two hundred and forty monthly payments, one-half of which should be paid to B, a son of the insured, and the remaining one-half to C^ a daughter of the in- sured, provisions being made for payment in the event of the death of the beneficiaries named. The installments beginning with the were to be increased by such dividends as might be apportioned thereto. A is still living. Held, that the endowment policy in question was a gift by A to B and C and that that part of each installment paid under the policy to B and C which represents a return of the capital value received by them, that is, the cost of the policy to the donor, is not taxable income, but that that part of each installment which represents the gain derived by them or dividends apportioned to the installment, should be returned as taxable income. (B. 47-21-1931 ; O. D. 1108.) Gifts or bonuses to employees. — The interest of the re- cipient of a bonus or similar kind of income is centered upon the taxes which he may properly be called upon to pay on ac- count of the item. If it is adjudged an expense, he is fully taxable upon the amount received, because the employer has not paid any tax on the sum. Certain employers, however, prefer to make these payments tax-free to the recipients and to treat them as distributions of profits. In some cases such payments were made in good faith and charged as expenses, only to be subsequently disallowed by income tax inspectors. Naturally the recipients, in reporting the amounts received, should not have had to pay again the tax which had been paid in their behalf. The regulations prescribe in detail the procedure to be followed by the recipient of such income. 420 INCOME Commissions, fees and tips are taxable. — Regulation Commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, .... are income to the recipients ; as are also marriage fees, baptismal offerings, sums paid for saying masses for the dead, and other contributions received by a clergyman. evangelist or religious worker for services rendered (Art. 32.) Christmas gifts, however, are not considered income with- in the meaning of the law and are not supposed to be inchided in a return,"^ but if deducted by employers as additional com- pensation (as is usually the case) the amounts received are taxable. Ruling. Commissions advanced in payment for services of an advertising solicitor should be reported as gross income for the tax- able year in which received. Any portion of the commissions thus received, which are paid back, owing to failure of payment for ad- vertising, may be deducted as a loss for the year in which payments are returned. (C. B. i, page 67; O. D. 19.) The question arises as to the year in which the bonus should be reported. It is customary tor many concerns to set apart bonuses at the end of the year and pay them a few days after the close of the year. Ruling. In accordance with its annual practice, a company on December 31, 1916, set aside on its books a lump sum representing a part of its net profits for 1916 for the purpose of distributing the same to its employees as additional compensation for services ren- dered during that year. The actual disbursement of this fund was made on January 2, 1917. Held, that this additional compensation was taxable in the hands of the recipient employees at 1917 rates, since the setting aside of the amount to be distributed on the company's books on December 31, 1916, was not a sufficient compliance with the regulations to warrant treating it as income constructively received in 1916. (C. B. 3, page III; A. R. R. 182.)-* The Treasury also said in this case that "the amount set apart" was not subject to demand by the employees, and 'T. D, 2090 (December 14, 1914). Issued under Revenue Act of 1917. FROM PERSONAL SERVICES 421 therefore in effect the bonus could not be said to be "construc- tively" received"'"' in 19 16. Government pensions to widows are gifts. — Ruling. Held, that pensions paid by the United States Govern- ment to widows of soldiers, as such, are not taxable income for the reason that such pensions are not awarded as compensation for ser- vices rendered to the United States Government by the widows and are mere gifts or gratuities. (C. B. 4, 'page 84; O. D. 857.) Remuneration to executor provided by will held taxable. — In the case of United States v. J\iiidcrbilt,-'' the late Alfred G. Vanderbilt, by his w^ill, bequeathed sums varying from $200,- 000 to $500,000 to men named by him as executors and trustees under his will in "lieu of all compensation or commis- sions" for their services as such. These executors and trustees claimed that these sums were becjuests and therefore not tax- able, and did not include them in their income tax returns. The Internal Revenue Bureau took the view that the entire sums were in payment for services, and therefore were taxable income. Suit was brought and the court sustained the view of the Bureau. Compensation of the clergy. — The Treasury has held that a pension paid to a retired clergyman is taxable income. Ruling. The fact that the pensions are paid through the govern- ing body instead of by each individual church direct to the pensioners . is immaterial, as the churches and the governing body are part of the same religious organization and the fund out of which the pensions are paid is contributed by the churches by whom the retired clergymen were formerly employed. (I-2-17; I. T. 1157.) Ruling. A clergyman is not liable for any income tax on the amount received by him during the year from the parish of which he is in charge, provided that he turns over to the religious order of which he is a member, all the money received in excess of his actual living expenses, on account of the vow of poverty which he has taken. ' Sec page 387. '275 Fed. Advance Opinions, page log. 422 INCOME Members of religious orders are subject to tax upon taxable in- come, if any, received by them individually, but are not subject to tax on income received by them merely as agents of the orders of w^hich they are members. (C. B. i, page 82; O. D. 119.) Rental value of residence occupied by clergy is not taxable income. Law. Section 213 the term "gross income" — .... (b) Does not include the following items, which shall be exempt from taxation under this title: .... (11) The rental value of a dwelling house and appurtenances there- of furnished to a minister of the gospel as part of his compensa- tion; .... This exemption appears for the first time in the 192 1 law. Should taxes be eliminated from profits in computing bonus? — In calculating the amount of tax to be paid by re- cipients of commissions, bonuses, etc., which are based upon the profits of a business or a department thereof, the question arises as to the obligation, if any, of such recipients to assume a share of the tax paid by the business. Payments of such commissions, etc., are expenses of the business and should be treated as such by deducting them from gross income be- fore stating the net profits subject to excess profits and in- come taxes. It follows, therefore, that since the payments re- ferred to are reported as allowable deductions, no tax of any kind has been paid thereon by the business, but the recipients must personally pay income taxes'' on any amounts they may receive, subject, of course, to statutory exemptions, other income, etc. Obviously, then, in the absence of any specific agreement to the contrary, it would be unfair to the recipients to compute such commissions, etc., on the income of the busi- ness after deducting excess profits and income taxes. -^ ^ [Former Procedure] For any part of the year 1917, the 8 per cent excess tax had also to be paid. '"Decision Edgar W. S. Recdcr v. G. IVinthrop Coffin and Qn'mcy A. Gillmore, individually and as copartners, trading as Coffin & Gillmore, Court of' Common Pleas No. 3 (Philadelphia), June Term, 1918, No. 3268 (not reported). Extract from opinion: McMichael, P. J., November 15, 1918. "We have considered the question of deduction of income taxes before FROM PERSONAL SERVICES 423 This position is subject to modification in cases where there may be said to exist an understanding with an employee that federal income and excess profits taxes are to be de- ducted before ascertaining the amount available for distribu- tion to an employee who is on a profit-sharing basis and to the partners or stockholders. If an employee were on a salary basis the full amount of the salary, no matter how large, would be paid to the employee without deduction for federal taxes. Many employees who change from a salary to a so- called profit-sharing basis contend that, as they are held re- sponsible for their income taxes (and in 19 17 for the 8 per cent excess profits tax), employers have no right to transfer to them any part of a burden which fortuitously has been laid solely or chiefly upon the employer. In claiming the amount paid to the employee as a deductible business expense, the employer may be said to assent to the position that the em- ployee is not liable to a tax based on net income. In view of the very high income and other taxes imposed upon corpora- tions in the years prior to 1922, the whole matter becomes one of expediency. Employers and employees should come to an understanding and amend existing contracts by adding a clause setting forth the agreement which may be reached. In any event it is incorrect to calculate the taxes which would be pay- able if the employee had no interest in the business, and then charge the employee with a proportion of such amount equal to the percentage of profits to which he is entitled. This method is sometimes followed, but it imposes upon the employee part of a tax which is not paid to the government. If it is decided that the employee is to bear a proportionate share of federal taxes on the net income remaining after his compensation has been charged as an expense, it wall be neces- sary to use a somewhat complicated formula for determining the amount of net income remaining after deducting from allowing the plaintiff 5 per cent of the net profits as salary. We do not think this deduction should be made, as it is not in any way contcmpUtcd by the contract." 424 INCOME earnings the contf)ensation due to the employee; because the compensation due cannot be determined until taxes are al- lowed for — and taxes cannot be allowed for until the com- pensation due to the employee is determined. The following illustrations set forth as simple a formula as can be devised for reaching the desired result: FROM PERSONAL SERVICES 425 o a bD ^ ^^ w "^ O o (M y_ ^2 rt C^ ~ ^ t: <5 W -I m o Oh Et ^•5 c bo *^ O •S.2 rt .. lU c ^ o J2 o („ o o "^ o >« ^ • •*- bo i2 5 ^ .^ ^ ^ P O J3 bo C *- ■'^ _o **^ rt C — -=■:= S OJ:^ O '•«•" H g, -^H ^<^ E u bo _2 « 3 O 13 "T U3 M ^<-> a. X c H o E 4.> u < u o X 2 c H^ H — IT) O Cl. "" O (A ID U E On "^ K! >-• ..J, '.2 iJ — O 1) w o X H H ^H 2 C/2 o aj JH C/2 x; LO w "a « So 428 INCOME In the following illustration, a knowledge of algebra is not necessary."^ Method of Calculating Federal Taxes and Bonus When Bonus IS Based on Net Profits after Deducting Federal Taxes Given: A corporation with an invested capital of $840,000 makes a profit of $470,000 before calculating taxes and has an agreement with its manager to pay him 10 per cent bonus on net profits after paying taxes. In this case the entire bonus comes out of the 40 per cent bracket. Taxes before applying bonus amount to $173,124. The change in taxes as result of allowing bonus would be as follows : Decrease in excess profits tax 40% of bonus Decrease in normal tax 10% " " Total decrease 50% " " Increase in normal tax as result of decreased credit account less excess profits paid, 10% of 40%, or 4% " " Net decrease in tax 46% " " As result of decrease in taxes there is more profit in which the manager would participate to extent of 10 per cent, or 4.6 per cent of the bonus. Calculation of Bonus Profits before taxes $470,000.00 Taxes — before applying bonus 173,124.00 Balance $296,876.00 10% bonus on above $ 29.687.60 4.6% of $29,687.^10 = 1,365.63 4.6% of 1,365.63 = 62.82 4.6% of 62.82 = 2.89 4.6% of 2.89 = .13 Total bonus $31,119.07 Calculation of Tax Profits $470,000.00 less $31,119.07 = $438,880.93 20% Bracket 20% of invested capital $168,000.00 Excess profits credit 8% of invested capital plus $3,000 70,200.00 20% tax on balance $97,800.00 $19,560.00 "From Journal of Accountancy, September, 1920, FROM PERSONAL SERVICES 429 40% Bracket Profit $438,880.93 20% on invested capital 168,000.00 Balance taxable at 40% $270,880.93 108,352.37 Total excess profits taxes $127,912.37 Income Tax Profit $438,880.93 Credits : Excess profits taxes plus $2,000 129,912.37 Balance taxable at 10% $308,968.56 30,896.86 Total tax $158,809.23 Proof Profit before tax and bonus $470,000.00 Taxes 158,809.23 Balance $311,190.77 10% bonus to manager 31,119.07 In case the bonus came out of the 20 per cent bracket the decrease in taxes would be 28 per cent and the additional bonus to manager would be 10 per cent of that amount, or 2.8 per cent of the bonus. When the bonus comes out of the 40 per cent bracket the amount of bonus before figuring taxes plus 4.8217813 per cent of itself will give the final bonus. "'^ If it comes out of 20 per cent bracket, use 2.880656 per cent. In case part of the bonus comes out of the 40 per cent bracket and the balance out of 20 per cent bracket, the calculation would be as follows : A corporation with an invested capital of $100,000 makes a profit of $21,000, and has agreed to pay its manager 10 per cent of net profits after calculating tax. The tax, before deducting bonus, would be $3,880. Calculation of Bonus Profit before bonus and taxes $21,000.00 Tax before deducting bonus 3,880.00 Balance $17,120.00 10% bonus on above 1,712.00 Before deducting bonus there was a profit of $1,000 in the 40 per cent bracket, but after deducting bonus the entire tax would '" This statement i.s erroneous. The sentence should read : "When the bonus comes out of the 40 per cent bracket, the amount of bonus (after figuring taxes as though bonus were not an allowable deduction) plus 4.8217813 per cent of itself will give the final bonus." 430 INCOME fall in the 20 per cent bracket. The reduction in taxes as result of allowing the tentative bonus of $1,712 would be as follows: 46% of $1,000.00 in 40% bracket $ 460.00 28% of $712.00 in 20% bracket 199-36 Total saving in taxes on first calculation of bonus $ 659.36 Manager gets 10% of this amount 65.94 2.8% of $65.94 1.85 2.8% of $1.85 .05 Total additional bonus $ 67.84 Tentative bonus 1,712.00 Total bonus $1,779.84 The proof works out as illustrated in the first example. Compensation "of Whatever Kind and in Whatever Form Paid" The law specifies that compensation for personal services shall be reported as income even if received in some form other than cash. Taxable income is to include compensation "of whatever kind and in whatever form paid." The regula- tions governing the valuation of services not paid for in cash read as follows: Regulation. Where services are paid for with something other than money, the fair market value, if readily realizable, of the thing taken in payment is the amount to be included as income. If the services were rendered at a stipulated price, in the absence of evidence to the contrary such price will be presumed to be the fair value of the compensation received (Art. 33.) Recision of salary contract. — Ruling. A contract was entered into between A and the M Company, whereby the compensation of A for the year 191 8, in addi- tion to his salary, was fixed at a certain per cent of the net income from the business. This contract was later modified and a stated amount agreed upon as the maximum liability of the corporation, which sum was paid to A in 1919, in full settlement of the contract for 1918, and was reported by A in his income tax return for 1919. Owing to dissatisfaction on the part of some of the stockholders over the second contract, an agreement was reached whereby the money received by A thereunder in 1919 was returned to the com- pany on March — , 1921, and all rights under the contract waived. I FROM PERSONAL SERVICES 431 The contracts of employment were fully performed in 19 19 when the amount agreed upon was paid by the company to A in full settle- ment of the contracts. As there can be no recision of an executed contract there was no obligation upon A to refund any of the money so received. The transfer of the amount to the company on March — , 1921, was purely a voluntary act on his part and for income tax pur- poses the amount transferred must be considered a gift. (B. 43-21- 1882; O. D. 1073.) A contract can be legally rescinded by mutual consent. It is not necessary to support this statement by legal decisions. It is established business practice. If the foregoing ruling was decided on that point alone, it is not good law. Premiums paid by employer on group life insurance — not income to employee. — Regulation Premiums paid by an employer on policies of group life insurance covering the lives of his employees, the bene- ficiaries of which are designated by the employees, are not income to the employees (Art. 33.) Prior to March 20, 1920, the Treasury held payments of this character to be additional income of the employee. The employer, however, may deduct such premiums paid as "ordi- nary and necessary expenses. "^^ Compensation received in the form of stock. — Regulation Compensation paid an employee of a cor- poration in its stock is to be treated as if the corporation sold the stock for its market value and paid the employee in cash (Art. 33.) The proper valuation of such stock is often a matter of considerable difficulty and its true worth for purposes of taxation in many cases is not the same as the sum shown on the books of the company.^" When there is an actual market price for the stock such price is the proper one to use. The ''Bulletin 12-20-793; O. 1014. ''' [Former Procedure] The "actual value" of such stock charged on the books of the corporation as an expense was the basis used previously. (Reg. 33. Art. 139.) 432 INCOME problem is complicated when there is no market value be- cause the stock is not bought and sold on an exchange or when the directors have placed an "optimistic" value upon the shares. In case the recipient of the stock is one of the directors and as such has been a party to a formal determination that the services performed were equal in value to the par value of the stock, he would have dif- ficulty in discussing this valuation with a revenue agent. If he was not a party to the valuation placed upon the stock by the corporation he should return the stock at the value which in his best judgment represents its actual worth, which would also represent the cash value of his services. He would not be bound by a nominal quotation for the stock on an exchange or by sales prices which might not represent "fair" prices. The principles followed by the Treasury in fixing the value to be placed on stock received in payment for services, when the value at the date of issuance is unknown, are stated in the following : Ruling It being an entirely new venture, the market price for the stock at the time of the incorporation and the issuance of stock was not known. Shortly thereafter, the taxpayer, as a part of the agreement, proceeded to make a market for the stock. That is to say, he had it listed on the curb and arranged for bringing it to the attention of the public. For his services the taxpayer received in payment shares of the stock of the corporation and voting trust cer- tificates ( non-negotiable ) . No stipulated cash value appears to have been placed on the tax- payer's services. Where services are paid for in something other than money, the fair market value of the thing taken in payment is the amount to be included as income. If stock of a corporation is received in payment for services rendered, such stock must be considered as equivalent to cash, providing it has any actual money value. It is to be treated as if the corporation sold the stock for its market value and paid the employee in cash. (See art. 33 of Regulations 45.) To constitute taxable income, however, the value of the stock received must be so fixed as to be capable of measurement at the time of receipt. If its value can not be measured in terms of cash or money's worth, then it can not be considered income for income-tax purposes. (19-19-494.) The value of stock which has no market price may be estimated by resort to the value of the assets capitalized and attendant circum- FROM PERSONAL SERVICES 433 stances which may affect the value of such assets. (Goodwin v. Wil- bur, 104 111. App., 45; Collins V. Denny, 89 N. W., 1012; Virginia v. West Virginia, 238 U. S., 202.) In the case of inventions, their value is dependent upon proven utility or the likelihood of practical use- fulness and therefore stock issued thereon will have a corresponding value. If an inventor should sell a recently patented invention to a manufacturer before its use has been tested, but simply upon its apparent usefulness, it may be said that the invention at that time is worth what is paid for it, because a price has been offered and paid. The measure of value is the price paid. {Burke Hollow Coal Co. v. Lawson, 151 S. W., 657; Johnson-Brinkman Commission Co. v. Wabash R. Co., 64 Mo. App., 590.) Stock issued upon such invention would be worth the value of the invention, measured by the price which the manufacturer has paid for it. Where the inventor himself forms a company and issues stock upon his invention and there are dealings in said stock at or within a reasonable time after the issuance thereof, prices then paid may be said to be evidence of the value of the invention capitalized and therefore of the stock at the time of its issuance. This is upon the principle that a subsequently existing fact is evidence of some pro- bative value of the prior existence of the same fact. (See Hum- phreys V. Minnesota Clay Co., 103 N. W., 338; Atwood v. Bears, 8 N. W., 55.) The taxpayer has received something which he did not have be- fore. If what he has received is of value and that value is capable of measurement, he has received income. (19-19-494, supra.) The fact that the stock received sold in the open market within a very short time after the date of its issue and receipt by the taxpayer is strong evidence that it had value at such date and the prices received in such sales are evidence of the measure of its value within the principles above laid down. However — In the case of subsequent existence as evidence at the time in issue, there is the disturbing contingency that some circumstance oper- ating in the interval may have been the source of the subsequent existence, and the propriety of the inference will depend on the likeli- hood of such intervening circumstance having occurred and been the true origin. (Sec. 437, Wigmore on Evidence. See also Doll v. Henne'ssy Merc. Co., 81 Pac, 625.) Consequently, even though the inference is strong that the first prices brought in the sale of the stock in question represent its true market value at the date of issue and receipt by the taxpayer, still the activities of the taxpayer in bringing the stock to the attention of the public in a favorable light might have been the cause for a large portion of the prices so received. Such activities can not, how- ever, be said to account for all of such prices. It is therefore fair and reasonable to conclude, in view of the range of prices over a 434 INCOME period of two years, that the price received over and above the stated par value was due to the taxpayer's efforts at publicity, and that the value of the stock when received by him was its par value. (See Mojfitt V. Hereford, 34 S. W. (Mo.)' 252.) .... It is therefore held, in the peculiar circumstances of this case, that stock, based upon a new and untried invention, received in pay- ment for services is income to the person receiving the stock to the extent of its market value. The market value at the time of receipt is to be fixed by taking into consideration the first prices brought for such stock w-hen placed on sale within a reasonable time after such receipt, due allowance being made for intervening circumstances affecting such value. (B. 1-20-656; O. 962.)^^ The foregoing ruling is quoted in full because it describes the Treasury's method of determining gain. When a loss is claimed the Treasury does not use the same formula. When an inventor endeavors to fix the value of his patents at March I, 191 3, he is not given the benefit of such statements in the ruling as this : "In the case of inventions, their value is de- pendent upon proven utility or the likelihood of practical use- fulness." ^ In no part of the ruling is there any mention of the formula of the Supreme Court in defining income.^* It must be remembered that only income can be taxed, and only income which has been realized to such an extent that it is the equiva- lent of cash. The Supreme Court has never approved the principle that income can be imputed to a transaction when the stock or other property received has no market value. Stock purchase schemes for employees. — Ruling. Where a corporation offers its employees the oppor- tunity to purchase shares of its stock, and the title to the stock re- mains in the corporation until it is fully paid for, it is held that the so-called dividends credited to the account of the employee purchas- ing the stock as part payment for the stock are not in fact dividends, as dividends can not legally be declared on unissued or treasury stock. The amounts so credited, which are measured by the dividends declared on the outstanding stock, constitute additional compensation to the employees and taxable as such. Where other amounts in the nature of special allowances are. upon the fulfillment of certain conditions, credited to the account of 'See Chapters XVI and XVII. 'See page 533, ct scq. FROM PERSONAL SERVICES 435 such subscriber as part of the payment for his stock, and where pro- vision is made for the payment of certain amounts in the event the subscriber does not default in any payment on the stock being pur- chased and complies with certain other conditions, it is held that such amounts are in the nature of additional compensation. It is held, further, however, that as the interest of the subscriber is merely a contingent interest which may be defeated by failure to execute the terms of the agreement upon which the stock is issued, the so-called dividends and special allowances credited to the account of the subscriber do not constitute taxable income to such subscriber until the terms of the agreement have been completed. (C. B. 4, page 76; O. D. 763.) In the foregoing ruling, what are called dividends are held to be additional compensation to employees, in which case the payments are allowable deductions to the corporation ; whereas dividends are not. In order to carry out the purpose of the corporation, stock equal to the aggregate . accruing credits should be issued to trustees who can receive and disburse the dividends in behalf of the beneficial owners. In the following case the corporation issued the stock to trustees, but the result was a contingent rather than a vested beneficial interest in the employees. Rulings. A corporation issued in the name of its employees shares of its stock as compensation for services rendered. The employees executed the certificate of transfer on each share of stock purporting to transfer the stock to the principal owners of the stock of the cor- poration, designated trustees. The conditions of the purported is- suance and transfer of the stock were that it should be held by the trustees until the dividends thereon, paid regularly to the trustees, should equal the par value of the stock, after which the dividends and stock were to become the property of the employees. In case of resignation or discharge of an employee prior to the time of receiv- ing title to the stock, he was to receive the dividends paid to the trustee on account of the stock issued in his name, and in case of his death they were to be paid to his next of kin. Held, that title to the stock and to the so-called dividends did not vest in the employees until the conditions imposed by the agreement between the corporation and employees were fulfilled. Consequently the payments made to the principal owners of the stock of the corpora- tion, the amount of which was measured by the dividends paid on the outstanding stock, are not dividends as defined by section 201 (a) of the Revenue Act of 1918, but the amount thereof is additional 436 INCOME compensation for services rendered, and constitutes income to the employees in the year in which the title vested in them, subject both to normal tax and surtax. When title to the stock vests in the employees they should return as taxable income the fair market value of such stock at that time. Any dividends thereafter paid by the corporation would be true divi- dends as defined by section 201 (a) and subject only to surtax. (C. B. 4, page 76; O. D. 791.) Where the members of a firm establish an employees' profit- sharing fund by transferring a given sum of money to certain employees in trust, such fund being invested in the business of the firm and the interest paid annually to a certain class of employees, who hold certificates entitling them to participate in the profits of the fund, such certificates being subject to cancellation at the pleasure of the firm, the income from the fund is taxable as a part of the firm's income. (C. B. 2, page 76; S. 1329.) There are many forms of profit-sharing funds and plans. The Treasury holds that income from such funds, although paid to the employees, is in the first instance income of the owner of the fund and that such owner is the firm when "such fund is neither a separate business venture nor an irre- vocable trust." The ruling is sound. The actual payments to employees are an allowable deduction. The restriction on the deduction applies only when the transfer of funds is in name only.^^ Ruling. Bonuses paid by a corporation, partly in cash and partly in stock of the corporation, which stock was purchased by the corporation on the open market, in accordance with a plan laid down by its board of directors, to the most deserving of its employees (which must be recognized as meaning most deserving on account of services rendered), represent additional compensation to the em- ployees and as such are deductible by the corporation and taxable to the recipients. The fact that the corporation did not deduct the amount representing these bonuses from gross income in its return would not affect the taxability of the bonuses in the hands of the employees. The amount to be considered as taxable income is the actual amount of cash, plus the market value of the stock, when received by the employees. (C. B. 3, page 144; O. D. 570.) See also section 219 (f). FROM PERSONAL SERVICES 437 Compensation received in the form of notes. — Regulation. Notes or other evidences of indebtedness received in payment for services, and not merely as security for such payment, constitute income to the amount of their fair market value. A taxpayer receiving as compensation a note regarded as good for its face value at maturity, but not -bearing interest, shall treat as income as of the time of receipt the fair discounted value of the note at such time. Thus, if it- appears that such a note is or could be discounted on a 6 or 7 per cent basis, the recipient shall include such note in his gross income to the amount of its face value less discount computed at the prevailing rate for such transactions. If the payments due on a note so accounted for are met as they become due, there should be included as income in respect of each such payment so much thereof as represents recovery for the discount originally deducted. (Art. 34.) That is to say, if on October i, 1921, A received in pay- ment for services rendered a promissory note for $1,000 pay- able in 6 months, without interest, he would return the dis- counted value (assuming the current rate to be 6 per cent), approximately $970, as income for 192 1. When the note is collected in 1922, he would return $30 as income. The maker of the note, however, is permitted to deduct in 192 1 the full $1,000. If the note bears interest, say at 6 per cent, A would return in 1921 the discounted value, viz., $1,015, and for 1922 he would return $15. The maker of the note would deduct $1,000 in 1 92 1, and $30 in 1922. If the note could not be discounted no return need be made for 1920. This privilege is extended to instalment houses and it cannot be withheld from others similarly situated. Ruling. A corporation keeping its accounts on the basis of actual receipts and disbursements loans money, the loans being se- cured by first mortgages on property of the borrowers. The cor- poration receives as commission second mortgages on the property payable in 5 or 10 annual installments without interest. The second mortgage notes received as compensation for services should be reported as income at their fair discounted value as at the date of receipt. If the notes are not marketable at a fair discount value, each installment payment should be included in gross income in its entirety by the corporation in the year in which received. (B. 46-20-1302; O. D. 728.) 438 INCOME Although notes may be regarded as "good for face value at maturity," as stated in article 34, if not "marketable at a fair discount," the income need not be reported until payment is made. In the business of architects, contractors -and banks, sec- ond mortgage bonds are often taken as part payment for services rendered. These securities usually have no market value. If books are kept on an accrual basis the income to be reported should be on an estimated market or discounted value of the second mortgages. When the books are closed an inventory may be taken since the mortgages are part of the stock-in-trade. If books are kept on a cash basis, the bonds should not be reported as income until realized in cash. Compensation for services received by partnership. — Ruling. Shares of stock and cash received by a partnership for underwriting the reorganization of an insolvent concern in which a deceased partner owned stock, the transaction being undertaken in order to protect the interests of the decedent's estate and the entire amount received therefrom being turned over to his estate, represent taxable income to the partnership regardless of the fact that no dis- tribution was made to the individual partners and irrespective of the reasons for which the partnership entered into the transaction. (C. B. 2, page 72; O. D. 542.) The foregoing is apparently based on the assumption that although the partnership was practically engaged in a chari- table undertaking, it received income for services and made a gift to the deceased partner's estate. Compensation received in the form of rent and board. — Regulation When living quarters such as camps are furnished to employees for the convenience of the employer, the ratable value need not be added to the cash compensation of the employees, but where a person receives as compensation for services rendered a salary and in addition thereto living quarters, the value to such person of the quarters furnished constitutes income subject to tax (Art. 33.) Many factory superintendents, as part consideration for their services and not necessarily for the convenience of the FROM PERSONAL SERVICES 439 employers, are permitted to live, rent free, in houses belong- ing to their employers. Under this ruling they are required to ascertain the rental value thereof and report it as taxable income. The rental value of a minister's house is exempt from taxation."** While the rules laid down on this point are in themselves equitable, they can scarcely be considered consistent with the rule under which persons owning their own houses are not tax- able on the rental value. In other words, there is a discrimina- tion between the man who pays no rent because he lives in the house he owns and the man who pays no rent because he lives in his employer's house, rent free, because of his services. In the latter case income tax is collected on the rental value. In the former case no income tax is assessed on the rental value. Rulings. Board and lodging furnished seamen in addition to their cash compensation is held to be supplied for the convenience of the employer and the value thereof is not required to be reported in such employees' income tax returns. (C. B. i, page 71; O. D. 265.) Where the employees of a hospital are subject to immediate ser- vice on demand at any time during the twenty-four hours of the day and on that account are required to accept quarters and meals at the hospital, the value of such quarters and meals may be considered as being furnished for the convenience of the hospital and does not represent additional compensation to the employees. On the other hand, where the employees are on duty a certain specified number of hours each day and could, if they so desired, obtain meals and lodg- ing elsewhere than in the hospital and yet perform the duties re- quired of them by such hospital, the ratable value of the board and lodging furnished is considered additional compensation. (C. B. 4, page 85; O. D. 915.) The following rule differs from the foregoing. Ruling. The fair rental value of buildings occupied by em- ployees of the Indian service should be included in the compensation of such employees if the rental value has been charged to the appro- priation from which the compensation of the employees is paid and the amount covered into the Treasury as miscellaneous receipts. (C. B. 4, page 85; O. D. 914.) ""Law, section 213 (b-'i). See page 422. Prior to 1921, the rental value had to be included in gross income. 440 INCOME Even though the rental is charged to an appropriation it would seem that the quarters furnished are for the con- venience of the employees. Ruling. The regulations of the Public Health Service provide that officers of such service are entitled to quarters, heat, and light, and that employees, such as attendants, dietitians, internes, nurses, and reconstruction aids, are entitled to quarters, subsistence, and laundry. These items are furnished to such persons in respect of a service which they render and as an inducement to them to enter the Public Health Service. It is held, therefore, that the value of the quarters, subsistence, laundry, heat, and light furnished the officers and employees referred to constitutes income to such officers and employees and must be re- turned by them as income for the year in which received. (C. B. 4, page 112; O. D. 904.) "Supper money" not taxable. — Ruling. "Supper money" paid by an employer to an employee, who voluntarily performs extra labor for his employer after regular business hours, such payment not being considered additional com- pensation and not being charged to the salary account, is considered as being paid for the convenience of the employer and for that rea- son does not represent taxable income to the employee. (C. B, 2, page 90; O. D. 514.) Compensation received in the form of heat and light, tele- phone, automobile and other service. — Regulatton. Amounts received by, or paid for, an officer for heat and light shall be returned as income. (T. D. 2079, November 24, 1914.) This applies to army officers who receive, in addition to their salaries and allowances for rent, a further allowance for heat and light. ^' Since the amounts paid are readily ascertain- ^' Copy of Office Memorandum No. 17, issued by General Staff, U .5. A., March 3, 1919. "i. The following letter from the office of the Commissioner of the Bureau of Internal Revenue is published for the information and guidance of all concerned : 'With a view to assisting persons in the military and naval forces of the United States in preparing their income tax returns for the year 1918, attention is called to the holdings of this office under previous income tax acts and to the provisions of the revenue bill as passed by Congress 'It has been held that interest on deposits made with disbursing FROM PERSONAL SERVICES 441 able, it may be assumed that all army officers whose aggregate incomes exceed the exemption pay the tax thereon. There are many other individuals who receive allowances of a simi- lar nature and should be taxed thereon. For instance, many corporation officers, particularly those who live near indus- trial plants, receive or enjoy telephone service, fuel, use of automobiles and many other perquisites which under the rul- ing cited are taxable. It is usual for officers of automobile concerns, manufacturers and dealers to have the full use of motor cars for pleasure and business purposes. Officers of railroad companies receive passes good over their own and officers after September i, 1917, under authority of section 1305 Rev. Stat., as amended by the act of July i, 1906, on deposits made under authority of section 203 of the Act of October 6, 1917, and on amounts of compensation not drawn, represents taxable income; and that the follow- ing items represent compensation for services rendered and should be returned as income: 'Quarters furnished within the allowance provided by law; or a room furnished as quarters only, that is, a room other than barracks to which several men are assigned. 'Heat and light furnished within the allowance provided by law. 'Allowance drawn from the government as tlie equivalent of cloth- ing not drawn. 'The commutation .of rations. 'Markmanship pay or extra duty pay. 'Traveling pay to discharged officers or enlisted men. 'Mileage allowance, claiming as a deduction the actual necessary traveling expenses. 'Allowance in lieu of subsistence while traveling under orders, claim- ing as a deduction the actual necessary traveling expenses. 'On the other hand, it has been held that the following items are furnished by the government for its own purposes rather than as com- pensation to the officer or enlisted man and the money equivalent thereof should not be returned as income : 'Clothing and rations furnished in kind. 'Gratuitous medical and hospital treatment. 'Tent or other temporary shelter. 'Room furnished at a permanent military post used for sleeping quarters and office combined. 'The family allowance provided for under article 2 of the War Risk Insurance Act was held to be subject to tax prior to the amendment of June 25, 1918. In view of this amendment, allotments, family allowances, compensation and death or disability insurance payable under the War Risk Insurance Act of September 12, 1914, as amended, were held to be exempt from tax and the former ruling was made to apply only in the case of assessments made prior to the date of the amendment, June 25, 1918.'" 442 INCOME Other lines. These are used for personal as well as business purposes. An individual, for instance, may use a pass to go to and from his golf club or on pleasure trips. Should emoluments of this kind be reduced to their equiva- lent in money and be reported as taxable income? The point is really an important one, for the income tax to be success- ful must be administered impartially and equitably. If army officers, who are not overpaid, are required to pay the tax on the money equivalent of rent, light and heat, then other in- dividuals, most of whom are better able to pay, ought to pay on similar income. "Compensation for personal service of whatever kind and in whatever form paid" is hardly subject to doubt as to its meaning. One difficulty which will arise is that of drawing the dis- tinction between compensation which takes the form of re- duced living expenses (taxable because not allowable as de- ductions) and the receipt of similar privileges which do not reduce the living expenses of the recipient. For instance, automobiles are frequently furnished to salesmen exclusively for business use. Here, of course, no return would be made. If the salesman is permitted to employ a car for personal or family use, should he ascertain the rental value for the time so used and include such amount as taxable income? The an- swer is "yes" only in case the salesman would purchase a car himself were this car not furnished free of charge. Only then would the item be the equivalent of a reduction of "per- sonal, living or family expenses." Or, stated another way, return should be made of an amount representing the worth of the automobile service to him personally and individually. If, on the other hand, an officer of an automobile concern has the exclusive use of a car and does use it for other than busi- ness purposes, and if it is a fair assumption that he would own and operate a car even if he had to pay for it, then he should ascertain the total cost of operation for a year and prorate such cost equitably, reporting as taxable income the estimated saving of expense arising from the- use of the car FROM PERSONAL SERVICES 443 as additional compensation. Of course, he would report on the basis of what the actual cost to him would be, taking the benefit of manufacturers' or wholesale prices, rather than what he would have had to pay if he had not been in a position to secure such concessions. There may be in some cases a question as to whether or not some items like those discussed above are compensation or gifts. This probably depends legally upon the contractual relation between the one who pays and the recipient. If the rent, fuel, automobile and similar privileges are part of the employment contracts, express or implied, and thus show on their face that more or less value attaches thereto, the cash equivalent of the items is taxable. If, however, the privileges are not part of a contract and are pure gifts, and if no diminu- tion of cash compensation results therefrom, they do not con- stitute taxable income. Compensation received in the form of per diem allowances and mileage. — The 19 18 regulations^® specifically provided that congressmen, army officers and others who received stated al- lowances per mile or per diem to cover traveling or living ex- penses, and allowances for stationery, secretarial services, etc. should return as income any excess of such allowances over actual expenses. Article loi (a) of the 1921 regulations provides, in effect, for the same procedure. In the case of liberal allowances such as congressmen receive, part of the allowance obviously is taxable and the regulation calls attention to this case specifically. In other cases, such as that of army officers, the allowance closely approximates the expenditure and it may not be worth while to attempt an exact accounting. There is, however, a definite obligation imposed upon the recipient to keep such a record as will indi- cate at the close of taxable periods whether or not return should be made. The record of deposits in one's cheque book usually is sufficient. '' Regulati(jns 45, Art. 292. 444 INCOME The Treasury has held that transportation charges paid by the government on account of the transportation of the famihes of army ofificers are in the nature of additional com- pensation.^^ Ruling. A person in the service of the American Red Cross receiving maintenance but no pay should return as income any excess of the amount receive'd for maintenance over his actual Hving ex- penses. (C. B. I, page 66; O. D. ii.) Compensation received in the form of deductions for pen- sion funds^ etc. — When deductions are made from the salaries or wages of employees (other than public) to cover com- pulsory or voluntary contributions to pension, sick or insur- ance funds, such payments or deductions should be added to the amounts received in reporting income which is subject to tax. Regulation pensions or retiring allowances paid by private persons .... are income to the recipients ; .... (Art. 32.) Proceeds of accident insurance and damages not taxable. — Law. Section 213. That .... "gross income" — . . . . (b) Does not include .... (6) Amounts received, through accident or health insurance or under workmen's compensation acts, as compensation for personal injuries or sickness, plus the amount of any damages received whether by suit or agreement on account of such injuries or sickness.""* .... Insurance proceeds, when taxable and not taxable. — Regulation, (a) Upon the death of an insured tlie proceeds of his life insurance policies, whether paid to his estate or to any !)eneficiary (individual, partnership, or corporation), directly or in trust, are excluded from the gross income of the beneficiary (b) During his life only so much of the amount received by an in- sured under life, endowment, or annuity contracts as represents a re- turn, without interest, of premiums paid by him therefor is excluded from his gross income (r) \^'hether he be alive or dead. '"Bulletin 50-21-1975; O. D. 1135. *" [Former Procedure] Payments made to injured employees by corporations under the accident compensation laws of the several states constitute taxable income of the employees. (T. D. 2570, November 6, 1917.) This was reversed by T. D. 2747 (July 12, 1918), the principles of which are adopted in the present law. FROM PERSONAL SERVICES 445 the amounts received by an insured or his estate or other beneficiaries through accident or health insurance or under workmen's compensa- tion acts as compensation for personal injuries or sickness are ex- cluded from the gross income of the insured, his estate and other beneficiaries. Any damages recovered by suit or agreement on ac- count of such injuries or sickness are similarly excluded from the gross income of the individual injured or sick, if living, or of his es- tate or other beneficiaries entitled to receive such damages, if dead. .... Since June 25, 1918, no assessment of any federal tax may be made on any allotments, family allowances, compensation, or death or disability insurance payable under the War Risk Insurance Act of September 2., 1917, as amended, even though the benefit accrued before that date (Art. ']2..') Article 72 of Regulations 45 is amended as above to ex- empt the proceeds of insurance paid to a corporation bene- ficiary, thus complying with the new law. The above regulation explains the provisions of the statute, which includes in the exemption amounts paid either to the in- sured or his estate, together with allotments, allowances, and war risk insurance and compensation.'*^ Ruling. Where an individual takes out a policy of insurance in favor of his estate which is assigned to a corporation as security for money advanced without interest or other charge to pay a premium thereon, and upon the death of the insured the corporation deducts the amount of the indebtedness from the proceeds of the policy paid to it as assignee, and turns the balance over to the executor of the estate, the corporation should not for income tax purposes include the proceeds of the policy in its gross income. The function of the corporation was merely that of an intermediary in the collection of the proceeds of the policy. (C. B. 4, page 72; O. D. 804.) Premiums paid by corporation — income to officer in certain cases. Ruling. If a corporation pays the premiums on an individual life insurance policy carried on the life of one of its officers or em- ployees who is permitted to designate the beneficiary and in which the corporation is not in any way a beneficiary, premiums so paid will, in the absence of satisfactory evidence to the contrary, be presumed to constitute taxable income to such officer or employee. (C. B. 3, page 104; O. D. 627.) " See page 350 ct scq. CHAPTER XV INCOME FROM BUSINESS The line between the profits resulting from business, dealt with in this chapter, and the profits resulting from appre- ciation of property, discussed in Chapter X\"II, must be some- what arbitrarily drawn. Most business, of course, consists of dealing in property, while all dealings in property are usu- ally thought of as "business" transactions. An attempt is made to distinguish between income from the purchase and sale of merchandise, securities and other property by dealers, and income or profits realized by in- vestors and others who are not dealers. General principles regarding the nature and taxation of appreciation of fixed assets and investment securities, real estate, etc., are discussed in Chapter X\^II. Sales and exchanges of property (not form- ing part of a dealer's stock-in-trade) are discussed in Chap- ter X\T. The discussion of inventories and other "current" assets is, consequently, retained in this chapter. Law. Section 213 the term "gross income" — (a) Includes gains, profits, and income derived from .... trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from .... securities, or the transaction of any business carried on for gain or profit, .... Gross income from business defined. — Regulation. In the case of a manufacturing, merchandising or mining business "gross income" means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. In determining the gross income subtractions should not be made for depreciation, depletion, selling expenses or losses, or for items not ordinarily used in computing the cost of goods sold.^ (Art. 35.) This statement of course does not modify those sections of the 446 FROM BUSINESS 447 Business need not be lawful. — The law of 191 3 (section II B) provided that the tax was levied on the gains from "any law^ful business carried on for gain or profit." In the law of 1916, the word "lawful" is omitted and it does not reappear in either the 19 18 or 1921 law. This would seem to indicate a direct intention on the part of Congress to make "stealings" and "winnings" taxable as well as "earnings." Income from gambhng and bootlegging would, of course, come under this head. In this country there is not a large class of professional gamblers or others transacting an unlawful business, but such as can be reached should be taxed. Occasional betting, how- ever, is frequent, millions of dollars being wagered on the results of political campaigns, athletic contests, etc. The win- nings are subject to tax. What they win cannot be termed a gift or any other item specifically exempt from taxation, and "gains derived from any source whatever" are taxable. One should, therefore, include all receipts from bets in his income tax return. This in some cases would be a considerable item in the year of a presidential election. It would seem that net losses should be deducted when the transactions were entered into for profit. It would not be wise to claim credit for a net loss arising from betting, but there is a clear obligation to return a net gain. British practice. — In England it has been held that a professional bookmaker is liable to assessment under the in- come tax law. The court decided that : Decision. (Syl.) Persons receiving profits from betting sys- tematically ca-rried on by them throughout the year, are chargeable with income tax on such profits in respect of a "vocation. "- In France, also, the government is taxing income from gambling, as stated in a press dispatch. However, in France, law and regulations which permit the use of recognized accounting practices. A taxpayer will not be required to change his method of accounting merely to ascertain items of "gross income." ' i'arlridgc v. M allandainc , L. R. 18 Q. B. Div. 276 (1886). 448 INCOME gambling is not "illegal" when conducted under government license. Those who patronize the lotteries on a large scale and whose quarterly winnings may amount to 1,000,000 francs have learned to their dismay that the new taxes strike a double blow at them. First they must pay 20 per cent outright to the city of Paris as the tax on unforeseen revenues. Then when they have deposited the balance of their winnings in a bank it becomes a part of their gen- eral yearly revenue and is taxable another 15 per cent.^ Speculation in "futures/' etc. — The purchase and sale of ''futures,'" which chiefly concern those who deal in cotton and other commodities on exchanges, are often called gambling and those who indulge in such transactions do not always consider that their gains are taxable income. It is immaterial whether the transactions are called business deal- ings, speculation or gambling. If they result in net gain, the profit must be returned as taxable income.* Accounting Procedure Fiscal year for individuals. — The 1921^ law provides that an individual may compute his net income on the basis of his "annual accounting period (fiscal year or calendar year, as the case may be).'"^ An individual business man or a partner may simply make his personal tax year coincident wnth his business fiscal year; or if he desires to make his personal return on the basis of the calendar year, he may report his income from a business to the end of its fiscal year only, with- out attempting to restate the accounts as of December 31. It is, however, difiicult and annoying to make tax returns for a period other than the accounting period adopted by an individual. The end of December is a very inconvenient time for many taxpayers to state their accounts. Under the pres- ' New York Herald, November 21, 1920. * For discussion of deductibility of losses, see Chapter XXIX. ° The provision was first inserted in the 1918 law. ° Section 212 (b), see page 64. FROM BUSINESS 449 ent law it is possible to select and report for a year ending on the last day of any month most convenient for the taxpayer. The receipt or accrual basis and the proper accounting procedure for each are fully discussed in Chapters XIII and XIV. Computation of business income of contractors. — The business of contracting offers some peculiar difficulties in the calculation of income. The regulations deal with them as follows : Regulation. Income from long-term contracts is taxable for the I^eriod in which the income is determined, such determination depend- ing upon the nature and terms of the particular contract. As used herein the term "long term contracts" means building, installation, or construction contracts covering a period in excess of one year. Persons^ whose income is derived in whole or in part from such contracts may, as to such income, prepare their returns upon the following bases : (o) Gross income derived from such contracts may be reported upon the basis of percentage of completion. In such case there should accompany the return certificates of architects or engineers showing the percentage of completion during the taxable year of the entire work to be performed under the contract. There should be de- ducted from such gross income all expenditures made during the tax- able year on account of the contract, account being taken of the mate- rial and supplies on hand at the beginning and end of the taxable period for use in connection with the work under the contract but not yet so applied. If, upon completion of a contract, it is found that the taxable net income arising thereunder has not been clearly re- flected for any year or years, the Commissioner may permit or re- quire an amended return. (b) Gross income may be reported in the taxable year in which the contract is finally completed^ and accepted if the taxpayer elects as a consistent practice to so treat such income, provided such method _ ' [Former Procedure] Under the old regulations this special pro- vision for contractors applied only to corporations (Reg. 33, 1918, Art. 121). The term "person," as used in the 1918 and 1921 laws, includes individuals and corporations. ' A contractor keeps books on an accrual basis. When the contract is completed the final income must be completed and returned in accord with the regulations whether the work is paid for in full or in part. (B. 52-21- 1991; O. D. 1147.) 450 INCOME clearly reflects the net income. If this method is adopted there should he deducted from gross income all expenditures during the life of the contract which are properly allocated thereto, taking into consideration any material and supplies charged to the work under the contract but remaining on hand at the time of completion. Where a taxpayer has filed his return in accordance with the method of accounting regularly employed by him in keeping his books and such method clearly reflects the income, he will not be required to change to either of the methods above set forth. If a taxpayer desires to change his method of accounting in accordance with paragraphs (a) and (b) above, a statement showing the com- position of all items appearing upon his balance sheet and used in connection with the method of accounting formerly employed by him, should accompany his return.^ (Art. 36.) This regulation is in substance identical with the similarly numbered article in Regulations 45. However, the last para- graph is new and permits a contractor to use his own account- ing method, if such method clearly reflects the income, or to change to one of the bases designated by making the neces- sary adjustments in his accounts. It has been held that having elected to report on the basis of completed work, amended returns \\ill not be accepted on another basis. A change of basis was allowed, however, as to subsequent years. For Treasury ruling, see C. B. 4, page 86; O. D.933. A foreign corporation having a long-term contract from which it had no net income from the United States but re- ceiving gross income therefrom in 1919, was rec^uired to file a return showing ''its election to report any profit derived from the contract in the )-ear in which it would be completed." ( 1-3-36; I. T. 1 1 70.) Contractors should be able to prepare their accounts on the accrual basis. Their dif^culties are by no means insur- mountable. * [Former Procedure] Regulations 33 and T. D. 2161 (February 19, 1915) did not provide for the adjustment of income of any year which had been overstated or understated, by the filing of amended returns for such period, whereas such provision was contained in Reg. 45, Art. 36. FROM BUSINESS 451 Reserves for discounts. — In certain industries, notably tex- tiles and leather, it is a general custom to allow high rates of discount for payment in thirty days. These rates may be as high as 4, 6, 7 or 10 per cent. Manifestly customers cannot afford not to avail themselves of discounts at these high rates; in fact a manufacturer would decline to do business very long with any customer who did not make it a practice to pay such bills within thirty days. When the rate of discount is only i or 2 per cent, the issue is not of very great importance, but when the rates are higher the amount of tax may be materially affected by whether deduction is claimed for the amount of discount actually taken by customers or for the amount of dis- count accrued. The manufacturer recognizes that the face amount of the invoice carrying a high rate of discount should be re- duced by the amount of discount in order that his accounts may reflect true income. This is ordinarily accomplished by establishing a reserve both at the beginning and at the end of the fiscal year to offset the amount of discount included in the accounts receivable. A manufacturer who determines his income on the basis of discounts actually taken without al- lowance for the increase or decrease in the discounts on out- standing accounts receivable is misleading himself. The amount reserved at the end of a taxable year for dis- counts which it is expected will be deducted by customers is, in effect, regarded by the Treasury as an allowable deduction. Ruling. A corporation keeping its accounts on an accrual basis will not be permitted to deduct from gross income a sum in anticipa- tion of the amount the corporation may be required to allow as cash discount on accounts due and payable in the succeeding year. But any amounts so allowed in the succeeding year before the return is filed may be deducted from gross sales for the previous taxable year. (C. B. i, page 221 ; O. D. 146.) The following regulation, providing for the determination of deductions for bad debts, confirms the procedure suggested, and in effect permits the setting aside of the discount which is expected to be allowed on each sale. 452 INCOME Regulation If a taxpayer computes his income upon the basis of valuing his notes or accounts receivable at their fair market value when received, which may be less than their face value, the amount deductible for bad debts in any case is limited to such original valuation. (Art. 151.) In a ruling on the valuation of goods on hand, the Treas- ury has held that "taxpayers who as a matter of settled prac- tice do not deduct cash discounts from purchases" may not deduct "the average amount of discount received."^" It may be inferred, however, that if the taxpayer adopts the practice of deducting cash discounts from purchases, and adheres to it, the deduction will be allowed. Inventories When a concern maintains a stock of any kind of prop- erty which it periodically renews as it exhausts it, the proper procedure in order to determine profit or loss is to inventory the stock. Regarding inventories the law provides : Law. Section 203. That whenever in the opinion of the Com- missioner the use of inventories is necessary in order clearly to deter- mine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income. The 19 18 law for the first time gave the Commissioner specific authority to require inventories, although they have as a matter of fact been used under regulations of the Treas- ury ever since the passage of the 1909 law.^^ '"C. B. I, page 56; O. D. 326. " [Former Procedure] Even under the regulations issued to con- trol the procedure under the 1913 law and in spite of the doubtful authority in the law for the use of the accrual method, the Treasury specified that inventories should be used in certain cases. Regulation. "In order that certain classes of corporations ma^ arrive at their correct income, it is necessary that an inventory, or its equivalent, of materials, supplies and merchandise on hand for use or sale at the close of each calendar (or fiscal) year shall be made in order to determine the gross income or to determine the expense of operation. FROM BUSINESS 453 Regulation. In order to reflect the net income correctly, in- ventories at the beginning and end of each year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing- factor (Art. 1581.) Estimated inventories are not permitted. — Ruling. A taxpayer who for many years has elected to take inventory only every two years, and used an estimated inventory in the return for the intermediate year, making any necessary adjust- ments in the return for the following year when an actual inventory was taken, may not apportion his total earnings for the two years 1917 and 1918 equally between such years for income tax purposes. (C. B. I, page 62; O. D. 133.) It would seem, however, that if an estimated inventory which can be verified by the "gross profit" test has been used in former years, and there is no material fluctuation in the rate of gross profit to the date when an actual physical inventory is taken, such estimate must be acceptable. Inventory must be taken as of one fixed date for entire business. — Ruling. Taxpayers will not be permitted to adopt one period for inventorying and closing their books applicable to one part of their business and a different period applicable to another part thereof. (C. B. I, page 62; O. D. 289.) Inventories in the case of amended returns. — Ruling. Where amended returns are filed it is not permissible to value the inventories in the amended returns on a basis different from that employed in the original returns, unless the audit of the returns in this office reveals the necessity for employing a different basis. (B. 50-21-1970; O. D. 1 132.) "A physical inventory is at all times preferred, but where a phys- ical inventory is impossible and an equivalent inventory is equally accurate, the latter will be acceptable. "An equivalent inventory is an inventory of materials, supplies an-d merchandise on hand taken from the books of the corporation." (Art. 161, Reg. 33, January 5, 1914.) Regulations 33, 1918, article 120, contained this direction regard- ing inventories: "and they must be taken where the business con- sists of buying and selling commercial commodities." 454 INCOME If inventories have been taken on any basis other than that of "cost" or "cost or market, whichever is lower," amended returns may be filed and either one of the two bases mentioned above may be used. In a specific case in which revenue agents at first refused to recognize change from "cost" basis to "cost or market, whichever is lower," they assented when an analysis of the method originally used by the taxpayer showed that the basis was not strictly one of "cost." What inventory includes/- — Regulation The inventory should include raw materials and supplies on hand that have been acquired for sale, consumption, or use in productive processes, together with all finished or partly finished goo^s (Art. 1581.) The regulation refers to goods "on hand" which is synony- mous with a physical inventory. Physical inventories or their equivalent are absolutely necessary in every concern handling materials or goods; but recognized accounting prin- ciples do not require that a physical inventory be taken of everything on hand on a specific date. If a book inventory is trustworthy and the entire stock is actually verified in whole or in part at various times during the year, taxpayers need have no hesitancy in stating that article 1581 has been complied with. The Treasury has ruled that advances to a foreign cor- poration by an American firm may not be inventoried, even though a considerable decline in the exchange rate has oc- curred. Ruling. In taking inventory for the purpose of determining taxable net income in accordance with article 1581 of Regulations 45, it is not permissible to include claims which the taxpayer may have against other persons and which have depreciated in value on ac- count of a decline in exchange rates or for any other reason. (C. B. 2, page 50; O. D. 541.) In view of the tremendous decline in the principal foreign exchanges, any conservative balance sheet would show such '' See page 458, "Goods purchased but not delivered." FROM BUSINESS 455 assets ''inventoried" at the current rate of exchange/^ Strictly speaking, the word "inventory" does not include accounts receivable, but a fall in exchange rates is equivalent to a fall in the market value of goods. The accrued loss should be claimed. Under the 1921 law it can be included in the reserve for bad debts. Goods of a certain value have been exchanged for other property, viz., a chose in action. When valued at the equivalent of cash the chose in action is worth less than the sales value of the goods. True net income cannot be deter- mined unless the resulting loss is taken into account. Bailments — when included in inventory. — In some branches of business it is customary to send material to other concerns for certain processing, for instance, bleaching or dye- ing. At the date of the inventory such items are included in the inventory if they are to be returned in kind; but some firms have varying arrangements for the return of the "prod- ucts of the property," such as flour for wheat. In such cases the Treasury holds that this exchange amounts to a sale, and the goods returnable under such arrangements cannot be in- cluded in the inventory. Ruling. The delivery of copper bullion to a smelting and re- fining company where it is mixed with other bullion and concentrates of different metallic contents under a contract by which the smelting and refining company is to return the equivalent of the metallic con- tents of such ore previously determined by assay, less commissions and other allowable charges, constitutes a sale and not a bailment. Only so much of the metals as had been redelivered by the refining company at the close of the taxable year belonged to and should have been included in the inventory of the taxpayer as of that date. (C. B. 2, page 45; S. 1373.) In the detailed opinion of the solicitor the general rule is stated. But the rule is well settled that when, by the terms of the contract under which property is delivered by an owner to another, the latter is under no obligation to return the specific property either in its identical form or in some other form in which its identity may be "Sec Chapter Xlll. 456 INCOME traced, but is authorized to substitute something else in its place, either money or some other equivalent, the transaction is not a bail- ment, but is a sale or exchange. {Austin v. Seligman, i8 Fed., 519, 520.) The effect of this ruling is to permit concerns to anticipate the profit or loss upon products which have been converted but not dehvered to the actual customers. It would apply only to concerns which adopt such practice as a settled policy. The refined copper returnable to the M Company on December 31, 1917, and December 31, 1918, should, in each instance, have been set up in an account receivable, and if returns were made on an accrual basis, should have been so returned. There is this difference, however, between such an account and an ordinary account receivable, namely, that it is an account receivable in metal and not in money. Under Treasury Decision 2609 and article 1582 of Regulation 45 the copper actually returned to the corporation prior to the dates stated should have been included in the respective inventories as of those dates at cost, or cost or market, whichever was lower, and it would seem clear that the copper receivable could not have had a different value for the purpose of inventory than that which the copper, if actually received, would have had. For the purpose of determining the value of such account, therefore, the copper receivable should be priced at cost, or cost or market, whichever was lower.^* The Treasury in the foregoing case has departed from its usual position and has required receivables to be inventoried as if no sale had been made. General basis for valuation of inventories.^^ — Law. Section 202. (a) That the basis for ascertaining the gain derived or loss sustained from a sale or other disposition of property, • "Art. 1582 permits the inventory, under certain conditions, to be taken at less than cost or market. See page 458. " [Former Procedure] Cost price was prescribed by the directions printed on the corporation return No. 1031, as revised October, 1916. This is the statement which appeared: "In case the annual gain or loss is determined by inventory, mer- chandise must be inventoried at the cost price, as any loss in salable value will ultimately be reflected in the sales during the year when the goods are disposed of." This direction was ignored by those who desired to have their ac- counts reflect their actual financial condition. The general Treasury FROM BUSINESS 457 real, personal, or mixed, acquired after February 28, 1913, shall be the cost of such property; except that — (i) In the case of such property, which should be included in the inventory, the basis shall be the last inventory value thereof; .... Regulation. The Act provides two tests to which each inven- tory must conform: (i) It must conform as nearly as may be to the best accounting practice in the trade or business, and (2) it must clearly reflect the income. It follows, therefore, that inventory rules can not be uniform but must give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business. In order to clearly reflect income, the inventory practice of a taxpayer should be consistent from year to year, and greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation so long as the method or basis used is substantially in accord with these regulations. An inventory that can be used under the best accounting practice in a balance sheet showing the financial position of the taxpayer can, as a general rule, be regarded as clearly reflecting his income. The basis of valuation most commonly used by business con- cerns and which meets the requirements of the Revenue Act is (a) cost or (b) cost or market, whichever is lower In respect to normal goods whichever basis (a) or (b) is adopted must be applied with reasonable consistency to the entire inventory. Taxpayers were given an option to adopt the basis of either (o) cost or (b) cost or market, whichever is lower, for their 1920 inven- decision dealing with inveiiitories in force at the time of the passage of the 1918 law was as follows: Regulation, "i. For the purposes of income and excess profits tax return, inventories of merchandise, etc., and securities, will be subject to the following rules: "A. Inventories of supplies, raw materials, work in process of production and unsold merchandise must be taken either (a) at cost, or (b) at cost or market price whichever is lower, provided that the method adopted must be adhered to in subsequent years unless an- other be authorized by the Commissioner of Internal Revenue. "B. A dealer in securities who in his books of account regularly inventoried unsold securities on hand either (a) at cost, or {b) at cost or market price whichever is lower, may, for the purposes of in- come and excess profits taxes, make his return upon the basis upon which his accounts are kept; provided that a description of the method employed shall be included in. or attached to the return, that all the securities must be inventoried by the same method, and that that method must be adhered to in subsequent years unless an- other be authorized by the Commissioner of Internal Revenue. "C. Gain or loss resulting from the sale or disposition of assets inventoried as above must be computed at the difference between the inventory value and the price or value at which sold or disposed of. "2. In all other cases inventories must be taken at cost or at value as of March i, 1913, . . . ." (T. D. 2609, December 19, 1917.) 458 INCOME tories, and the basis adopted for that year is controlling and a change can now be made only after permission is secured from the Commis- sioner. Goods taken in the inventory which have been so inter- mingled that they can not be identified with specific invoices will be deemed to be either (o) the goods most recently purchased or pro- duced, and the cost thereof will be the actual cost of the goods pur- chased or produced during the period in which the quantity of goods in the inventory has been acquired, or (b) where the taxpayer main- tains book inventories in accordance with sound accounting sys- tem in which the respective inventory accounts are charged with the actual cost of the goods purchased or produced and credited with the value of goods used, transferred, or sold, calculated upon the basis of the actual cost of the goods acquired during the taxable year (including the inventory at the beginning of the year) the net value as shown by such inventory accounts will be deemed to be the cost of the goods on hand. The balances shown by such book inventories should be verified by physical inventories at reasonable intervals and adjusted to conform therewith. Inventories should be recorded in a legible maner, properly com- puted and summarized, and should be preserved as a part of the accounting record of the taxpayer. The inventories of taxpayers on whatever basis taken will be subject to investigation by the Com- missioner, and the taxpayer must satisfy the Commissioner of the correctness of the prices adopted. The following methods, among others, are sometimes used in tak- ing or valuing inventories, but are not in accord with these regula- tions, viz. : (a) Deducting from the inventory a reserve for price changes, or an estimated depreciation in the value thereof. (b) Taking work in process, or other parts of the inventory, at a nominal price or at less than its proper value. (c) Omitting portions of the stock on hand. (d) Using a constant price or nominal value for a so-called nor- mal quantity of materials or goods in stock. (e) Including stock in transit, either shipped to or from the tajt- payer the title of which is not vested in the taxpayer. (Art. 1582.) The foregoing regulation is an admirable exposition of good accounting practice and is a vast improvement over some of the former regulations dealing with inventories. It will be found that balance sheets properly prepared reflect good ac- counting practice in the taxpayers' trade or business. The law gives the Commissioner wide discretion in the matter of inventories and it is to be hoped that many of the irritating FROM BUSINESS 459 differences of opinion which grew out of former regulations will disappear. The five methods which are specifically disapproved are in themselves technical departures from good accounting prac- tice. In practice the necessary writing down of inventory values to meet actual market conditions, adhering strictly to the new regulations, will in many cases produce the same net result as if one or more of the methods disapproved had been used. Early in 1920, the Treasury held: Ruling If inventories have been taken in the past on the basis of cost and the request is now made to change to "cost or market, whichever is lower," the reasons for the request should be carefully scrutinized and the request refused if it appears that the principal reason therefor is to reduce the tax payable for 1919 (C. B. 2, page 54; A. R. M. 38.) Later, but prior to T. D. 3108,^'^ this position was reconsid- ered on the ground that in "many instances the taxpayer has had no real election, but has been forced to take his inventory on either basis at cost, since cost was lower than market " Ruling The Committee therefore recommends that Memo- randum No. 38 be modified to the extent that where it can be shown that market at the close of 1918 and 1919 was above cost the taxpayer may now elect to take his inventory upon a cost or market basis, whichever is lower, provided that such practice is consistently adhered to in the future, but that the memorandum in question stand so far as it applies to those cases where there was an opportunity to take inventories at a figure lower than cost because market was lower than cost at the close of 1918 or 1919, and consequently there was a real election to continue upon a cost basis. (Ruling 13-20-804, modified.) .... (C. B. 3, pages 65, 66; A. R. M. 85.) "Cost or market price" is not illegal. — The regulations quoted above reiterate and amplify the principles originally laid down in T. D. 2609, the legality of which was questioned; but the Attorney General, to whom the question was referred, "ad- ' December, 1920. 46o INCOME vised upon the basis of a decision of the Supreme Court/^ that the methods of taking inventories authorized by T. D. 2609 are ])crmissible."^^ Inventories at cost. — Regulation. Cost means : (i) In the case of merchandise on hand at the beginning of the taxable year, the inventory price of such goods. (2) In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, pro- vided a consistent course is followed. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods. (3) In the case of merchandise produced by the taxpayer since the beginning of the taxable year (a) the cost of raw materials and supplies entering into or consumed in connection with the product, {b) expenditures for direct labor, (c) indirect expenses incident to and necessary for the production of the particular article, including in such indirect expenses a reasonable proportion of management ex- penses, but not including any cost of selling or return on capital, whether by way of interest or profit. (4) In any industry in which the usual rules for computation of cost of production are inapplicable, costs may be approximated upon such basis as may be reasonable and in conformity with established trade practice in the particular industry (Art. 1583.) Purchase discounts actually earned are treated by some as a financial gain and by others as a reduction of cost. Rulings. Taxpayers who as a matter of settled practice do not deduct cash discounts from purchases, but who take the merchandise purchased into their inventories at invoice price (less trade or other discounts other than strictly cash discounts), carrying the discounts in a discount account, may not, in valuing their closing inventories for income tax purposes, deduct from the invoice price of the mer- chandise on hand at the close of the taxable year the average amount of cash discount received on such merchandise; neither may the amount of cash discount earned, to be reported as income, be de- creased by an amount representing the estimated cash discount re- ceived on merchandise on hand at the close of the year. (C. B. i, page 56; O. D. 326.) "Doyle V. Mitchell Brothers, 247 U. S. 179, 38 S. Ct. 467, 62 L. Ed. 1054. "31 Op. Att. Gen. — ; T. D. 2744, July 3, 1918. See page 482. FROM BUSINESS 461 Held, tliat a wholesale liquor dealer who, for years prior to 1918, exercised the option of including excise taxes in cost of mer- chandise in calculating inventory may not amend such inventory and treat such taxes as business expenses for 1918. (C. B. 4, page 41; A. R. M. 121.) Allocated cost method permitted. — Regulation. A taxpayer engaged in mining or manufacturing who by a single process or uniform series of processes derives a product of two or more kinds, sizes, or grades, the unit cost of which is substantially alike, and who in conformity to a recognized trade practice allocates an amount of cost to each kind, size, or grade of product which in the aggregate will absorb the total cost of production, may use such allocated cost as a basis for pricing inventories, provided such allocation bears a reasonable relation to the respective selling values of the different kinds of products. (Art. 1587.) The foregoing regulation is in accord with the law which permits any inventory method which accords with good ac- counting practice. Special procedure has been prescribed in the cases of the tobacco and lumber industries and may be extended to any other industry in which conditions justify a departure from the general rule. Average cost method permitted — tobacco industry. — Ruling Tobacco companies taking inventory on the monthly average cost method, no method more nearly approaching theoretical accuracy being practically possible, may continue to use such method in reporting for income tax. The method followed, as understood by the Committee, is an aver- age cost method and not an average cost or market method. Accord- ingly, if the market should be below the average cost at the close of a given year, the average cost shall be the basis of valuation and not the lower market price. Companies adopting average-cost methods of inventorying for income-tax purposes should be required to adhere to that method in future years. (C. B. 2, page 50; A. R. R. 18.) If average cost represents as nearly as can be determined actual cost, and market prices are lower at the end of any year, taxpayers cannot be denied the right to value inventories at market prices. 462 INCOME Average market price not permitted/" — Ruling. A company taking its inventory upon the basis of the average of the market prices prevailing over a period of years does not conform to the method of computing inventories in accordance with articles 1 581-1585, Regulations 45, and it should therefore be required to file amended returns. (C. B. i, page 55; T. B. M. 31.) Average cost method — lumber manufacturers. — The following illustration shows the importance of the method referred to in article 1587.-° The point is that each grade is assigned a cost relative to all other grades. If most of the high grade is sold, the low grade remaining in the in- ventory will not be given an average cost value inflated in effect, by taking in high grade not on hand. The computation is based on the following : "For discussion of farm price method, see Chapter XXXIX. ™ "Lumber Costs," by Edmund M. Meyer, Journal of Accountancy," August, 1921. Regulation, "i. Because of the impracticability of determining accu- rately the costs properly assignable to each species, grade, and dimension of lumber making up the product of the mill, lumber manufacturers may use as a basis for pricing inventories the average cost to the manufacturer of producing the inventoried products during the taxable year for which the return of net income is made. "2. If the quantity of lumber on hand at the time of inventory is greater than the total quantity of lumber produced during the current tax- able year, it is evident that the excess stock has been carried over from the previous year's production, and such excess shall be valued at the average cost of production for the preceding taxable year. "3. A taxpayer who regularly allocates in his books of account such average cost to the different kinds and grades of lumber in proportion to the selling value of such kinds and grades may. subject in each case to the approval of the commissioner upon audit of the return, make his returns of net income on that basis. "4. The term lumber manufacturer as used in this article means a per- son who manufactures lumber from logs, as distinguished from a remanu- facturer of lumber." (Reg. 45, Art. 1587.) FROM BUSINESS 463 •Si'O 1^ r 00 en ^ , 00 o\ »> ^ U („ \6 ctS >< w w-im' rf ui lu ,'5 "^ i^ <«• <*9- •0 ^ VO tT wcq On a IT) CO >0 ^ -M ni I^ Tf 1^ 0\ in o) 00 0) CT- ^bL rC oioo' d; IT) M j^ «/i- 4«- ^N^o r^ C '-' 0) p- 10 (X) oi d\ u , (N vo OJMH « a* < u >< « 00 -t rf VO j_. U -^COOO Pk <0 T3 ro 01^ (^ 5^ fe 0\\0 VO '^ 1-. CO M ro -^ 1— 1 & fO d\ CO U P Q « tn O) '^ K^ --' r=: — . J5 13 — ■^ (J -- n> 01 ^ ^ tr. *-< U fc P Tt TT O 01 " r^ 1-1 o o\ o\ ^ O m oj m m ro ro i-i 0\^0 ■^ fO 10 w^ t-H^ CM Tf O o in o i-;\o^oq_vq_ j>. ro w lovd" "-roo" oi > t^ r^ ro in i-i CO 04 Ch covo O'l o • c c c c r^llSESES •- 2::^ 00000 -? "H '-' 0) CO -^ m ,- c3 ■ . . 5 d d d d d o p^ ^ -o 00 p On 10 ^ W- 'n i_i & Tl- (U rN ID m- rt ^ 0/1 ■5 CO ^^ Ji* T/D rt •-' I-. X! 1» 13 .^ 00 "i: oj • -4 t- ol aj rO . ■>. K c« n ^ 01 fA^ > u J2 vr> 'n cyj 00 l-H w- ^ 14-1 Pi < 464 INCOME ~ Inventories at market. — Regulation.-^ Under ordinary circumstances and for normal goods in an inventory, "market" means the current bid price prevail- ing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer, and is applicable in the cases (a) of goods purchased and on hand, and (b) of basic elements of cost (materials, labor, and burden) in goods in process of manufacture and in finished goods on hand; exclusive, however, of goods on hand or in process of manufacture for delivery upon firm sales contracts (i.e., those not legally subject for cancellation by either party) at fixed prices entered into before the date of the in- ventory, which goods must be inventoried at cost. Where no open market exists or where quotations are nominal, due to stagnant mar- ket conditions, the taxpayer must use such evidence of a fair mar- ket price at the date or dates nearest the inventory as may be avail- able, such as specific purchases or sales by the taxpayer or others in reasonable volume and made in good faith, or compensation paid for cancellation of contracts for purchase commitments. Where the taxpayer in the regular course of business has offered for sale such merchandise at prices lower than the current price as above defined, the inventory may be valued at such prices less proper allowance for selling expense, and the correctness of such prices will be de- termined by reference to the actual sales of the taxpayer for a rea- sonable period before and after the date of the inventory. Prices which vary materially from the actual prices so ascertained will not be accepted as reflecting the market. (Art. 1584.) The foregoing regulation accords with good accounting practice. The Treasury now recognizes that the current bid price may not represent what a purchaser might have to pay if he attempted to buy in quantities ; what the taxpayer would prob- ably pay is a much fairer test of the market value than apparent bid prices in abnormal markets such as obtained at the end of 192 1. The foregoing regulations, in recognizing abnormal con- ditions, throw a considerable amount of responsibility on the good judgment and good faith of the taxpayer. Probably the most important factor in fixing market prices " See Chapter XXIX, where claims for shrinkage in inventory losses are discussed. FROM BUSINESS 465 is qtiantity.^^ If the quantity on hand is in excess of the reason- able requirements of the taxpayer, the nominal market price for a small quantity usually is not the market price for larger quantities. In a declining market it is proper to assume that replacement market prices for large quantities are considerably below ruling market prices. ^^ At the end of 1920 many users of steel products had placed large orders for steel. When the general price decline came, the demand for their finished product vanished overnight, particularly in the automobile industry, yet the price of forg- ings and other raw material showed no decline because the steel mills had large accumulated orders on their books. Using the nominal "bid" prices prevailing at the date of the in- ventory would have compelled these manufacturers to pay taxes at the high rate on enormous inventories which they were not able to liquidate for some very considerable time. In connection with an interpretation of the terms (a) cost, and (b) cost or market, whichever is lower, questions have arisen as to whether certain items in an inventory may be priced at cost (which is less than market) and other items of exactly the same kind, which cost more, may be reduced to market. For illustration, certain lots of pig iron may have cost $20 per ton. Other lots may have cost $25 and additional lots may have cost $30. When inventory is taken the market price is $25. Where the lots can be readily identified the first lot should be kept at cost, viz., $20 per ton, the second lot should be kept at market, viz., $25 per ton, and the third lot should be marked down to market, viz., $25 per ton. Article 1582 implies that in the same inventory some items may be taken at cost and some (when the market has dropped) at less than cost. No other method would properly interpret the term "cost or market, whichever is lower," nor conform to good accounting practice. '"See R. H. Montgomery, Auditing, Theory and Practice (1921 edition), page 127. "' See page 468. 466 INCOAIE Ruling. This office acknowledges receipt of your letter of Sep- tember 7, 1921, making inquiry as to whether Article 1582, Regula- tions 45, 1920 edition, provides for a change in the method of apply- ing the basis of cost or market whichever is lower, in valuing an inventory. In reply you are informed that the change of wording in Article 1582, Regulations 45, 1920 edition, is not intended to change the former method of applying the basis of cost or market to each item of the inventory. In employing the basis of cost or market whichever is lower, the lower value of each item listed in the inventory must be placed upon the particular item. You will note that one item may be valued at cost while another may be valued at market. The valua- tion to be placed on the item is determined by the fact that either cost or market value is the lower. (Letter to Prentice-Hall, Inc., signed by E. H. Batson, Deputy Commissioner, dated September 20, 1921.) There seems to have been some confusion in the minds of taxpayers as to the practical appHcation of the "cost or market, whichever is lower'' method. Ordinarily it is not feasible to segregate or identify the various lots which were sold or still remained in stock. To do so involves a minute segregation of accounts, such as is found in a comprehensive cost system. In the ordinary course the stock purchased first must be as- sumed to be the stock sold first, and the stock to be inventoried would be that last purchased. The cost of these last lots is compared with the market price, and the lower of the two is taken. Net selling prices. — A further recognition by the Treas- ury that apparent market prices are often not real, particularly in the case of goods that are shopworn, obsolete, or that have deteriorated from some other cause, is found in the new regu- lation. The author has contended in the past that "for many reasons merchandise may have to be valued below cost ; over- stock; damage or deterioration; changes in styles and shapes; obsolescence — going out of date; sizes and qualities seldom used; broken lots.'""* The new regulations give effect to this contention. '"Income Tax Procedure, 1921, page 349. FROM BUSINESS 467 Regulations Any goods in an inventory which are unsal- able at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes, including second-hand goods taken in exchange, should be valued at bona fide selling prices less cost of selling whether basis (a) or (&) is used, or if such goods consist of raw materials or partly finished goods held for use or consumption, they should be valued upon a reasonable basis, taking into consideration the usability and the condition of the goods, but in no case shall such value be less than the scrap value. Bona fide selling price means actual offerings of goods during a period ending not later than 30 daj^s after inventory date. The burden of proof will rest upon the taxpayer to show that such exceptional goods as are valued upon such selling basis come within the classifications indicated above, and he shall maintain such records of the disposition of the goods as will enable a verification of the inventory to be made (Art. 1582.) The foregoing article assumes that the goods inventoried would not be replaced and that they are worth the gross sales price subsequently realized less expense of selling. It is the most reasonable method of inventorying such goods. It does not, however, give to a new fiscal period any element of profit. If the merchandise is of such a nature that the market price can be obtained, it is more conservative to use market prices than net selling prices."^ Are the inventory regulations in accord with accounting procedure? — The regulations quoted are in accord with sound commercial practice assuming that "market price" will be con- strued to mean a fair and reasonable price. Inventories should be valued at "cost or market, whichever is lower," except when trade conditions or long-continued custom calls for a still lower basis.^'' Apparent market prices may not be true market prices. This is particularly the case in a falling market, but may be equally true when a rising market indicates speculative prices arising out of shortages (which may be only temporary). In such cases, goods pur- "' See page 464. -'Art. 1584. _^es INCOME chased at the speculative prices may at inventory time appear to be worth cost and the apparent market price may be even higher, but a conservative concern would hesitate before rec- ognizing such values as real. Therefore, no matter how^ staple or salable the goods may be, if the market price has declined the inventory should be reduced to correspond. As stated in the new regulations, merchandise may for various reasons have to be inventoried below cost.^^ Portions of inventories usually priced at less than either cost or market. — In some cases it will be necessary to con- tinue to price portions of an inventory at less than either cost or market. Businesses such as those of agricultural imple- ment and automobile manufacturers frequently find that they have on hand large stocks of spare parts which are not worth cost or the nominal market. As a matter of fact, small quantities may be selling freely and at a very high rate of profit. But inventories must not be taken on the supposition that an entire stock is worth as much proportionately as a small part. A hatter has in stock 100 perfectly good hats. He may sell 50 of them at a good profit. If he then takes stock, and, from experience knows that the most the future market will absorb is 40, ordinary business practice requires him to inventory 40 at cost or market, whichever is the lower, or 50 at the same aggregate price, but at a less unit price. This is not a departure from, but is an adherence to, the principle of inventory valuation which conforms "to the best accounting practice." Future demand is one of the controlling factors in the determination of market prices. If on December 31, 1921, it were known that the future demand was decreasing, that factor would have its influence on market prices of that date, but no one would be war- " For full discussion of factors which influence inventory valuations, see Auditing, Theory and Practice (1921 edition), by R. H. Montgomery, pages 117 to 172. FROM BUSINESS 469 ranted in assuming that further declines would take place thereafter unless in preinous years it had been customary to carry stock at less than cost or the market. It is obvious that if such a custom were an old one the government might not lose through its continuance, because a change in policy would result in the adjustment of the returns of previous years, which would in most cases leave the net result for 1921 unchanged. The Treasury, however, has gone on record as being op- posed to the so-called "base stock," "minimum" or " cushion" method. As stated by the Treasury: Ruling. According to the base-stock method of taking inven- tories a manufacturer or dealer values at the same price year after year the minimum quantity of goods which he must have on hand at all times. (C. B. i, page 51 ; T. B. R. 65.) In the detailed opinion it was held that : The base stock method of taking inventories is not warranted by the law or the Regulations. The Treasury's arguments against this method are : 1. The method has not been widely adopted. 2. To sanction its use would be discriminatory. 3. It is not the "accounting practice" followed by a ma- jority of manufacturers. 4. It assigns profits and losses on the minimum inventory to the year in which such inventory is liquidated, by ignoring sales of individual items in the inventory and treating the minimum inventory as a unit. 5. It disregards gains that may be considered quasi- capital gains and are taxable under American (as distinguished from British) income tax laws. 6. In substance, it results in offsetting an inventory gain of one year against an inventory loss of another. Goods purchased but not delivered. — In all cases when goods have been shipped the consignee should consider the 470 INCOME goods as part of his inventory and include the full purchase price among his liabilities. If the market price of the goods at closing time is less than cost the inventory will be reduced. Regulation Only merchandise title to which is vested in the taxpayer should be included in the inventory. Accordingly the seller should include in his inventory goods under contract for sale but not yet segregated and applied to the contract and goods out upon consignment, but should exclude from inventory goods sold, title to which has passed to the purchaser. A purchaser should in- clude in inventory merchandise purchased, title to which has passed to him, although such merchandise is in transit or for other reasons has not been reduced to physical possession, but should not include goods ordered for future delivery transfer of title to which has not yet been effected. (Art. 1581.) The proper taking of **in transit" and other parts of the inventory is facilitated by planning ahead of the inventory date. Careful segregation and compilation of information on the following points will avoid neglect of matters which are often overlooked: 1. Invoices received for goods not yet received. 2. Goods received but no invoices. 3. Goods returned by customers but credit not yet passed. 4. Goods returned and billed back by customers but not yet received. 5. Goods on consignment. 6. Goods at other plants for processing or which are held on order. 7. Goods sold awaiting shipment but not yet billed. When contracts have been entered into for future delivery, and such contracts are not subject to cancellation, it may be important to consider whether or not any loss has arisen in respect thereto. If the purchases were set aside by the seller and charged on the seller's books to the purchaser, the latter should also reflect the transaction in his books. Other- wise the profit to the seller would have appeared in his tax returns for 192 1, but the shrinkage in value, if any, to the FROM BUSINESS 471 purchaser would not have appeared in the latter's returns until after 1921. If the goods are not dealt with as sales by the seller, the purchaser can hardly expect to take up any loss on his books. It may be urged that if a purchaser contracts in November, 1921, for cotton goods to be delivered in January, 1922, and at December 31, 1921, the market price is 10 cents a yard less than the purchase price, he should be able to deduct the 10 cents a yard loss in his 192 1 returns as reflecting the market price on December 31, 192 1. The answer is that goods not received may never be received; that before the goods are received the market may again advance, and that no loss has been realized. On the other hand, a true balance sheet of the purchaser would show a reserve for the loss accrued to December 31."* If the loss must be set up to reflect actual conditions, there must be some merit in the contention that true net income for the year 1921 cannot be determined unless and until what has taken place in 1921 is reflected in the tax returns. When there is a considerable shrinkage in prices and it is desired to reflect in the current year the accrued losses on forward orders, it is legal and proper, prior to the closing date, to cancel orders, pay the loss due to cancellation, and reinstate the orders at the current market prices. In some trades it is customary to place orders for future delivery on the books. In such cases the inventory-at-market "" "The balance sheet, for instance, might show stock on hand large enough or too large for the normal requirements of the business. Unful- filled contracts outstanding at the date of the balance sheet which call for the receipt of additional stock, which may not be readily salable, will result in an actual liability, whereas the offset, the stock to arrive, will be an asset of doubtful value. "In every audit, therefore, the auditor should call for copies of all orders for future delivery. If such orders call for stock in excess of the current and reasonable prospective demand, mention thereof should be made in the balance sheet. The details reported should depend on the circum- stances of each particular case." [Auditing, Theory and Practice (3rd edi- tion), by R. H. Montgomery, page 260.] 472 INCOME basis would enable credit to be taken for the loss in 1921, If such a custom has been followed for a period of years or is general in a trade, it may be continued. Otherwise the prac- tice should not be initiated as at December 31, 1921. Tax- payers are on notice, however, that the Treasury has ruled that goods to which title has not passed cannot be inventoried. A question arose from a claim for loss under section 204,^^ due to decline in value of the inventory, as to w^hether or not the material covered by contracts for future delivery could properly be included in the inventory.^" Ruling On September 30, 1918, none of the X material on account of which losses were subsequently sustained had been delivered to the company, and hence none was included in the inven- tory on which the assessment for 1918 was made. The company did not at that time own this X material, and presumably much of it had not even been produced. The company did not own it but only had a contract for its purchase. It could not, therefore, have properly been included in an inventory of the company's property as of that date (C. B. 3, page 88; T. D. 3044.) Futures.^^ — During the year 1921, the Treasury removed its inhibition against the inclusion in the inventory of such futures as constitute "hedges" against actual spot or cash transactions. Prior to the issue of A. R. M. 135, the Treas- ury had consistently refused to permit the inclusion of "hedges" in the inventories of dealers in cotton, grain and similar commodities. The author has contended for many years that such disregard for recognized accounting practice is not in accordance with the law. Ruling. The leading cotton and grain exchanges of the country and some of the leading individual dealers in these commodities ap- peared by counsel or in person before the Internal Revenue Bureau to urge that "hedge" transactions in "futures" shall be accorded recogni- tion in the taxpayer's balance sheet at the close of each taxable year "' 1918 law. " See Chapter XXIX. " [Former Procedure] Prior to 1921 the Treasury held that "trans- actions in 'futures' unclosed at the end of the taxable year form no integral part of the cost of the commodity included in the taxpayer's inventory." (C. B. 3, page 66; A. R. \[. 100.) FROM BUSINESS 473 and shall be thus taken into consideration in computing taxable in- come. Such consideration h^s been heretofore denied by the Internal Revenue Bureau to taxpayers engaged in these lines of business for the reason that transactions in "futures" have been held not to be "closed transactions" within the meaning of the regulations, where such transactions, entered into in one taxable year, had been carried forward into the year following. In thus holding the Bureau appears to have relied very largely upon its previous decision [A. R. M. 100, Dec. 1920 Cum. Bull. p. 661 in which decision there was considered nothing more than inventories of cotton and grain merchants, no other aspects of the case being at that time under consideration, and what was said referred only to the valuation of such inventories and to the proposal to determine profit or loss by treating such transactions either as additions to or de- ductions from the taxpayers' inventories. At the hearing the Bureau was deeply impressed with the force lit the arguments presented by counsel and with the seriousness of the situation that would unquestionably develop in the cotton and grain trades should the present practice in denying to taxpayers the right of including in their balance sheets their liabilities or assets under these "hedges," be confirmed and established as the recognized practice of the Bureau. From its previous opinion the Bureau now finds no cause to deviate and holds it to be self-evident without reference to the legal question involved, that any proposition to add to an inventory the value of a commodity, the title to which is not at the time actually vested in the taxpayer or to deduct from an inventory the value of a commodity, the title to which may or may not be vested in the taxpayer, but which is to be delivered only at some time in the future, cannot by any correct system of reasoning or logic be maintained. The case now presented for consideration involves quite a differ- ent principle and the proposition is not identical with, nor in fact in any degree parallel to the previous decision of the Bureau. In the present decision there is involved firm contracts entered into in good faith for a consideration and enforceable under the law, the •value of which (and consequently the profit or loss resulting there- from) can be absolutely fixed and determined at any minute of any business day. To deny to these contracts at any time during their life Governmental recognition as actual liabilities or actual assets (as the case may be) would be futile, nor could such a contention be sustained in the courts where recognition has heretofore been fully accorded them. The Bureau accordingly holds that dealers in cotton and grain, and in such other commodities as are dealt in in a similar manner, may for the purpose of determining taxable income, incorporate in their balance sheets at the close of any taxable year, such open "future" 474 INCOME contracts to which they arc parties as are "hedges" against actual "spot" or cash transactions: provided, that no purely speculative trans- actions in "futures" not off-set by actual "spot" or cash transactions, may be so included or taken into the taxpayer's account in any manner until such transactions are actually closed by liquidation; and pro- vidcd further, that the values of the commodity covered by such open "future" contracts shall not be added to nor deducted from the in- ventory of the taxpayer. ( Special summary of Memorandum No. 135, May 23, 1921, prepared by the Committee on Appeals and Re- view, for release July 15, I92i.)32 It has been held that the ruHng made in A. R. M. 135 is appHcable to all dealers in commodities "as are dealt in in a manner similar to that outlined in such ruling," and particu- larly to millers who hedge future contracts for wheat against unfilled flour sales. ^" Obsolete stock may be written down or off. — The prin- ciple of cost or market, wdien applied to inventory items which have become obsolete or nearly so, is feasible. If there were a reasonable demand for the items they would not be classed as obsolete. If the demand has definitely fallen off or has ceased, the market value has correspondingly de- clined and such stock may, in accordance with the principle, be written down to its market value or marked off entirely if it has no market value. In many lines of industry, notably the automobile indus- try, new designs have rendered obsolete much of the finished goods carried in the inventory. When this is known before the end of the year, the obsolescence is certainly definite and should be reflected in the inventory values.^* Income from sales of small quantities which form part of a large lot. — When a stock of materials or goods consists of a number of units it is sometimes difficult to determine the measure of profit or loss which should be assigned to the dis- "'For complete ruling, including extracts from briefs filed, see B. 31-21- 1750; A. R. M. 135. '' 1-3-30; J. T. 1 166. "' For discussion of "marked selling price" valuation applicable to obso- lete stock, see page 468. FROM BUSINESS 475 position of a part of the stock pending the sale of the entire lot. In theory the aggregate of the cost or inventory price can be distributed to each unit and thus the profit or loss on each sale would be easily determined, but in practice it is well known that it may be easy to dispose of part of a large stock whereas the remainder may never be sold. It is claimed by some that the entire proceeds of first sales should be credited against the entire lot and that no profit should be taken until the purchase or inventory price is ex- ceeded or it is known that it will be exceeded. In other cases profit or loss is shown in each item as it is sold. This is one of the questions which must be settled accord- ing to good accounting practice. It requires that where unusual conditions obtain, the item should receive special treatment. This, in turn, must be controlled by the good judgment and good faith of those in charge of the business. The foregoing reasoning is applied to stocks of liquor, since the difficulty of disposing of them has recently increased. The Treasury seems to feel, however, that such stocks have a "market value." Ruling The prohibition law, as understood by the com- mittee, permits the use of distilled liquors and wines in the manu- facture of medicines and in the filling of prescriptions for medicinal use. The provision for these legitimate demands, therefore, gives to the goods available to supply them some value, and it is presumed that there can be readily established the market value for the supply- ing of such demands. It is true that the demand is not sufficient to create a market for all the goods held in stock, and that an attempt to sell for this purpose at one time very considerable part of the stocks on hand would doubtless flood the market and break it down to a very low figure. In a measure, however, this was true before the enactment of prohibition laws, as the supply of liquor on hand was always in excess of any immediate demand therefor (C. B. 2, page 53; A. R. M. 33.) Inventories by retail dry goods and other retail dealers. — Among the specific classes of taxpayers to whom special meth- ods of inventorying have been allowed are "retail merchants." 476 INCOME It is noteworthy that the Treasury is recognizing trade prac- tices in various trades and that where they are long established taxpayers are allowed to adhere to them. Regulation. Retail merchants who employ what is known as the "retail method" of pricing inventories may make their returns upon that basis, provided that the use of such method is designated upon the return, that accurate accounts are kept, and that such method is consistently adhered to unless a change is authorized by the commissioner. Under this method the goods in the inventory are ordinarily priced at the selling prices, and the total retail value of the goods in each department or of each class of goods is reduced to approximate cost by deducting the percentage which represents the difference between the retail selling value and the purchase price. This percentage is determined by departments of a store or by classes of goods, and should represent as accurately as may be the amounts added to the. cost prices of the goods to cover selling and other ex- penses of doing business and for the margin of profit. In computing the percentage above mentioned, proper adjustment should be made for all mark-ups and mark-downs. A taxpayer maintaining more than one department in his store or dealing in classes of goods carrying different percentages of gross profit should not use a percentage of profit based upon an average of his entire business, but should compute and use in valuing his in- ventory the proper percentages for the respective departments or classes of goods. (Art. 1588.) While this method in the article quoted is limited to "retail merchants," it w'ill be noted from the following letter of the Commissioner that the method will be permitted to those stores which follow essentially the practices of such retail merchants as retail dry goods stores. Ruling. Reference is made to your letter of January 13, 1921, relative to T. D. 3058, issued August 16, 1920 (Article 1588 of Reg- ulations 45. — Inventories of retail dry goods dealers) asking for further details as to prope'r procedure within the meaning of the regulations. Your questions are taken up and answered in the order in which you presented them. 1. The use of the retail method is by the decision confined to retail dry goods dealers. Other organizations and individual stores who conduct retail establishments and follow essentially the retail method of dry goods stores, may be allowed this method upon application to the Bureau of Internal Revenue. 2. The designation of the method as a "cost" method. It was not FROM BUSINESS 477 intended that the apparent limitation should be inflexible. It is rec- ognized that on a constant or rising market the retail method is ap- proximately a "cost" basis, and that on a falling market it results in a reduction to "cost or market whichever is lower." 3. Preserving records. There must be a permanent form of re- cording by departments, purchases showing the firm name, date of invoice, invoice cost and retail sales, stock, etc. It must be borne in mind that under no circumstances will arbitrary standard percentages of purchase mark-up be allowed in the determination of the "cost" or "cost or market" value of retail inventories; but that such per- centages must be the purchase mark-up percentage disclosed by the department records of the fiscal period for which the return is made. 4. Opening inventory. In Section "A" the words "the value of all merchandise as received" is inclusive of inventory at the beginning of the period. The purchase mark-up must be computed as follows: Cost: Inventory at cost at beginning: purchases at cost; transportation. Retail: Inventory at sales price: purchases at sales price. 5. Appreciation in retail values of goods on hand. Within the meaning of the Article, it is proper to include as a part of "original retail sales price" the actual increase in the original sales price which has been brought about by market conditions or by incorrect pricing when the goods were put into stock. For the convenience of the ex- amining officer, a special form should be provided; complete informa- tion by items of the increase from the original retail must be shown ; reference, if possible, must be made to the original invoice; entry and the reason for the increase freely explained. All such amended retail increases must be approved by the buyer of the department and mer- chandise manager or other responsible official and they should be sO' filed that quick reference to them may be made. Entry of such in- creased retail prices properly belongs in department purchase books, al- though it may be set up as a separate item in the accumulated records of the department. The same forms that are used to record such price increases should not be used for mark-downs and in no instances will a store be allowed to include as retail increases a mark-up which has been taken as a correction or cancellation of a mark-down ; such mark-up must be regarded and treated in all cases as opposite to mark-down. 6. Proper vmrk-dozvns substantiated by record of facts mill be permitted. The decision is not intended to disturb the procedure in stores which have properly handled mark-downs, but instances where arbitrary reductions from retail values have been made because of the desire to provide for depreciation and obsolescence with no actual offering to the public of the goods on which the mark-downs were claimed, cannot be recognized. Under no circumstances will a store be 478 INCOME allowed to depreciate its stock in any way except by the offering of it to its customers at such reduced prices. The procedure of stores in regard to mark-downs will be deemed proper if in any fiscal year or period of that year the goods so marked down are in proportion to current sales, stock on hand, to mark-downs of preceding months of preceding year, or if evidence can be submitted as to market changes which have forced a reduction in retail prices necessary to bring about a parity with the selling price of the same goods which have been purchased or could be purchased at a reduced cost. In conclusion it should be noted that a store which has employed this retail method in the past, may now specify in the return that such method is used, as a basis of valuing inventories, regardless of the fact that in past years it reported on a "cost'' or "cost or market, whichever is lower" basis. However, the use of the retail method will not be recognized unless it has been correctly followed through- out the entire fiscal or calendar year period for which the return is made. (Letter to the National Retail Dry Goods Association, New York, N. Y., signed by Commissioner Wm. M. Williams, and dated January 21, 192 1.) Market value of goods in process and finished goods. — One of the most difficult problems of manufacturers arises from work in process and finished goods. This question is of major importance in a time of demoral- ized markets, such as have confronted so many industries at the close of 1920 and 192 1. The following comparison illustrates the problem : Finished Goods Replacement Cost, Actual Cost i. e., Actual Market Material $100 $ 50 Labor 200 120 Overhead 200 200 Totals $500 $370 This assumes that material has declined 50 per cent and labor 40 per cent. Overhead may remain at the same figure or be changed. Work in process should be valued by applying the ratios of decline thus obtained to the actual cost of the inventory of goods in process. Different stages of completion will require adjustment. FROM BUSINESS 479 The Treasury permits the foregoing adjustment of mate- rial prices and also permits the replacement basis in labor and expense! items. The physical property which is inventoried is goods in process (or finished goods). If goods and wages have declined, the product of goods and wages declines in value. An inventory is not at "market" unless it is adjusted to what is practically a replacement basis as at the date of the inventory. In addition to the present cost of replacement, considera- tion should be given to the selling prices in effect for such goods, goods in process and finished goods at the present time, which for inventory purposes should be valued at not more than their selling value less shipping or other costs yet to be incurred. The selling price of goods is a measure of the demand for them and a supplemental indication of their present market value, even when market value is considered from a replace- ment rather than from a sales point of view. Goods sold for future delivery. — Article 1584'"' provides that goods sold for delivery at fixed prices already agreed upon and op hand at date of inventory, must be inventoried at cost. If sold at prices which yield a normal profit, the requirement is sound if there is no possibility of cancellation and if the credit of the buyer is beyond c^uestion. When goods for future delivery have been sold at a loss, they should be inventoried at market, as if they were not sold. The following authoritative statement has been made pub- lic by the American Institute of Accountants.^*' The treatment of inventories by companies having contracts for sale of goods at prices yielding a profit above cost was considered. It was agreed that where goods have been bought specifically for such contracts, they should be taken at cost even if that be higher than market, both for general accounting and tax purposes. This should apply only if the contracts are enforceable contracts with responsible '"^ .Sec page 464. '" Special Bulletin No. 7, December, 1920. 48o INCOME people — not in cases where enforcement would involve such risk of a bad debt as to be unwise. It was recognized that the question as to applying goods on hand to such contracts where they were not earmarked was difficult, and the firm (of accountants) should not be disposed to question any reasonable course adopted by any client in this matter. Ruling In the contracts involving the delivery of goods in the future the company at no time makes any particular appropria- tion of any particular goods to fill any particular order or portion thereof until the time specified for the delivery of the goods to the carrier. At the time of entering into the contract, in a majority of the cases the purchaser gives his promissory note in settlement for the goods. The notes do not bear interest until maturity, and gener- ally the due date of the note is fixed at the time of the delivery of the bulk of the order if that time is determinable at the time of enter- ing into the contract. The nature of the goods is such that they deteriorate rapidly, consequently only such goods are manufactured at any particular time as are necessary to fill and complete shipments of orders for delivery at the particular time the goods are manu- factured. Held, that under the provisions of section 213 (a) of the Revenue Act of 1918, the M Company is not required to treat its contracts covering unfilled and undelivered orders for its goods as gross sales for the year in which the order is taken and the contract entered into, but that the sale of the goods can not be properly considered as hav- ing taken place until the goods are delivered to the carrier for ship- ment to the buyer, or in those cases in which the purchaser is to call for the goods at the place of business of the company, until there is a specific identification of the goods manufactured and they are put in a deliverable state. (C. B. 4, page 95; O. D. 826.) Where no specific goods are appropriated to the contract, but dehveries are made from regular stock, such goods should be inventoried on the basis of cost, or cost or market, which- ever is lower, depending on which of these two methods is employed by the taxpayer. Notice to Treasury of method adopted. — When the peculiar conditions of any business make a literal compliance with the regulations difficult or impossible, it is advisable to attach a statement to the return to the effect that inventories were taken at what the taxpayer believed to be market values, but that owing to the difficulty of ascertaining trustworthy mar- FROM BUSINESS 481 ket values the taxpayer reserves the right to amend the return if it subsequently be found that the information was inac- curate. Dealers in securities may use inventory method.^^ — Regulation. A dealer in securities who in his books of account regularly inventories unsold securities on hand either (a) at cost or (b) at cost or market, whichever is lower, or (c) at market value, may make his return upon the basis upon which his accounts are kept; provided that a description of the method employed shall be included in or attached to the return, that all the securities must be inventoried by the same method, and that such method must be ad- hered to in subsequent years, unless another be authorized by the commissioner. For the purpose of this rule a dealer in securities is a merchant of securities, whether an individual, partnership, or corpora- tion, with an established place of business, regularly engaged in the purchase of securities and their resale to customers; that is, one who as a merchant buys securities and sells them to customers, with a view to the gains and profits that may be derived therefrom. If such business is simply a branch of the activities carried on by such person,^^ the securities inventoried as here provided may include only those held for purposes of resale and not for investment. Taxpayers who buy and sell or hold securities for investment or speculation, and not in the course of an established business, and officers of corpora- tions and members of partnerships, who in their individual capacities buy and sell securities, are not dealers in securities within the mean- ing of this rule. A dealer in securities is not entitled to the benefits of section 206^'-* with reference to the gain from the sale of securities. (Art. 1585.) Many "dealers in securities" are partnerships. Securities which are really investments may have been carried in the in- ventory. If it is desired to secure the benefits of section 206 (capital gains), there seems to be no reason why such secur- ities should not be taken out of the inventory and carried as investments, if they are such in fact. Prior to issuance of T. D. 2609 (December 19, 191 7), those '■ [Former Procedure] Dealers in securities were included in the pro- vision entitling taxpayers to adopt "cost or market, wliich is lower" as a basis for 1920 inventories. (C. D. 4, page 52; M. 2703.) ^° Banks and other institutions having established departments for the merchandising of securities. '"Section 206 refers to capital gains. See Chapter XVII. 482 INCOME who dealt in things other than "materials, supplies and mer- chandise" were not permitted by the regulations to calculate their losses or gains by the usual methods, but were required to keep an accurate record of each item (even if these items ran up into the tens of thousands), its cost and the date and its sale and the date (even though many years subsequent). Most taxpayers were unable to comply with these requirements and therefore their modification became necessary. The Treasury announced that the authority for T. D. 2609 and for the gen- eral extension of the inventory method to dealers in securities was an opinion of the Attorney General,*" viz. : Ruling. The Attorney-General has advised upon the basis of a recent decision of the Supreme Court [Doyle v. Mitchell Brothers. decided May 20 last (247 U. S. 179) ] that the methods of taking inventories authorized by T. D. 2609 are permissible. That decision, supplemented by the last paragraph of T. D. 2649 defining "a dealer in securities," therefore continues to stand as a regulation of the Department. (T. D. 2744, July 3, 1918.) T. D. 2649 (January 30, 1918) agrees substantially with article 1585 as regards the definition of a "dealer in securities." Since the case of Doyle r. Mitchcll,^^ relied upon by the At- torney General, arose under the 1909 law, and since all Su- preme Court interpretations of a revenue law^ are retroactive to the date of the law, it follows that dealers in securities have had full power to inventory their securities under all income tax laws since 1909. The privilege, extended to taxpayers by article 1582 (as amended in December. 1920, by T. D. 3108), of changing from the "cost" basis of valuation to "cost or market," is applicable to dealers in securities. *- ^^'ho may or may not use inventories is clearly indicated, in so far ^s the Treasury is concerned, by reference to T. D. 2649, referred to above. "An individual, partnership, or cor- poration, with an established place of business and whose prin- "'31 Op. Alt. Gen. "247 U. S. 179, 38 S. Ct. 467, 62 L. Ed. 1054 *-Q. B. 4, page 52; Mim. 2703. FROM BUSINESS 483 cipal business is the purchase of securities, and their resale to customers," impHes a general definition. For "securities" sub- stitute merchandise, stock-in-trade generally, or any other commodity forming the essential productive factors in the principal business of the taxpayer, and those commodities are subject to the process of inventorying. The test is legi- timate dealing and manufacturing as against spasmodic or "on-the-side" dealing. There is not much difference between a "dealer" who buys and sells securities and a "speculator" or an investor who buys and sells securities. In man}^ cases taxpayers who claimed that they were "dealers" and who were denied the classification by the Treasury, will now benefit by the capital gains privilege. Inventory method — when applicable to "short SALES." — Ruling. Where a taxpayer has "borrowed" stock in order to make a "short sale" the gain or loss arising from such transaction can not be accrued upon the books of the taxpayer at the close of his taxable year by treating as an offsetting obligation the market value of the stock sold "short" as of that date; the gain, or loss is deter- mined when the amount of stock sold "short" is repurchased for return to the lender and the transaction closed. (C. B. i, page 62; S. 1 179.) The Treasury holds that "the short sale dealer in open short sales, having no stock in his possession to which he has title, consequently has no stock which he can inventory." When applied to one who is not a dealer in securities the ruling is sound, but there is no good reason why a dealer in securities should not inventory all his trades, at least to the same extent as is permitted in the case of "hedges." (See page 472.) The case is not analogous to dealing in futures or to the forward business of dealers in merchandise. Short sales are not usually made as "hedges" but in the ordinary course of business as individual transactions. The dealer does have physical property to inventory, viz., the cash proceeds of the sale. But the cash proceeds are worth more or less than 484 INCOME their face value, depending on fluctuations in the price of the stock or other property which must be replaced in kind. There- fore the cash reserve must be increased or decreased at inven- tory time or the accounts will not reflect the results of the dealer's business on an accrual basis. The author is of the opinion that a dealer in securities should be permitted to inventory short sales on the basis of cost or market, whichever is lower. The inventory method is supposed to make unnecessary the closing of trades to establish closed transactions. What can be done indirectly should be permitted if done directly. A dealer can readily cover all his short sales before the end of the year and arrange to resell the same or similar classes of stocks, etc., immediately thereafter, l)ut he should not be required to go through a foolish form when the inventory regulations provide a more reasonable method. Returns of dealers in securities. — In preparing returns on form 1040, the taxpayer who has c[ualified as a dealer in se- curities is not required to enter the items of his business in schedule D,*" but should use schedule B. On line i of schedule B there should be entered the sales price of all securities sold, and on line 4 there should be entered the cost price of securi- ties purchased. When the dealer has kept his books on an accrual basis and has taken inventories, lines 6 and 8 should be used to record the inventories at the beginning and end of the year. If it is not feasible for a dealer in securities to enter the gross sales price in line i, because his books show only gross profits, he should then enter the item of gross profits on line I and not attempt to set up the cost of securities held on line 4. This method is permissible because it accords with accepted accounting principles. But schedule B is not intended to be used by those who are not dealers in securities. Speculators or investors who may carry on many hundreds of transactions during the year must 'AH references in this chapter are to 1921 forms. FROM BUSINESS 485 either qualify as dealers in securities or they must report under schedule D. It has been urged that an active trader can- not readily prepare schedules which show the sales price and cost of all securities dealt in. If such trader keeps books show- the details of each transaction and if he keeps an account show- ing the gross profit or gross loss on each transaction, it may be permissible to use such totals in schedule D with an explan- ation that those figures agree exactly with the regular books of accounts kept by the taxpayer and open to the income tax inspectors. On the other hand, if such taxpayer does not keep regular sets of books which can readily be verified, the Treas- ury is fully justified in requiring the detail of every transaction during the taxable year. If some such compilation is not made, the taxpayer himself does not know what his profits or losses have been and, if a compilation is made, there is no reason why a copy of it should not be attached to form 1040 in support of schedule D totals. Inventories of securities by a bank maintaining a department for dealing therein. Ruling. Reference is made to your letter of May 26, 1919, wherein you ask whether a bank that maintains a branch for the purpose of buying and selling securities has the full status of a recog- nized dealer in securities. In reply, you are advised that a bank or other institution having a regularly established department for the merchandising of securities, even though that department is subordinate in importance to other departments, is entitled to the same benefit of using the basis provided for in Article i'585 of inventorying securities acquired and held for resale, as one who is solely a dealer in securities. In so far as the bank or other institution carry on, with an es- tablished place of business a department for the merchandising of securities, it is in respect of such department treated in the same way as any other security merchant. It should be noted, however, that the method of inventorying provided for in Article 1585 has no application and can not be extended to taxpayers simply buying and selling secur- ities for investment or speculation. (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, dated June 28, 1919.) 486 INCOME Dealers in foreign exchange may use inventory method. — Ruling. A dealer in foreign exchange — that is, one who regu- larly engages in the purchase and resale to customers of foreign money with a view to the gains and profits that may be derived therefrom — who, in his books of account regularly inventories unconverted for- eign money on hand either (a) at cost or (b) at cost or market value whichever is lower, may make his return upon the basis upon which his accounts are kept. A taxpayer who is not a dealer in foreign exchange but merely purchases foreign money on his own account or as an incident of his principal business may not inventory such unconverted foreign money at the close of his taxable year. The realization of the gain or loss is postponed until the foreign money is disposed of or converted. (C. B. 4, page 6i ; O. D. 834.) When foreign exchange is purchased incident to the busi- ness such as that of an importer, there would seem to be no good reason why the amount held at the end of the year should not be inventoried. It is as to such importer an asset used in trade, and should therefore be subject to the usual rules for valuing trade assets. Dealers in second-hand automobiles may use inventory method.— Ruling. A dealer may value used or second-hand automobiles included in a closing inventory on the basis of cost or market which- ever is lower, in accordance with article 1582 of Regulations 45, if he can furnish satisfactory evidence of the market value of such second-hand automobiles at the date of the inventory. (C. B. 4, page 49; O. D. 888.) Real estate dealers not permitted to use inventories. — Ruling. A taxpayer, engaged in the real estate business, is not permitted to inventory real estate which is held for sale for the pur- pose of calculating net income subject to Federal income tax. (C. B. 4, page 47; O. D. 848.) Method of valuing inventories when a partnership is suc- ceeded by a corporation.— The question arises as to how an opening inventory should be taken when a corporation suc- ceeds a partnership, the latter having taken its closing inven- FROM BUSINESS 487 tory at cost, and the market value now being greater than cost. If the transfer constitutes a closed transaction (and the partners have paid a tax on the appreciation), the opening inventory of the corporation for tax purposes would be the increased value. If the transfer is a continuing transaction, the basis used by the partnership should be continued. Under the 1921 law,** however, such a transfer would not be a closed transaction if the control of the corporation is in the former partners and "the amounts of stock, securities, or both, received by such persons are in substantially the same proportion as their interests in the property before such trans- fer." It would appear that, on the one hand, the partners need not pay a tax on such appreciation at the time of the transfer, and that, on the other hand, the corporation may take up the inventory at its present value as the corpora- tion is a separate entity and therefore may properly value any property acquired by it at the value it had at time of acquisi- tion and for which its securities are issued. At first glance it might appear that some income is escap- ing taxation but this is more apparent than real. The corpora- tion as such pays no tax on the appreciation, as it occurred prior to its acquisition of the property. The members of the former partnership, however, would pay on the appreciation if, as, and when realized by the sale of their holdings of the corporation's stock. Under the 1921 law" their investment in the corporation's stock is in such a case deemed to be the same as their investment in the partnership which had valued the inventory at cost. Income from Sale of Property on the Instalment Plan Under T. D. 3082, October 20, 1920, amending article 42 of Regulations 45, the Treasury made it possible for instal- " Section 202 (c-3). " Section 202 (d). 488 INCOME nient dealers, under the 1918 law, to report only profits realized in cash collections. The same procedure is permitted under the 1921 law. Law. Section. 202. . . . . (f) Nothing in this section shall be construed to prevent (in the case of property sold under contract pro- viding for payment in installments) the taxation of that portion of any installment payment representing gain or profit in the year in which such payment is received. Generally speaking, the regulations consider sales to be on the instalment basis when less than 25 per cent of the purchase consideration passes to the vendor at the time the sale is ef- fected, and when the balance of the consideration is payable in specific instalments. Such a condition obtains whether the title rests with the vendor until purchase is completed, whether the title passes to the vendee under a lien agreement, whether the title be reconveyed to vendor by a chattel mortgage, or whether title be conveyed to trustees pending performance of contract. Regulation. Dealers in personal property ordinarily sell either for cash, or on the personal credit of the buyer, or on the installment plan. Occasionally a fourth type of sale is met with, in which the buyer makes an initial payment of such a substantial nature (for example, a payment of more than 25 per cent) that the sale, though involving deferred payments, is not one on the installment plan. Dealers in personal property who sell on the installment plan usually adopt one of four ways of protecting themselves in case of default: (a) through an agreement that title is to remain in the seller until the buyer has completely performed his part of the trans- action ; (b) by a form of contract in which title is conveyed to the purchaser immediately, but subject to a lien for the unpaid portion of the purchase price; (c) by a present transfer of title to the pur- chaser, who at the same time executes a reconveyance in the form of a chattel mortgage to the seller; or (d) by conveyance to a trustee pending performance of the contract and subject to its provisions. The general purpose and effect being the same in all of these plans, it is desirable that a uniformly applicable rule be established. The rule prescribed is that in the sale or contract for sale of personal property on the installment plan, whether or not title remains in the vendor until the property is fully paid for, the income to be returned by the vendor will be that proportion of each installment payment which the gross profit to be realized when the property is paid for FROM BUSINESS 489 bears to the gross contract price. Such income may be ascertained by taking as profit that proportion of the total cash collections re- ceived in the taxable year from installments sales, (such collections be- ing allocated to the year against the sales of which they apply), which the annual gross profit to be realized on the total installment sales made during each year bears to the gross contract price of all such sales made during that respective year. In any case where the gross profit to be realized on a sale or contract for sale of personal property has been reported as income for the year in which the transaction occurred, and a change is made to the installment plan of computing net income, no part of any installment payment received subsequent to the change, representing income previously reported on account of such transaction, should be reported as income for the year in which the installment payment is received; the intent and purpose of this provision is that where the entire profit from installment sales has been included in gross income for the year in which the sale was made, no part of the installment payments received subsequently on account of such previous sales shall again be subject to tax for the year or years in which received. Where the taxpayer makes a change to this method of computing net income his balance sheet should be adjusted conformably. If for any reason the vendee defaults in any of his in- stallment payments and the vendor repossesses the property, the entire amount received on installment payments, less the profit already re- turned, will be income of the vendor for the year in which the prop- erty was repossessed, and the property repossessed must be included in the inventory at. its original cost to himself, less proper allowance for damage and use, if any. If the vendor chooses as a matter of con-' sistent practice to treat the obligations of purchasers as the equivalent of cash, such a course is permissible. (Art. 42.) When can sales of personal property be deemed to be on the instalment plan? — Rulings. If a stockholder of a corporation sells stock to em- ployees of the company for consideration of 10 per cent cash and the balance in installment payments, secured by notes covering a period of 10 years, that proportion of each installment payment re- ceived during the taxable year which the gross profit to be realized bears to the gross contract price should be reported as income for the year during which installment payments were received. (C. B. i, page 75;0. D. 134.) Where the stockholders of a corporation sell their shares in the corporation for a price in excess of cost and receive a cash payment not in excess of 20 per cent of the total price, the purchasers agreeing to pay the balance in a number of semiannual installments and deposit collateral with trustees as security for the faithful performance of 490 INCOME the contract, the transaction is not an installment sale within the meaning of article 42, Regulations 45. The entire consideration in- volved in the sale must be treated as the equivalent of cash in the year when the sale is consummated. (C. B. i, page 75; O. D. 290.) The last ruling may or may not be sound, depending on the circumstances of the case. If the deferred payments (80 per cent) are not m fact the equivalent of cash, no tax can be imposed. Under the law no income arises until the actual equivalent of cash is realized. Many deferred payments are not discountable on any reasonable basis. In such cases the following ruling governs. Ruling. In the case of sales of personal property where sub- stantial initial payments are made (more than 25 per cent of sale price), obligations of the purchasers need not be regarded as the equivalent of cash if it is shown clearly that such obligations, even though represented by notes or other paper in negotiable form, can not be discounted or otherwise converted into cash without material loss because of lack of credit on the part of the buyer and the nature of the property involved. In such cases profit may be reported as provided for sales on the installment plan. (C. B. 3, page 107; O. D. 7150 The foregoing is sound and in strict accord with the law. The author has been unable to ascertain why instalment houses should receive consideration not extended to any other class of taxpayers and wholly unjustified by any reason- able interpretation of the regulations regarding closed trans- actions. Other businesses in changing from one method of account- ing to another have always been required to file amended re- turns as far back as may be necessary to protect the govern- ment's interests. Other businesses in which accounts and notes receivable have been less liquid than the notes receivable taken by instalment houses have been required io return the entire profit on the accrual basis. The instalment house sells goods for a substantial cash payment and often takes promissory notes for the balance. The latter are more readily discountable in ninety cases out of one hundred than are the securities re- FROM BUSINESS 491 ceived in exchanges of other property; but under the regula- tions no tax is imposed until the notes are collected at maturity. The treatment of instalment houses is not too liberal; the injustice lies in the refusal of the Treasury to interpret the 1918 and prior laws with half as much liberality in thousands of cases in which taxpayers were far less able to pay the tax. Method of computing taxable profit by instalment houses. — The detailed procedure outlined in the following ruling serves to give effect to two principal changes in the Treasury's former requirements.**^ First. Any collections applicable to instalment sales already reported as income are credited to accounts receivable. No part of such items is used in computing realized profits for the taxable year. This avoids double taxation. Second. Collections as made are segregated according to the years in wiiich the sales were made. Segregation is also made in the books for each year of — (a) Sales (b) Gross profit (unrealized) Ratio of (b) for each year to (a) for each year for which cash is collected in current year applied to the collections in current year gives income to be reported as realized profits of current year. To illustrate, assume : C u 3 " ■Z'O '» o\ « n « ^ te M UE.S $2,000 8,000 Instalment ^ ^ sales con- p p tracts (Sale g g made durin respective years) "0 1> 01 (U_^ m °- ^ -0 u "> ■" ° c IJ « $24,000 37,500 "« « S " $6,000 12,500 (b) ^ l£ in fn be 20% 25% $10,000 $80,000 (a) $61,500 $18,500 The problem is to compute the realized profits. The rul- See Income Tax Procedure, 1920, pages 309-314. 492 INCOME ing says that such profits should be computed by taking the same percentage of the cash collections made during the tax- able year on account of instalment sales contracts of either that or prior years, as the total unrealized profits on instalment sales contracts for the year against which the collection ap- plies, bear to the total instalment sales made during that re- spective year. Applying the gross profit for each year to the collections applicable to the respective years, we have : 1920, 20 per cent of $2,000 = $ 400 1921, 25 per cent of $8,000 = 2,000 Realized profits for 1921 $2,400 Rur.iNGS. The procedure outlined in T. P). R. 24'^ has been recon- sidered and as a result of such reconsideration the following has been adopted where a taxpayer engaged in merchandising upon the install- ment plan has heretofore made returns upon the basis of treating the profit upon installment sales as realized as at the date of sale and now wishes to change to the basis of reporting the profit as being realized as at the date of collection of the outstanding accounts. 1. In accordance with the provisions of article 42 (as amended) of Regulations 45, the balance sheet as at the beginning of the tax- able year, which shall be filed as a part of the return, shall carry the installment sales contracts unliquidated and remaining in force as at the date that this system of accounting is adopted and made efifective by the taxpayer, as accounts receivable, such unliquidated installment sales contracts having been inventoried and determined as at that date. Cash collections on account of such contracts will be credited directly to such accounts receivable and no part of such collections will be included in computing realized profits for the taxable year. 2. As from the beginning of the taxable year, the following accounts should be set up : (a) Goods purchased, which will be charged with the amount of inventory of the goods on hand at the beginning of the taxable year and with the expenditures for goods purchased during the year. (b) Goods sold (cost value), which will be credited with the cost value of all goods sold during the year. (c) Installment sales contracts (year date), which will be charged only with the amount of installment sales contracts made " Under the former ruling, when a change was made in the instalment method, cash collections applying to sales already reported were included in the new computation. FROM BUSINESS 493 during the year specified. This account for each year will be credited with all cash collected during that year, or in subsequent years, upon installment sales contracts for that year only, and with the unpaid installments of defaulted or canceled contracts for that year. (d) Unrealised gross profits on installment 'sales contracts (year date), which will be credited only with the amount of unrealized gross profits upon installment sales contracts made during the year specified. This amount will be the total of the installment sales con- tracts for that year reduced by the cost or inventory value (as car- ried in account (a) goods purchased), of the actual goods sold and covered by the contracts; the balance remaining being the amount of the unrealized gross profits. The proforma monthly (or annual) journal entry would be : Dr. Cr. Installment sales contracts (year date) $ To goods sold (cost value) $ Unrealized gross profits on installment sales contracts (year date) $ (e) Realized profits on installment sales contracts, which will be credited from month to month (or at the end of the year), with the profits realized by cash collections upon all installment sales con- tracts of any year. Such profits should be computed by taking the same percentage of the cash collections made during the taxable year on account of installment sales contracts of either that or prior years, as the total unrealized profits on installment sales contracts for the year against which the collection applies, bear to the total install- ment sales made during that respective year. Corresponding debits should be made to unrealized gross profits on installment sales con- tracts for the year affected by such collections. If adjustments to any or all of these various accounts become necessary in order that it or they may accurately reflect the facts, such adjustments may be made either monthly or as at the end of the taxable year. It is believed that sufficient has been said above to indicate the use that is to be made of these special accounts and it is not necessary to discuss any of the other accounts which would normally be main- tained. It will be noted that the foregoing plan which will be permitted upon an explicit statement of facts made to the Commissioner of Internal Revenue by a taxpayer engaged in merchandising upon the installment plan is not a change from an accrual basis to a cash received and paid basis. In the opinion of this office, the income of a merchandising concern can not be correctly reflected upon the lat- ter basis, as the use of inventories is absolutely essential. The plan herein outlined is, therefore, merely such a modification or adapta- tion of the ordinary accrual method of accounting as in the opinion of this office will enable the accounts of the taxpayer clearly to reflect 494 INCOME his net income. Where in the past another method has been used that has failed to reflect the taxpayer's net income an amended return or returns for such year may be made. In cases where the taxpayer has in the past exercised the option of reporting the profit as realized as at the date of sale and now wishes to change to a basis of reporting the profit as realized as at the date of collection of the outstanding installments, either of which method is allowable under article 42 of Regulations 45, amended re- turns for years prior to the date that the above outlined system of accounting is adopted and made effective by the taxpayer, will not be required or allowed unless in the opinion of the Commissioner such former method has failed to reflect the net income. (C. B. 3, page 105; O. D. 623.) O. D. 623 does not contemplate that where a change is made to the basis of reporting the profit from installment sales as being realized as at the date of the collection of the outstanding accounts, any part of the unliquidated installment sales contracts at the date the new basis is adopted, which are to be carried as accounts receivable on the balance sheet at the beginning of the taxable year in which the change is made, should be excluded from surplus in computing invested capital for the taxable year. (C. B. 4, page 87; O. D. 793.) If books have been so kept that the cost of each article sold was not shown, gross profit may be determined by taking the average per- centage of gross profit on gross sales. If several different lines of merchandise are handled, on which the average percentages of profit differ, the gross profit on total sales of each different class of mer- chandise should be computed separately. (C. B. i, page 75; O. D. 25.) Where a taxpayer is engaged in business making cash, personal credit, and installment sales, the percentage of gross profit to be re- ported on the installment sales, as provided in article 42 of Regula- tions 45, is the percentage of gross profit on all sales made during the year in which the installment sale was made, regardless of whether they were cash, personal credit, or installment sales. (B. 47-21-1930; O. D. 1 107.) The two preceding rulings are confusing. In O. D. 25 taxpayers are required to make separate computations where the percentage of gross profit on different classes of goods sold on the instalment plan differs materially, whereas in O. D. 1 107 taxpayers are required to compute gross profit on all classes of sales. In the case of instalment houses which have adequate cost records, the latter ruling does not give accurate results and is FROM BUSINESS 495 contrary to the principle laid down in article 42 of Regulation 62, that the income "may be ascertained by taking as profit that proportion of the total cash collections received in the taxable year from instalment sales .... which the annual gross profit to be realized on the total instalment sales made during each year bears to the gross contract price of all such sales made during that respective year." As a practical mat- ter it may apply to a concern which can not segregate the cost of items sold on the instalment basis from other sales. Application of instalment payments. — Since collections made in one year may apply to sales made in different years, each showing a different rate of gross profit, the following rules for applying the cash payments made by customers are important in determining the proportion of such payments to be reported as income. Rulings. When income from sales of personal property on the installment plan is reported as provided in article 42 of Regulations 45, the payments made by a purchaser having several accounts should be allocated to the particular account or accounts to which under the terms of the contracts of sale such payments are to be applied. (B. 39-21-1838; O. D. 1045.) In cases of continuous accounts covering sales of personal prop- erty, the income from which is reported on the installment plan as pro- vided in Treasury Decision 3082, the cash payments received should be allocated in accordance with the generally recognized principle of law governing such cases, that is, that failing application by the vendee, the cash payments should be applied to the earliest items of the account. (C. B. 4, page 88; O. D. 815.) Computation of bad debts in case of instalment sales. — Ruling. The amount to be deducted from gross income as a bad debt in cases of sales of personal property on the installment plan. in which the unpaid installment obligations of the purchaser become worthless and are charged off and the property is not recovered by the vendor is such proportion of the defaulted payments as represents the capital investment, that is, the cost of the goods sold, and this amount must be deducted for the year in which the default occurred. Let it be assumed that the taxpayer's installment sales (contracts) for the year 1919 were $300,000 and that the cost of the goods sold 496 INCOME and covered by such contracts was $100,000; then the unrealized gross profits would be $200,000 and the rate of profit for that year would be established at 66^i per cent. Let it be assumed, further, that during the years 1919 and 1920 the cash collections on account of such contracts were $266,700; then the entries covering these transactions would be as follows : Installments sales contracts, 1919 $300,000 To goods sold (cost value) $100,000 To unrealized gross profits on installment sales contracts, 1919 200,000 Rate of gross profit — J^ or 66J/3 per cent. Unrealized gross profits on installment sales contracts, 1919 177,800 To realized profits on installment sales contracts 177,800 Cash collections during 1919 and 1920 for ac- count of 1919 $266,700 Yi thereof 177,800 At the close of 1920 the accounts, as affected by the above trans- actions, would stand as below : DEBITS Cash $266,700 Installment sales contracts, 1919 33-300 $300,000 CREDITS Goods sold (cost value) . . . $100,000 Unrealized gross profits, etc. 22,200 Realized profits, etc 177,800 $300,000 Of the above balance of $33,300 to the debit of installment sales contracts, two-thirds, or $22,200 (shown as a balance to the credit of unrealized gross profits), is to be accounted for and taxed as profit as, when, and if collected. The remaining one-third is the capital invest- ment representing the cost of goods sold. But let it be assumed that the whole or any part of the balance of the installment sales contracts, amounting to $33,300, was defaulted in 1919 or at any later time; then the question arises: How should the loss occasioned by such defaults be treated for purposes of determining the income and excess profits tax ? The answer is that the proper portion (two-thirds in this case) of the amount of the defaulted payments should be charged against the unrealized profits and the balance (in this case one-third), repre- senting the cost of the goods sold, should be allowed to the taxpayer as a deduction for losses actually sustained during the taxable year. This method of treatment should be followed wdiether the goods are or are not recovered. If the goods are not recovered, it correctly reflects the facts without further entries upon the books. If the goods are recovered, their fair market value at the time of recovery should be credited as realized profits for that year, with a corresponding debit FROM BUSINESS 497 to the account of goods purchased. The difference (debit balance) between the two accounts of goods purchased and goods sold should reflect the value of the physical inventory at any given date. (C. B. 4, page 86; O. D. 792.) Reserves for unearned interest, collection expenses, etc., good accounting practice. — Ruling. A taxpayer who sells merchandise on the installment plan may not allocate the expenses incident to producing the income to the year in which the profits on the sale of the goods are realized, but should deduct such expenses in his income-tax return as for the year in which incurred and paid or accrued. (C. B. 4, page 123 > O. D. 844.) When goods are sold on the instalment plan there is in- cluded in the sales price an adequate allowance for bad debts, for the costs of collection, interest and other carrying charges. No specific segregation of the selling price is made, but the items are there nevertheless. There can be no net income until provision is made for costs and expenses. Usually collection and similar expenses are relatively small, but in the instalment business such expenses are high. At the end of each accounting period (or oftener), if accounts are kept on the accrual basis, there should be taken out of gross sales on the instalment plan such part thereof as may be said to represent the actual cost of carrying and collecting the accounts. If the future costs and charges can be segregated with reasonable accuracy into interest, collection charges, and similar expenses, the separ- ation should be made. It is somewhat doubtful whether reserves of this kind were allowable deductions heretofore, but since the 19 18 and 1921 laws call for the use of the best accounting practice in each trade, there should be no question about the propriety of set- ting up such reserve accounts to provide for interest and ex- penses charged to customers, but not collected from the cus- tomers and not yet expended for these purposes. When re- turns are made on the cash basis now permitted, these reserves cannot be claimed as deductions. 498 INCOME Income from the sale of real estate on the instalment plan. — Regulation. Deferred payment sales of real estate ordinarily fall into two classes when considered with respect to the terms of sale, as follows : (i) Installment transactions, in which the initial payment is rela- tively small (generally less than one-fourth of the purchase price) and the deferred payments usually numerous and of small amount. They include (o) sales where there is immediate transfer of title when a small initial payment is made, the seller being protected by a mortgage or other lien as to deferred payments, and (b) agreements of purchase and sale which contemplate that a conveyance is not to be made at the outset, but only after all or a substantial portion of the agreed installments have been paid. (2) Deferred payment sales not on the installment plan, in which there is a substantial initial payment (ordinarily not less than one-fourth of the purchase price), deferred payments being secured by a mortgage or other lien. Such sales are distinguished from sales on the instalment plan by the substantial character of the initial payment and also usually by a relatively small number of deferred payments. In determining how these classes shall be treated in levying the income tax, the question in each case is whether the income to be reported for taxation shall be based only on amounts actually re- ceived in a taxing year, or on the entire consideration made up in part of agreements to pay in the future. (Art. 44.) When obligations of purchasers are not the equiva- lent OF CASH. Regulation. In the two kinds of transactions included in class ( I ) in the foregoing article, installment obligations assumed by the buyer are not ordinarily to be regarded as having a readily realizable market value, ■'^ and the vendor may report as his income from such transactions in any year that proportion of each payment actually re- ceived in that year which the gross profit to be realized when the property is paid for bears to the gross contract price. If the return is made on this basis and the vendor repossesses the property after default by the buyer, retaining the previous payments, the entire amount of such payments, less the profit previously returned, will be ^' [Former Procedure] Permission to calculate a proportion only of instalments received as realized income was conditioned upon "title re- maining in the vendor until fully paid for." (Reg. 33, IQ18. Art. T17.) In the regulations covering the 1918 law the expression "equivalent of cash" was used instead of "readilv realizable market value." (Reg. 45, 1 918, Art. 45-) FROM BUSINESS 499 income to the vendor and will be so returned for the year in which the property was repossessed, and the property repossessed must be in- cluded in the inventory at its original cost to himself (less any depre- ciation as defined in articles 161 and 162). If the taxpayer chooses as a matter of settled practice consistently followed to treat the obliga- tions of the purchaser as having a readily realizable market value and to report the profit derived from the entire consideration, cash and deferred payments, as income for the year when the sale is made, this is permissible. If so treated the rule prescribed in article 46 will apply.*» (Art. 45.) Ruling. In February, 1917, A purchased land and improvements for a consideration of 46.r dollars. On September — , 1917, an agree- ment for the sale of the property was entered into between A and his wife, parties of the first part, and B, party of the second part, for a consideration of yox dollars, payable as follows : %.r dollars cash, receipt of which is acknowledged, 9^x dollars cash, to be paid on or before November — , 1917, 3}i-r " " " " " " December — , 1919, 3^,r ' " " " " " December — , 1920, 3}ix " " " " " " December — , 1921, 3}ix " " " " " " December — , 1922, 3x " " " " " " December — , 1923, and the balance thereof, to wit : The sum of 42,r dollars to be paid on or before the day of June, 1927, in accordance with the note and mortgage executed by the parties of the first part to C, which mortgage is of record, all deferred payments to draw interest at y per cent per annum, interest payable annually, and the party of the sec- ond part reserves the right to pay said sums at the due date thereof or any part thereof in multiples of $100 at any time, and upon re- ceipt of the payment of any such sum, interest on such sums so paid shall thereupon cease. In determining the amount of the initial payment it has been the practice to consider as the equivalent of cash mortgages assumed by the purchaser. In the present case, however, it does not appear that the purchaser assumes the mortgage on the property referred to above. He merely agreed to pay an amount to the seller equal to the amount of the mortgage on or before June — , 1927, as the final payment on the property. That the seller was not released by this agreement from liability on the mortgage is indicated in the statement in the letter from the taxpayer's representative that "the holder of the original mortgage against the property refused to release the taxpayer until payment of his obligation has been made in full." The amount of the mortgage, 42.r dollars, should not, therefore, be considered as the equivalent of cash in determining the amount of the initial payment in this transaction. (B. 46-21-1918; A. R. M. 140.) " Sec page 500. 200 INCOME Even if the mortgage had been assumed in the foregoing case, the sale would still be one of an instalment nature, since the down payment was small. Where lien notes are given to cover future payments for property purchases, such notes are considered as cash to the extent of their discountable value. ^° When land is sold for part cash and part oil, if oil is found, the right to receive oil has not a "definitely ascertainable value" and no income is realized until the total payments received by the vendor exceed the cost or March i, 1913, value of his land.^^ When obligations of purchasers are the equiva- lent OF CASH. Regulation. In class (2) in article 44 the obligations assumed by the buyer are much better secured because of the margin afforded by the substantial first payment, and experience shows that the greater number of such sales are eventually carried out according to their terms. If these obligations have a readily realizable market value, as defined by article 1564, they are to be considered as the equivalent of cash and the profit realized from the transaction is taxable income for the year in which the initial payment was made and the obli- gation assumed. If the buyer defaults and the seller regains title to land by agreement or process of law, retaining payments previously made, he may deduct from his gross income as a loss in the year of re- possession any excess of the amount previously reported as income over the amount actually received, and must include such real estate in his inventory at its original cost to himself (less any depreciation as defined in arts. 161 and 162.) If the obligations have no readily realizable market value, the amount of the initial payment shall be applied against and reduce the basis, as provided in section 202 and articles 1561-1564, of the property sold and if in excess of such basis, shall be taxable to the extent of the excess. (See art. 1658.) Gain or loss is realized when the obligations are disposed of or satisfied, the amount being the difference between the basis as provided above and the amount realized therefor. (See arts. 153, 1561, and 1568.) (Art. 46.) Even though the first payment is substantial in amount, if it is made in some form (note, property, etc.) that has not C. B. 4, page 89; O. D. 842. C. B. 4, page 89; O. D. 889. FROM BUSINESS 501 a readily realizable market value, the transaction is not closed and no income is realized. ^^ The two foregoing articles (45 and 46) must be reasonably construed. If transactions in class (2) are substantially the same as those in class (i) the Treasury could not hold that one is the equivalent of cash and the other not. Initial payment includes all payments during tax- able YEAR. Ruling. An individual who sold a parcel of real estate in 1918 for 60X dollars received a payment of 5.1- dollars on March i, 1918, the date on which the sale was consummated, a payment of 2y^x dollars on July i, 1918, and a payment of lo.r dollars on December I, 1918, or a total of 173^-r dollars during the year 1918. It was provided that the balance of the selling price would be paid in install- ments falling due on December i of each year thereafter, including the year 1922, such deferred payments being secured by crop mort- gages and additional collateral security. In order to ascertain whether this sale comes within the ruling in article 45 of Regulations 45 under wbich a taxpayer is permitted to report only the proportionate part of each installment payment representing profit as income for the year in which received, the entire amount of the selling price received in cash during the taxable year in which the sale was made is to be taken into consideration in determining whether or not the initial payment was a substantial one. Since in this case the sum of the payments received in 1918 was more than one-fourth of the selling price, the vendor should have included the entire profit realized on the sale in his return for 1918. (C. B. 3, page 108; O. D. 569.) It IS, however, reasonable to assume that the security for the deferred payments was not the equivalent of cash, in which case the entire profit should not have been held to be taxable in 1918. • Payment in notes not readily discountable. — Ruling. In the case of real estate sales involving deferred pay- ments, even though substantial first payment is made, if the notes given by buyers of real estate can not be discounted nor sold on account of lack of credit of the buyers, such notes need not be re- " For full discussion, see Chapter XVI. 502 INCOAJE garded as the equivalent of cash, and the vendors may report as their income from the proposed transaction for each year only the propor- tion of each payment actually received in that year which the gross profit to be realized when the property is paid for bears to the gross contract price. (C. B. i, page 76; O. D. 181.) If because of decline in value and curtailment of credit, notes given for property cannot be marketed, the sale of the property may be treated as one made for deferred payments. RuLiNc inasmuch as the notes covering the unpaid balance of the purchase price are not merchantable because of lac'k of credit on the part of the purchasers and the decrease in the value of farm land since the date of the original sale agreement, it is held that the transactions. in question should be treated for income tax purposes as deferred payment sales of real estate on the installment plan. The administrators of the estate of ... . should, therefore, include in the income tax return of the decedent for the period from the beginning of his taxable year to the date of his death, that pro- portion of each installment payment received by the decedent during such period which the gross profit to be realized when the prop- erty is paid for bears to the gross contract price. (Extract from letter to John E. Hughes, Chicago, 111., signed by Acting Deputy Commis- sioner E. H. Batson, by M. E. Stickley, Head of Division, dated April 27, 1921.) Payment in u.sed cars. — Ruling. A dealer in automobiles who takes used machines as part payment on sales of new cars is required to report the entire profits realized on the new cars for the year in which received regard- less of the fact that part of the payments received are in the form of used machines. The fair market value of the used cars takeji as part payment is deemed to be the value at which they were taken in on the sales. In case the used cars are later sold, the basis for determining gain or loss will be the value placed on them for income tax purposes when received, or if inventories are employed and the cars were on hand at the beginning of the taxable year in which sold, the value at which they were included in the inventorv at that date. (C. B. 4, page 3.1; O. D. 782.) Under the 192 1 law the term "readily marketable" would be substituted for the words "fair market value." It is prob- able that in the automobile trade the former term is more ac- ceptable. FROM BUSINESS Sale of real estate in lots. 503 Regulation. Where a tract of land is purchased with a view to dividing it into lots or parcels of ground to be sold as such the cost shall be equitably apportioned to the several lots or parcels and made a matter of record on the books of the taxpayer, to the end that any gain derived from the sale of any such lots or parcels which constitutes taxable income, may be returned as income for the year in which the sale vi-as made. This rule contemplates that there will be a measure of gain or loss on every lot or parcel sold, and not that the capital invested in the entire tract shall be extinguished be- fore any taxable income shall be returned. The sale of each lot or parcel will be treated as a separate transaction and the gain or loss will be accounted for as provided in article 1561. "'■' (Art. 43.) The new regulation refers to any gain "which constitutes taxable income." For discussion of those transactions in which no gain is deemed to be realized, see Chapter XVI. Ruling For income tax purposes the sale of a per- petual easement on a specified number of acres of land to a railroad company is to be treated as though it were an outright sale of land where legal title passes at the time of sale, unless for some reason the fee of the owner has more than a merely nominal value, as for ex- ample, where the land is underlaid by a mine. (B. 43-21-1881 ; O. D. 1072.) Estimated development work may be included in cost. — Ruling. Profit realized on the sale of lots, the selling price of which includes the cost of certain development work already made or to be made in accordance with the contract of sale, should be based on the cost of the land to the vendor, or its fair market value as of March i, 1913, if acquired prior to that date, plus the actual and estimated future expenditures for development. If the estimated future expenditures should be subsequently ascertained to be incor- rect, amended returns should be filed as the basis for an adjustment of the tax for the years affected. The cost of such development having been taken into consideration in determining profit, expendi- tures for this purpose can not be deducted from gross income in sub- sequent returns. (C. B. 3, page 108; O. D. 567.) Repossession of real estate sold on instalment PLAN. — The foregoing regulation states that in case of repos- See Chapter XVI. 504 INCOME session ''the property repossessed must be included in the in- ventory at its original cost." Under another ruling, real estate dealers are not permit- ted to inventory real estate.^* Article 46,^^ which refers to real estate sales not on the instalment plan, uses similar language, as does article 42, which deals with sales of per- sonal property on the instalment plan. Since the Treasury has held that real estate dealers may not use the inventory method, this gives them the benefits of the capital gains provisions.^® The foregoing ruling merely provides that the cost of real es- tate sold and returned must not be written down. The net proceeds arising from the sale and return are of course tax- able. Proceeds of Property Requisitioned or Destroyed^^ Special provision has been made to prevent excessive taxa- tion in cases where compensation is received for property lost or destroyed through fire, storm, shipwreck or where property is taken under right of eminent domain, or requisi- tioned by the government for war purposes,^^ which is tem- porarily not replaceable. In such cases "replacement funds" may be established and the tax accounting postponed "for a reasonable period of time." Law. Section 214. (a) .... (12) If property is compul- sorily or involuntarily converted into cash or its equivalent as a result of (A) its destruction in whole or in part, (B) theft or seizure, or (C) an exercise of the power of requisition or condemnation, or the threat ^ See page 486. " See page 500. " Section 206. " [Former Procedure] T. D. 2706 (April 25. 1918) provided relief only in cases of property lost through war hazards. It also provided for the deduction of any mortgage obligation on such property from the replacement fund. Further, it permitted the valuation of the replaced property at an amount greater than that at which the old property was carried "to the extent that such new or restored property has an increased productive capacity." Some of the provisions now incorporated in the 1921 law were hereto- fore included in Reg. 45, Arts. 49 and 50, but without specific provision of law. See Income Tax Procedure, 1921, pages 374-377. "C. B. 4, page 43; O. D. 897. FROM BUSINESS 505 or imminence thereof; and if the taxpayer proceeds forthwith in good faith, under regulations prescribed by the Commissioner with the ap- proval of the Secretary, to expend the proceeds of such conversion in the acquisition of other property of a character similar or related in service or use to the property so converted, or in the acquisition of 80 per centum or more of the stock or shares of a corporation owning such other property, or in the establishment of a replacement fund, then there shall be allowed as a deduction such portion of the gain de- rived as the portion of the proceeds so expended bears to the entire proceeds. The provisions of this paragraph prescribing the conditions under which a deduction may be taken in respect of the proceeds or gains derived from the compulsory or involuntary conversion of prop- erty into cash or its equivalent, shall apply so far as may be practicable to the exemption or exclusion of such proceeds or gains from gross in- come under prior income, war-profits and excess-profits tax acts Law. Section 202 (d) .... (2) Where property is compulsorily or involuntarily converted into cash or its equivalent in the manner described in paragraph (12) of subdivision (a) of section 214 and paragraph (14) of subdivision (a) of section 234, and the tax- payer proceeds in good faith to expend or set aside the proceeds of such conversion in the form and in the manner therein provided, the property acquired shall, for the purpose of this section, be treated as taking the place of alike proportion of the property converted; .... The 192 1 law permitting the estabhshnieiit of a "replace- ment fund" has several new features. 1. The acquisition of 80 per cent or more of the stock of a company owning property similar to that lost is deemed a replacement. Under the old regulations it was necessary to "replace the property" lost or destroyed. 2. Under the 192 1 law an amount of the gain resulting from recovery may be deducted, based on the proportion of such proceeds expended for replacement to total proceeds. Assume the following: Cost of asset destroyed $200,000 Less: Depreciation to date of conversion 50,000 Depreciated cost $150,000 Amount recovered 250,000 Profit deferred $100,000 Amount expended in replacing assets substantially in kind. $150,000 5o6 INCOME Amount of profit allowed as deduction from income: 150,000 of 100,000 = 60,000 250,000 Taxable profit $ 40.000 The old regulation dealing with the profits to be reported reads : "the excess of the amount received over the amount actually and reasonably expended to replace or restore the property. "^^ The foregoing regulation was drafted at a time when re- placement costs were greatly in excess of normal, and un- doubtedly it was not expected that replacement would be made at an amount less than original cost or March i, 1913, value. Hov/ever, if property was replaced in 1920 at less than cost, the gain would be measured by the excess of the amount re- covered over cost or March i, 1913, value. In other words, the higher basis would be used in computing the profit. 3. The property acquired takes the place of a like propor- tion of the property converted. In the illustration above, the property acquired would be assigned a "cost" of 1 50,000 X $iSO,ooo, or $90,000, for the purpose of com- 250,000 /^ ^ ^ ' ' ^^ i i puting gain or loss on subsequent sale,®° and for depreciation. 4. The provisions of the 192 1 law are made retroactive to all prior income and profits tax laws as regards exemption from tax. Accounting for proceeds of conversion. — Regulations. In the case of pronerty which has been compul- sorily or involuntarily converted into cash or its equivalent as a re- sult of (a) its destruction in whole or in part, (b) theft or seizure, or (c) an exercise of the power of requisition or condemnation or the threat or imminence thereof, that amount received by the owner as compensation for the property which is in excess of the cost of the property (or other basis) should be included in gross income. How- ever, the gain to be included in gross income in the case where the property was acquired before March i, 1913, and its fair Reg. 45, Art. 49. Section 202 (d). FROM BUSINESS 507 market value as of that date was greater than its cost, is the excess over such value of the amount received. No taxable gain re- sults when the amount received is more than the cost but less than the fair market value of the property as of March i, 1913. In any case proper provision shall be made for depreciation to the date of the loss, damage, or transfer. However, if the taxpayer proceeds forthwith in good faith to replace the property, as provided in Section 214 (a) (12), see Articles 261-263 (Art. 49.) Sections 214 (a) (12) and 234 (a) (14) of the statute deal with cases where property is compulsorily or involuntarily converted into cash or its equivalent as a result of fire, shipwreck, theft, condemna- tion or similar causes enumerated in the statute. Under regulations prescribed by the Commissioner with the approval of the Secretary, the taxpayer is permitted to deduct gains which may be thus invol- untarily realized (through insurance or otherwise) when he proceeds forthwith in good faith to expend the proceeds of such conversion (i) in the acquisition of other property of a character similar or related in service or use to the property so converted, (2) in the acquisition of 80 per cent or more of the stock or shares of a corporation owning such other property, or (3) in the establishment of a replacement fund. When only part of the proceeds of such conversion is thus expended (for example, one-third) a corresponding part of the gain (in the example given, one-third) may be deducted. The statute also pro- vides that for the purpose of determining gain or loss the property acquired takes the place of a like proportion of the property con- verted (in the example given, one-third). (See Sec. 202 (d) (2) and art. 1567.)"^ The or restored property, to the extent of the re- placement, shall not be valued in the accounts of the taxpayer at an amount in excess of the cost of the old property (or of its value as of March i, 1913, if acquired before that date and such value is higher than the cost) after making proper provision in either case for de- preciation of the original property, plus the cost of any actual addi- tions and betterments. This provision relating to the involuntary conversion of property applies, so far as may be practicable, to the exemption or exclusion of the proceeds thereof or the gains derived therefrom from gross income under prior income, war profits, and excess profits tax acts. Articles 261, 262, and 263 have no application to property which is voluntarily sold or disposed of. As to replacement funds, see article 263. (Art. 261.) The law gives the taxpayer three Hnes of procedure. I. To replace the property with property similar in char- acter or related in service. See Chapter XVII. 5o8 INCOAIE 2. To acquire a minimum interest of 80 per cent in the stock of a corporation owning such property. 3. To establish a replacement fund. ' If a shipping company suffers the loss of one of its ships and, to obtain the use of another, purchases 80 per cent or more of the stock of another company owning a ship which can be used to replace its loss, such purchase of stock is deemed a replacement. Should the taxpayer not elect to follow any of the three courses of procedure outlined in article 261, any gain accruing from the transaction is taxable. Regulation. In cases of involuntary conversion of property within the provisions of sections 214 (a) (12) or 234 (a) (14) the gain must be included in income and no deduction will be allowed unless the taxpayer proceeds forthwith in good faith to expend the proceeds of such conversion in any of the three ways described in article 261. If the taxpayer does not elect so to expend the proceeds of the conversion, the gain, if any, shall be ascertained as provided in article 49. (Art. 262.) Replacement substantially in kind. — Ruling. Where a taxpayer elects to replace- a vessel by one somewhat larger, so long as the general type of the boat is the same as the boat lost or destroyed, it may fairly be taken as a replacement in kind within the meaning of article 49 of Regulations 45, in so far as it equals the tonnage of the original vessel. There should be charged against the replacement fund only such portion of the cost of the new vessel as would represent the cost of a boat of the carrying capacity of the old vessel, with allowance for depreciation. The period during which the replacement fund may be maintained may properly be limited to one year with the privilege of the taxpayer to apply at the end thereof for a further extension of time. (C. B. i, page 76; T. B. M. 61.) When, however, the replacement is another type of ves- sel, such as a barge in place of a tug, the Treasury denies the rehef. Ruling. Where the owner of a requisitioned tug uses the pro- ceeds to buy barges, this is not a replacement in kind as to come within the provisions of articles 49 and 50 of Regulations 45. (C. B. i, page y-j; O. 914.) FROM BUSINIiSS 509 Corporation purchasing replacement property from sub- sidiary. — Ruling. Where one of an affiliated group of corporations which file a consolidated return established a replacement fund in accordance with the provisions of article 50, Regulations 45, the expenditure of the replacement fund so established to replace a steamship in kind is not a replacement within the meaning of that term, when the steamship acquired to replace the one lost was acquired from another of the affiliated corporations. (B. 48-21-1942; A. R. M. 142.) Replacement funds. — Regulation. In any case where the taxpayer elects to replace or restore the converted property, but where it is not practicable to do so immediately, he may obtain permission to establish a replacement fund in his accounts in which part or all of the compensation so re- ceived shall be held, without deduction for the payment of any mortgage, and pending the disposition thereof the deduction shall be tentatively allowed. In such a case the taxpayer should make application to the Commissioner on Form 11 14 for permission to establish such a replacement fund and in his application should recite all the facts relating to the transaction and undertake that he will proceed as expeditiously as possible to replace or restore such property. The taxpayer will be required to furnish a bond with such surety as the Commissioner may require for an amount not less than the estimated additional income and war-profits and excess- profits taxes assessable by the United States upon the income so car- ried to the replacement fund. (See Sec. 1329 of the statute.) The estimated additional taxes, for the amount of which the claimant is required to furnish security, should be computed at the rates at which the claimant would have been obliged to pay, taking into consideration the remainder of his net income and resolving against him all matters in dispute affecting the amount of the tax. Only surety companies holding certificates of authority from the Secretary of the Treasury as acceptable sureties on Federal bonds will be approved as sureties. The application should be executed in triplicate, so that the Commis- sioner, the applicant, and the surety or depositary may each have a copy. (Art. 263.) The principal change in the foregoing article is that "part or all of the compensation" may be held in the replacement fund, instead of the "entire amount." The replacement fund may consist of compensation in cash and proceeds of property returned to taxpayer, when such property has been materially damaged. 5IO INCOME Rulings. Where the Government having requisitioned vessels from a taxpayer for use in the war, returns the same vessels in an unfit condition for their former use, giving the taxpayer a sum of money in lieu of restoration, the vessels are deemed to be substantially different property from that taken from the taxpayer, and the taxpayer may elect to sell the vessels returned and place the proceeds, together with the money paid him in lieu of restoration, in a replacement fund established under Articles 49 and 50, Regulations 45. (C. B. i, page 78; T. B. R. 41.) Where business property was destroyed by fire and the taxpayer immediately replaced such property with property of substantially the same kind, the excess of the cost of replacement over the amount of insurance received as compensation for the property destroyed can not be taken as a loss. It is treated as a capital expenditure, which is recoverable through depreciation deductions. (C. B. 3, page no; O. D. 697.) The principle of the foregoing rulings may be best illus- trated by the following examples : Ruling, i. When recovery '"is less than damage sustained:" Cost of asset $5,000.00 Replacement cost $5,000.00 Recovery $4,000.00 Loss --- $1,000.00 2. When recovery is "less than an amount necessary to make good the damage :" Cost of asset • $5,000.00 Replacement cost $11,000.00 Recovery $10,000.00 Loss (?) - $1 ,000.00 The investment, at cost, as indicated in each of the above illustra- tions is $5,000. This is the capital sum that may be returnable through depreciation or claimed as a loss if the asset is damaged or destroyed. In the recovery for loss or damage there is necessarily a conversion. In this conversion there would ordinarily be an immediate profit or loss determined by the amount of recovery. But under Treasury De- cision 2706 the determination of the profit or loss is deferred. This decision provides that an amount so recovered (b)^ requisition of property for war purposes or because lost or destroyed in whole or in part through war hazard) may be set aside in a "replacement fund" and "pending the disposition thereof tlie accounting for ga'n or loss thereupon may be deferred for a reasonable period of time." The excess of the amount so recovered "over the value or cost of the property, except so far as actually used for the replacement of the FROM BUSINESS 511 property in kind, is subject to the income, war income^ and excess profits taxes.'* This decision, therefore, provides for the determina- tion of gain by use of the replacement fund. If the entire fund is expended to replace in kind there is no profit or loss because an asset of no greater or lesser value has been acquired. Substantially there is no conversion — merely a substitution. The substitution of the asset "in kind'' is only one transaction and the profit or loss is measured by the use of all or a part of the replace- ment fund — not by an amount in excess of the replacement fund. Thus, if the recovery (as in illustration No. i) was $4,000 on an asset valued at $5,000 and it cost $5,000 to replace the asset, the de- ductible loss is $1,000. But if the recovery (as in illustration No. 2) was $10,000 the immediate profit of $5,000 can not be converted into a loss of $1,000 if it cost $11,000 to replace the asset. Any expenditure in addition to the amount recovered and held in the replacement fund represents the conversion of a current asset (cash) into a fixed asset. The Committee accordingly concludes that an amount in excess of recovery for loss expended for replacement of an asset "in kind" is not deductible as a loss when the entire fund so recovered is equal to or greater than the book value of the asset. (C. B. 4, page 92; extract from A. R. M. 122.) The foregoing ruling would work out as follows: A con- cern owned a ship which was carried on its books at cost (or value March i, 1913), less normal depreciation, viz., $100,000. In 1 9 19 it was lost or destroyed. Insurance amounting to $300,000 (its insurable value) was collected. Under the reg- ular practice income and excess profits taxes would be collected on $200,000.*^- On the assumption that it would cost $300,000 to replace the old ship with a new one no better than the old, the 1 92 1 law (retroactive in this respect to taxes under pre- vious income and profits tax laws) permits the taxpayer to credit the entire amount received to a replacement fund, and to withhold the payment of any tax on the excess received, provided"^ bond is filed for the tax which would be due if im- mediately assessed. If a new ship, which is "substantially" the same as the old, is purchased out of the replacement fund, at a cost of $300,000, no tax will be payable if the new ship "^If the ship is not replaced income tax would be assessed on $200,000, but relief might he granted as t(j the excess profits tax in certain circum- stances. See Appendix A, Chapter XV. "'Art. 263. 512 INCOME is carried in the accounts of the taxpayer at an amount not greater than that at which the old ship was carried. If the replacement is made at a cost of less than $300,000, say for $150,000, the gain to be reported is that proportion of the proceeds in excess of cost which the amount expended for replacement bears to the amount recovered, viz., 150,000 / T/N r c^ o 64 "^ (or ^) of $200,000, or $100,000."^ 300,000 Under the 192 1 law [section 202 (d-2)] a new prorated "cost" ($50,000) would be assigned to the replaced property, viz., that proportion of the cost of the property converted ($100,000) that the amount expended for replacement ($150,000) bears to the amount recovered ($300,000), that is, one-half. If the replacement cost is $350,000, the excess of cost over compensation received, viz., $50,000, must be added to the book cost, and must not be taken as a loss. The provision that the new ship must not be valued on the books at more than the book value of the old one is equi- table, because if it were so valued there would be an amount credited to profit and loss account upon which no tax had been assessed. Cash received from Alien Property Custodian. — The amount of cash received from the Alien Property Custodian as a return of property seized''^ by him may be placed in a re- placement fund. The provision is broad enough to include property seized by him under the law and converted into money. " [Former Procedure] T. D. 2706, approved April 25, 1918, read in part : "This excess of the amount received oivr the value or cost of the property, except so far as actually used for the replacement of the property in kind, is subject to ... . taxes." Art. 49, Reg. 45, (promulgated January 28, 1921) reads, in part, as follows: "the gain, if any, is measured by the excess of the amount received over the amount actually and reasonably expended to replace or restore the property." But see text on page 506. " Section 214 (a-12) reads "as a result of ... . seizure." FROAI BUSINESS 513 Recoveries for Damages, Patent Infringement, Claims, Bad Debts, etc. Regulation. Gains, profits and income are to be included in the gross income for the taxable year in which they are received^* by the taxpayer, unless they are included when they accrue to him in accordance with the approved method of accounting followed bj him A person may sue in one year on a pecuniary claim or for property, but money or property recovered on a judgment there- for rendered in a later year would be income in that year, assuming that it would have been income in the earlier year if then received. This is true of a recovery for patent infringement. Bad debts or ac- counts charged off subsequent to March i, 1913, because of the fact that they were determined to be worthless, which are subsequently re- covered, whether or not by suit, constitute income for the year in which recovered, regardless of the date when the amounts were charged off (Art. 51.) The foregoing article is a fair interpretation of the legal definition of income even though in many cases it has resulted inequitably. When accounts are kept on an accrual basis and an obvious error has been made, the returns of prior years may be reopened and corrected. When income is not reported for taxation because it is not deemed at the time to be taxable income, no just criticism can be imputed to a regulation which holds that if income was not reported when it appeared to accrue it must be reported when it is realized. When items which have never been included in gross in- come or which have been charged off as bad are collected, they are pruna facie taxable income (jf the year of realization. The courts carry this theory to an extreme not warranted by business practice. Good accounting practice requires that there be taken up as accrued and taxable transactions, those which are the equivalent of cash.^' x^ccounts and notes receiv- able due from and recognized by solvent debtors are deemed to be the equivalent of cash. Only in exceptional ca'^c^ vyov.ld accruals of tmcertain or indeterminate items be sanctioned by "Postponement of collection by reason of moratorium does not entitle taxpayer to omit income from accounts so affected from return for year in which received. (C. B. 4, page 98; O. D. 869.) "• See page t,^t,. 5H INCOME good accounting practice. The definitions of income in the law and regulations are strictly limited by the decisions of the United States Supreme Court. These decisions do not require the payment of tax on transactions which are not the equiv- alent of cash. Any regulation which attempts to set aside this theory is not sound. Ruling. The United States brought suit against the M Corpora- tion for the recovery and possession of oil lands. A receiver was ap- pointed to take possession of the lands and retain the proceeds of the sales of oil and gas produced thereon, pending a final judgment, which was rendered in 1919 in favor of the United States. Pursuant to an Act of Congress the United States in 1920 leased the land that was involved to the same corporation. Later, pursuant to the same Act, the Department of Justice proceeded with the settlement and ad- justment of the judgment against the company, whereupon by a decree of the court rendered in 1921, the receiver was directed to pay a part of the impounded money to the M Company, which is held to be tax- able income for the year 1921, when it was paid. (B. 39-21-1839; O. D. 1046.) Award of damages by arbitration board. — Ruling. The award in the year 1918 by a board of arbitration of X dollars to the M Company on its unliquidated claim to a portion of the proceeds arising out of transactions which took place in 1917 is income to the corporation for the year 1918 rather than 1917 (C. B. 2, page 82; S. 1335.) In computing damages the element of value at March i, 19 1 3, must not be forgotten. In the case of damages for infringement of patents, etc., it is quite possible that suits not yet settled, or those which have been settled during recent years, include payments which properly apply to the period prior to March i, 1913. Ruling. Certain property owned by an estate was in 1906 listed by a city to be condemned for public purposes. The property was not destroyed until 191 7. During that year a verdict was rendered awarding the estate x dollars, with interest at the rate of 6 per cent per annum from 1906, the date the property was listed for condemna- tion. Mandamus proceedings were instituted to enforce the settle- ment of this award, and in 1920 the estate received payment of the FROM BUSINESS 515 face value of the claim, together with interest accrued since 1906, and costs. Held, that the measure of taxable income is the excess of the sum of the principal and accrued interest actually received over the fair market value of the claim representing such principal and interest accrued as at March i, 1913. Such excess as regards the principal of the claim is taxable as of the year 1920, in which it was received. The amount of the interest received is exempt from income tax as interest on the obligation of a political subdivision of a State within the meaning of section 213 (b) 4 of the Revenue Act of 1918. The cost of mandamus proceedings was a replacement of the amount expended by the estate in the collection of a debt and should not be included in gross income of the estate. Nor should it be taken as a deduction in computing net income for the year in which expended. (C. B. 3, page 113; O. D. 591.) A taxpayer sued in 1908 to recover damages for patent infringement and in 191 1 a United States circuit court ren- dered a decision in his favor. The case was referred to a mas- ter, v^ho filed a final report with the court early in 1918. In the latter part of 1918, the case was compromised, and an amount agreed upon was paid to the taxpayer. The Treasury held: ". . . . the amount received in 1918 does not con- stitute taxable income for that year, for the reason that the right to receive this amount existed and was a part of the assets of the X Company on March i, 191 3." Claims. — The word "claims" indicates that liability is dis- puted. If claimants do not accrue the claims as income and if those against whom claims are made deny liability, it can hardly be held that taxable income arises unless and until there is realization of the equivalent of cash. It is now well settled that proceeds from claims, judgments, contracts, etc., definitely ascertained and vested before March I, 191 3, although received during some subsequent year, are not taxable net income."''' Bad debts. — When accounts or notes receivable have been Sec Arts 51 and 151, Cliaptcr XXX. 5i6 INCOME charged off because they are deemed to be worthless, it is proper to include any subsequent collections on account thereof as taxable income of the year in which realization occurs. It is not good accounting practice to reopen the accounts of \)rt- vious years under such circumstances; nor is it proper to re- open tax returns under similar conditions. Even if it develops subsequently that poor judgment is used and some accounts which were charged off should not have been charged off, it would bring about indescribable confusion in accounting and tax matters if it were permissible to reopen the accounts except under extraordinary circumstances. Business is conducted under ordinary conditions and superhuman knowledge is not imputed to business men. Under the accrual system books of account must be closed and income statements prepared periodically; when reasonable care is taken in closing books, subsequent adjustments must be made in subsequent accounts. Types of Business Income Taxable and Non-Taxable Taxable income can only arise from dealings with the public. — The types of business dealings here considered are with the public generally. For purposes of convenience or- ganizations are sometimes set up which operate as separate entities, but are entirely owned by one interest. Reference is not made to the relationship which exists between parent and subsidiary corporations or between affiliated corporations. Such relationships are discussed elsewhere. ®® But there are other cases in which a firm or an individual establishes branch houses or agencies which keep separate sets of books and prepare independent profit and loss statements. If the separa- tion is in form and not in substance income tax returns should not be made except by the sole owner. An English firm had an agency in the United States which purchased cotton in the United States and shipped it to Eng- land. The cotton was billed to the head office at market See Chapter XXII and page 196. FROM BUSINESS 517 prices on the day of shipment. A book profit of several hun- dred thousand dollars was shown on the books kept in this country. No cotton was shipped to any one except the actual purchasers. Not a dollar of actual profit was realized in this country. An income tax examiner held that a taxable profit was realized because it was shown on the books. The profit was a book profit only. No net income was realized. Upon appeal the inspector was overruled. Charging or crediting oneself at high or low prices can- not produce a profit or a loss. Dealing with the public is necessary to produce profit or loss. Ruling. Coal purchased by a company on bona fide contracts entered into prior to October 30, 1919, and shipped to tidewater for export on contracts entered into prior to that date was diverted by a Government agency for the use of certain railroads and the company is carrying these accounts on its books awaiting a decision by the Government as to the final settlement of the bills. Held, that the principle laid down in the last two sentences of article 52, Regulations 45, is applicable in this case, although these sentences refer to the unusual conditions prevailing at the close of 1918. The M Company should set up these accounts in a "Suspense Account" and eliminate them from their returns for 1919 and 1920, pending final settlement. There should be attached to such returns a full statement of the facts relative to the claims of the company on account of the diversion of the coal. When final settlement has been made, amended returns for the years 1919, and 1920, should be filed, including therein the income found to be due upon such final settle- ment. (C. B. 4, page 93; O. D. 816.) The foregoing riding attempts to apply the very doubtful provision of article 52^*^ of Regulations 45 to an imrelated mat- ter. In the foregoing case the shijjpers had accounts receivable at the end of 191 9 and 1920. If the accounts were not bad at the end of these years they could not, under the regulations, be charged off. There is no basis in the 19 18 regulations for ''eliminating" doubtful accounts. A proper interpretation of the laws would have permitted charging off bad debts," but the regulations specifically forbade it. The invoking of article '" See page 513. " Cliapter XXX. 5i8 INCOME 52 is versatile l)nt unsound. If permitted to stand it will bring about a vast number of amended returns and the inclusion in the accounts of subsequent years of the amount, if any, re- covered. Ruling. In 1914 the United States Government took over a cer- tain business of the M Company and held it until March, 1920, at which time it was returned to private ownership. In 1919, following the settlement of a dispute as to the corporation entitled to receive the income from the operation of the business, the United States Govern- ment paid the M Company the sum of 2.r-dollars representing earnings from 1914 to April 6, 1917. In 1920 it paid the company x dollars as rental from April 6, 1917, to March, 1920. The question arises as to how this income should be reported and also the manner and extent a claim for depreciation in value of the property may be made. Held, that inasmuch as the M Company kept its books on the cash receipts and disbursements basis, the amounts received in 1919 and 1920 must be treated as income for these vears. (C. B. 4. page 180; O. D. 948.) The foregoing ruling is not consistent with the Treasury's contention that unusual conditions are sufficient to modify general rules. It may be assumed that if the government "took over" and "held" the business from 1916 to 1920, failure during such period to keep accounts on an accural basis is the failure of the government and not of the taxpayer. The gov- ernment cannot take advantage of its own negligence to keep accounts of property held in trust according to good accounting methods. Gifts received by corporations not taxable as income.'- — Law. Section 213. [Individuals] .... "gross income" — . . . . (b) Does not include ■ • • • (3) The value of property ac- quired by gift, bequest, devise, .... Section 233. [Corporations] .... "gross income" means the gross income as defined in section 213, .... The foregoing section of the law applies to corporations as well as to individuals. The interesting question arises : How shall a corporation enter gifts on its books? If the "■ [Former Procedure] For procedure under 1909 and 1913 laws, see Income Tax Procedure, 1920, pages 322-323. FR(3M BUSINESS 519 values at date of gift are set up in the books, subsequent gains based on book vakies may or may not be taxable. It would seem to be necessary in all of such cases to ascertain from the donors the cost to them of the property donated and to note the cost in the ledger account. The maximum tax which can be imposed upon the net income of corporations after January I, 1922, is 12 V2 per cent. Individuals who own property for less than two years and who desire to sell it, apparently can donate the property to a corporation. When the corporation sells it the gain can be taxed only at the I2>^ per cent rate. The Treasury has held that upon the recision of a con- tract and repayment to the corporation by an employee of com- pensation paid under the contract in a prior year, such pay- ment was a gift to the corporation. (See O. D. 1073, cpoted on page 430. ) Sale by corporation of property acquired by gift. — Law. Section 20J. (a) . . . . (2) In the case of such prop- erty, acquired by gift after December 31, 1920, the basis shall be the same as that which it would have in the hands of the donor or the last preceding owner by whom it was not acquired by gift. If the facts necessary to determine such basis are unknown to the donee, the Com- missioner shall, if possible, obtain such facts from such donor or last preceding owner, or any other person cognizant thereof. If the Com- missioner finds it impossible to obtain such facts, the basis shall be the value of such property as found by the Commissioner as of the date or approximate date at which, according to the best information the Commissioner is able to obtain, such property was acquired by such donor or last preceding owner. In the case of such property acquired by gift on or before December 31, 1920, the basis for ascertaining gain or loss from a sale or other disposition thereof shall be the fair market price or value of such property at the same time of such acquisition; Forgiveness of indebtedness. — Regulation. The cancellation and forgiveness of indebtedness is dependent on the circumstances for its effect. It may amount to a payment of income or to a gift or to a capital transaction. If, for example, an individual performs services for a creditor, who in consideration thereof cancels the debt, income to that amount is t^2o INCOME realized by the debtor as compensation for his services. If, how- ever, a creditor merely desires to benefit a debtor and without any consideration therefor cancels the debt, the amount of the debt is a gift from the creditor to the debtor and need not be included in the latter's gross income. If a stockholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation.'^ .... (Art. 50.) One of the United States circuit courts of appeals has decided in a recent case that a debt forgiven is not income to the debtor.'* The court said : "Now, it seems to us hardly arguable that the cancellation of the debt in question was not in the category of capital .... The cancellation of the debt was a means of contribution to its capital account, quite as though the money had been contributed by the stockholder only to enhance the value of his stock." It is suggested that when stockholders or bondholders contemplate making good a deficit, attention should be given to both sides of the transaction. The creditor may desire to claim credit for the transaction as a bad debt deduction. Outlawed accounts held to be taxable income. — Decision. (Syl.) I'he amount of obligations of a railroad cor- poration carried on the books as liabilities, which became outlawed and were therefore written off during the taxable years 1910 and 1911, represented profit to the company which was properly included in its net income for the year in which so written off.'^^ Voluntary assessments paid by stockholders not taxable. — Regulation. Where a corporation requires additional funds for conducting its business and obtains such needed money through vol- untary pro rata payments by its stockholders, the amounts so re- ceived being credited to its surplus account or to a special capital account, such amounts will not be considered income, although there '' [Former Procedure] Tlie last st'iucncc of the corresponding article (51) in Reg. 45 (1919 Edition) reads: "If. however, a corporation to which a stockholder is indebted forgives the debt, the transaction has the effect of the payment of a dividend." '* U. S. V. Oregon-W ashvujtnn R. cr Xai'. Co., Circ. Ct. of App.. 251 Fed. 211 (April 24, 1918). "'Great Northern Ry. Co. :■. Lyncli, U. S. Disl. Ct., Dist. of Minnesota, 3rd Div., January 10, i sequent sale certain adjustments of the original cost or March I, 19 1 3, value have to be made. I, AW. Section 202 (e) Where property is exchanged for other property which has no readily reaHzable market value, to- gether with money or other property which has a readily realizable market value, then the money or the fair market value of the prop- erty having such readily realizable market value received in exchange shall be applied against and reduce the basis, provided in this section, of the property exchanged, and if in excess of such basis, shall be taxable to the extent of the excess; but when property is exchanged for property specified in paragraphs (i), (2), and (3) of subdivisions (c) as received in exchange, together with money or other property of a readily realizable market value other than that specified in such paragraphs, the money or the fair market value of such other property received in exchange shall be applied against and reduce the basis, provided in this section, of the property exchanged, and if in excess of such basis, shall be taxable to the extent of the excess The rule laid down in the foregoing section of the law may be stated as follows : \Vhen the transaction is not closed, the cash or other property having a readily realizable market value (other than the three exceptions stated) received in ex- change is regarded as a return ( in whole or in part, as the case may be) of the taxpayer's investment. The following illustrations show the two applications of the rule, when the transaction is regarded as a continuing one. Case I Land costing in 1915 I is exclianged in \ Securities (having no- readily $25,000 I 1921 for "/ realizable market value) ' ' Cash $10,000 In the above case the securities are regarded as taking the place of the land, but the cash received $10,000 is applied against the $25,000, so that the "cost" of the securities, upon resale, is deemed to be $15,000. EXCHANGES OR SALES OF CAPITAL ASSETS 593 Land costing in 1915 $25,000 is exchanged in 1921 for Case II (a) Land '"^ or (b) Securities in an 80 per cent controlled corporation *" or (c) Either one or both of the above two clashes, all having a readily reali- zable market value ; and (d) Cash, or securities of a kind different from those in (b) or (c) above, hav- ing a readily realizable market value of $10,000 In the second case, while any or all of the two specific classes of property (a) and (b) above may have a readily realizable market value, the receipt thereof is, under section 202 (c), deemed to be a continuing transaction in which neither gain nor loss is recognized. Therefore, only the value of property (d) in the illustration above, $10,000, is regarded as a return on account of the original investment of $25,000, and thus serves to reduce the basis to $15,000 for purpose of computing profit on any subsequent sale of property (a) or (b). If, in the foregoing illustration, property (d) had an aggregate value of $30,000 instead of only $10,000, a profit of $5,000 would have to be reported for the ])eriod during which the transaction occurred, and upon the sale of any of the property (c) or (b) the full amount realized would have to be reported as taxable income. Case III Stocks and bonds in company costing in 1915 $25,000 a r e exchanged in I 92 I for Securities in B Company, in a "reorganization" '' of A Com- pany, having a readily reali- zable market value; and Cash $10,000 ^ For discussion of property of a "like kind or use" [section 202 (c-i)], see page 545- '"Transfers of property to a corporation in which the transferors con- trol 80 per cent or more of the stock [section 202 (c-3)] is discussed at page 560. "" "Reorganizations" [section 202 (r-2)] are treated at page 557. 594 INCOME The third case above is also deemed to 1)e a continuing transaction, under section 202 (c), although the securities re- ceived in the "reorganization" have a readily realizable mar- ket value at the time of their receipt by the taxpayer. The amount of cash ($10,000), however, reduces the basis of the original securities, so that upon subsecjuent sale of the new securities their "cost" is deemed to be $15,000. Official illustrations. — The official illustrations, to- gether v\'ith a tabular statement thereof so that they may be readily followed, are given below : Regulation Examples. — (i) A exchanged certain property which he had purchased subsequent to March i, 1913, for $5,000, for real estate having no readily reahzable market value and $2,000 in cash. No gain or loss is realized from such exchange. However, if A subsequently sells the real estate, the difference be- tween the amount realized therefor and $3,000, the basis of the prop- erty exchanged reduced by the amount of cash received in the ex- change, is taxable gain or deductible loss, as the case may be (Art. 1568.) (1) Property, cost / :^ ^^.^u^r^aoA { ^^^^ ^^^^^'^ having no readily (after March i. - ^^ excnangecl . realizable market value 1913) $5,000 ) °^ ( Cash $2,000 Basis — "cost" of real estate received is $3,000, viz., $5,000 — $2,000. Regulation (2) A exchanged certain property which he had purchased subsequent to March i, 1913, for $14,000, for stock having no readily realizable market value and bonds having a readily realizable market value of $16,000. A realized a taxable gain of $2,000, the amount by which the fair market value of the bonds ex- ceeds the cost of the property exchanged. The entire amount re- ceived from the subsequent sale of the stock received in the ex- change constitutes taxable income (Art. 1568.) (2) Property, cost ) ■ „.._i-,„„„„,i ( Stock (having no readily realizable (after March i, - " exchanged 1 market value) 1913) $14,000 ) ° ( Bonds (market value $16,000) Taxable gain $2,000, viz., $16,000 — $14,000. Basis — "cost"' new of stock received is o. Regulation (3) A, in connection with a reorganiza- tion of a corporation, received in place of stock purchased by him subsequent to March i, 19 13, for $9,000, stock in a corporation a EXCHANGES OR SALES OF CAPITAL ASSETS 595 party to the reorganization together with cash in the amount of $4,000. No gain or loss is reahzed from the exchange. However, if A subsequently sells the stock, the difference between the amount received therefor and $5,000, the basis of the old stock reduced by the amount of cash received in the exchange, constitutes taxable gain or deductible loss, as the case may be (Art. 1568.) (3) Stock, cost (af- I is exchanged \ Stock in a "reorganization" ter March i, - tnr '1 r- u a- 1913) $9,000 ) ^""^ ( Cash $4,000 Basis — "cost" of stock received is $5,000, viz., $9,000 — $4,000. Regulation (4) A transferred to a corporation, all of the outstanding stock of v^^-hich was owned by him, property pur- chased by him subsequent to March i, 1913, for $40,000, in exchange for stock and $50,000 in cash. A realized from the exchange a tax- able gain of $10,000, the amount by which the amount of the cash exceeds the cost of the property transferred. The entire amount re- ceived from the subsequent sale of the stock received in the exchange constitutes taxable income (Art. 1568.) (4) Property, cost] . , A Stock (in a totally owned corpora- (after March i, I is exchanged , .on) at least 80 per cent con- 1913) $40,000 ' I f^'- 1 '';^Y J L Cash $50,000 Gain $10,000, viz., $50,000 — $40,000. Basis — new "cost" of stock received is o. Regulation It is assumed in the above examples that the property exchanged was not of a kind properly to be included in inventory. If the property exchanged was acquired prior to March i, 19 13, or by gift, devise, bequest, or inheritance, see articles 1561, 1562, and 1563 (Art. 1568.) The basis to be used in case of property acquired prior to March i, 19 13, is discussed at page 569. Property acquired by gift after December 31, 1920, is deemed to have, in the hands of the donee, the same cost or March i, 19 13, valtie as if still in the possession of the donor.^" Gifts acquired prior to December 31, 1920, and property ac- quired by devise, bequest or inheritance are treated at pages 620. ^" See page 619. 59^ INCOME Determination of Fair Market Price or Value at March 1, 1913 It should be noted that the law does not require the de- termination of "fair market value" on March i, 1913, but '■fair market price or value."' If fair market price can be ascertained, nothing further is needed. But it must be "fair," that is, representative and not narrow. The sale of a few shares of stock out of thousands is not a fair criterion. In addition the price must meet the common definition of "market," which presumes a willing buyer and a willing seller. If any one of these elements is lacking we use the alterna- tive provided in the law, viz., "value." Often the Treasury fails to consider the second standard and insists on the first. No specified method of determining values. — Regulation What the fair market value of property was on March i, 1913, is a question of fact to be established by any evidence which will reasonably and adequately make it appear (Art. 156 1.) Realizations may not occur for many years and it is some- times difficult because of the lapse of time to determine a fair value as of Alarch i, 1913.^^ It is advisable, therefore, if sales are at all probable, to give consideration to the factors un- derlying valuations and to accumulate evidence to establish true values as of that date. The cost of reproduction is rarely a satisfactory basis for the determination of fair market value as of any date. When applied to the present time we find that many properties are sold for less than it would cost, at present prices, to reproduce them. In many cases during the war. prices were paid far in excess of reproduction costs. Recent sales by willing sellers to willing buyers are the best bases of all. but the records of such sales are confined almost entirelv to stock and similar "For definitions of "value," see Income Tax I'rocedure, 1920, pages 343-344- EXCHANGES OR SALES OF CAPITAL ASSETS 597 exchanges. Reproduction cost may, however, be very useful evidence in estabhshing fair market value. What is "fair market value"? — The following extract from a charge to a jury which was approved'*^ on appeal by the United States Supreme C'ourt may be used as an authorita- tive guide in determining what is ''fair market value." Decision. The market value of goods is the price at which the owner of the goods, or the producer, holds them for sale; the price at which they are freely offered in the market to all the world ; such prices as dealers in the goods are willing to receive, arid purchasers are made to pay, when the goods are bought and sold in the ordinary course of trade The defendant asserts .... that the only way to arrive at the market value is to take the cost of production, to compute how much the manufacturer has actually disbursed in pro- ducing the goods, and that thus you have the actual market value. The United States, however, maintain that .... they are freely of- fered to all the world, and held at known and estalilished rates ; . . . . and at which they are ready to furnish them to all the world. If this latter state of facts be true, then it is evident that the prices at which the producers so hold them are the market prices The Treasury's definition of ''fair market value" is set forth in a ruling quoted in full on page 539. What is "value" March i, 191 3? — -In the absence of trustworthy data regarding "fair market price," the law gives taxpayers the alternative of determining the value of property on March i, 1913. The courts and text writers have fre- quently differentiated between the two terms and little diffi- culty is encountered in ascertaining the general principles to be observed. In the case of Virginia v. JVcst Virginia,"^ decided June 14, 191 5) by the United States Supreme Court, wherein the issue was to determine what proportion of Virginia's indebtedness the new state of West Virginia should pay, it became neces- sary to make adjustments of certain credits and debits as of January i, 1861, arising out of the valuation of certain rail- ^Cliquot, Chanipagiw. 3 Wall. 114. 70 U. S. J 14, 18 L. Ed. 116. '238 U. S. 202, 59 L. P2d. 1272, 35 S. Ct. 795. 5^8 INCOME way stocks and other securities as of that time. Justice Charles E. Hughes, in speaking of stock of Richmond, Fredericks- burg and Potomac Railroad Company (one lot amongst the several involved), said: Decisions. The fact, however, that there was no sufficient proof of market value was not an insuperable obstacle to the making of a fair valuation. It was clearly proper to introduce evidence tending to show the intrinsic value of the shares (Nelson v. First National Bank, 69 Fed. 798-803 ; Critch field v. Julia, 147 Fed. 65, 73; Henry v. A^. A. Construction Co., 158 Fed. 79, 81; Murray v. Stanton, 99 Mass. 345 ; Industrial and General Trust Co. v. Tod, 180 N. Y. 215, 232; State v. Carpenter, 51 Oh. St. 83; Redding v. Godkjuin, 44. Minn. 355; Moffitt v. Hereford, 132 Mo. 513.) Property concerning which no proof of value in the market can be given, because it is not brought into the course of trade and is incapable of any estimate in that mode is often the subject of legal valuation. In such cases the value is to be ascertained from such elements of value as the property represents, among which may be the cost of producing an article The question of value is not to be determined by considering the separate elements of which the property is composed, but by taking it as a whole, where it is, regard being had for the purpose for which it was intended and for which it is to be used.^° Where property is destroyed and injured which has a market value, this must be shown as the measure of damages; where it has no market value and a real value is shown, this is the measure of plaintiff's recovery; where it has neither a market value nor a real value, but it is shown what it would cost to replace or reproduce the article, then such costs is the measure of damages. But if the article has no market value nor real value, and it cannot be reproduced or replaced, then in that event it would be proper to show what it was worth to the plaintiff' '' .... Yet a thing not bought and sold in the market may have a value, as when it is an article fitted for a specific use of the owners, and worthless for every other purpose. To attempt to test it by the open market, where it is never offered for sale, and is never bought, would be absurd. In reason the cost of replacing it would ordinarily be the standard of its value. "■^ Ordinarily, when an article of sale is in the market, and has a ^^ Sutherland on Damages, Volume 2. Article 448, Fourth Edition. ^ iM. K. & T. Ry. Co. v. Crczis. 120 S. W. mo, 54 Tex. Civ. App. 612. ^^ Marlines V, State, 16 Tex. App. 122, quoting 3 Bish. Crim. Prac.^ sec, 751. EXCHANGES OR SALES OF CAPITAL ASSETS 599 market value, there is no difference between its value and the market price, and the law adopts the latter as the proper evidence of its value. This is not, however, because value and price are really con- vertible terms, but only because they are ordinarily so in a fair market. The primary meaning of value is worth, and this worth is made up of the useful or estimable qualities of the thing ""■' The "value'' of land sought to be condemned, which the petitioner is required to pay, is not what any one person would give for the land for his own particular use, but what could probably be obtained for it if a sale was desirable and a purchaser sought, applying the ordinary business methods to find him and to dispose of the prop- erty.'**> Valuation of patents. — The valuation of patents as at March i, 1913, is fully discussed in Chapter XVIII. Value of mines, oil wells, etc., March i, 1913." — The gen- eral principles underlying valuations as of a past date have been stated. In valuing mines, oil wells and other natural resources the Treasury requires many details. The burden of proof is properly put upon taxpayers to support their claims and any reasonable data required must be furnished or tax- payers may expect that claims will be disallowed. As the Treasury's requirements*" are available to all who are inter- ested it is not necessary to quote at length therefrom. ■ Computation of value of mines, etc., at march i, 191 3, OR ANY other GIVEN DATE. — ^The following table is used '' Kounts V. Kirkpatrick. 72 Pa. St. 376, 13 Am. Rep. 687. ^" Wciscr Valley Land & ll'atcr Co. z'. Ryan, 190 Fed. 417, in C. C. A. 221, (the quotation is from the syllabus to tlie case). " For detailed regulations describing the present value method, see Chapter XXX III. ''The following forms may be obtained upon application to the Super- intendent of Documents, Government Printing Office, Washington, D. C, for a nominal sum : Form D Schedules for valuation, depletion and depreciation E Schedule for valuation of coal properties F Schedule for valuation of deposits of non-metals O For oil and gas producers T General forest industries questionnaire for the years prior to 1919 T (Timber) Forest industries schedule 6oo INCOME by the Trcasiirv's engineers in the vakiation of mines, in those cases in which the valuation is based on the discounting of prospective earnings to present vaUie. Following the table is an illustration showing the application of the formula. Present Worth of Each Dollar of Operating Profit Accumulated during life of n years, assuming annual rate of production and operating profits per unit to be uniform and providing for interest on present worth at r' per cent annually and a payment into a sinking fund which at 4 per cent, interest com- pounded annually, will amount to the present worth, i.e., provide for return of capital, at the end of life. 'rs. 6% 7% 8% 9% 10% 12% 15% I •943396 934579 •925925 917431 90909-^ .892857 •869565 2 .908766 892946 .876891 861777 847176 .819408 . 781010 3 .876389 853937 .832607 812317 792993 .756976 .708694 4 .846052 818370 .792418 768072 745178 •703254 .648525 5 .817570 785469 •755780 728260 702675 .656540 .597680 6 . 790781 754961 •722245 692177 664641 ■615547 •554148 7 •765540 72663S •69143s 659519 630410 .579284 •S16457 8 .741717 700174 .663032 629635 S99440 •546979 •483507 9 .719198 675487 .636765 602251 571286 .518017 •454455 10 .697880 652354 .612404 577066 545581 .491906 .428649 1 1 ■677672 630699 .589748 553820 522019 .468244 .405574 12 .658489 610277 .568624 532281 500344 .446702 .384818 13 .640258 591066 .548887 512330 480337 .427009 .366049 14 .62291 1 572950 .530401 493737 461815 .408936 •348995 15 .606385 555828 •513053 476390 444619 .392292 •333431 16 .590625 539630 .496741 460167 428610 •376914 .319170 17 •575581 524283 •481376 444963 413671 .362663 .306056 18 .561205 509716 .466880 430685 399699 .349420 •293955 19 •547455 496371 •453178 417253 386603 .337082 .282754 20 •534292 482719 .44021 1 404592 374302 •32SSS9 •272358 2r . 5216S0 470171 .427920 392637 362729 •314774 .262682 22 •S09587 458216 •416255 381334 351818 ■304658 •253654 23 •497979 446805 .405166 370630 341517 24 .486835 435903 •394619 360479 331775 25 .476122 425477 ■384571 350840 322549 26 .465820 415496 ■374988 341675 313799 27 •455905 405935 •365S39 332951 305488 28 ■446356 396767 •357096 324637 297587 29 •437155 387970 •348734 316704 290063 30 .428283 379520 •340726 309127 282893 31 .419724 371399 •333054 32 .411462 363589 ■325695 33 •403483 356072 .318631 34 •395772 348832 •311846 35 .38S318 341856 ■305324 F.^c TORS IN Above Table 36 .381108 33SI28 .299049 I 37 38 •374130 •367375 .360832 328637 322371 316318 .293009 i .287190 .281581 n nr 1 nr' 39 R" - -I + 40 •354491 310468 .276171 Dern'ec from Hoskold's Formula 41 .348345 30481 1 .270950 42 .342385 299339 .265909 1 ^resent valu e of $1 per annum in Lp., 43 .336602 294043 .261038 ) 1 years, inte rest on cap tal being at 44 •330990 288913 .256328 c ne rate, r , and for redemption \- 45 •325540 283945 .251774 mother rate r, per :ent } 46 .320248 279128 ■247367 I 47 .315107 274459 .243100 / 'ti = where K" = ( I +r)-' 48 .310109 269929 .238967 =~i"^ ' ' 49 •305250 265533 .234962 i?" 50 ■300525 261266 .231079 EXCHANGES OR SALES OF CAPITAL ASSETS 6oi Example Copy of a memorandum prepared by the Metals Valuation Section of the Income Tax Bureau in determining the valuation of mine at March i, 1913. Italics are author's notes. Ore reserves March i, 1913 875,000 tons Gross value March i, 1913 (875,000 X $12.78) $11,182,500 Selling price of metal in ore reserves — -actual or anticipated. Gross cost March i, 1913 (875,000 X $7.1537) 6,259,487 Cost of mining and extracting metal in ore reserves — actual or anticipated and excliisiz'c of depletion and of depre- ciation of plant. Art. 206 of Reg. O2, defines such "cost" as comprising all cur- rent expenses of producing, preparing and marketing the mineral product sold, exclusive of federal income and profits taxes, allowable capital additions as defined in Art. 222 of Reg. 62. and deductions for depreciation and deple- tion, but including cost of rapairs and rcplaceinoifs neces- sary to inaintai)i the plant and equipment at its rated ca- pacity and efficiency. Net returns (actual or anticipated) $4,923,013 Present worth (discounting at 15% and 4%, using 8-vear life). Present ivorth is inclusive of cost of plant and is based on earnings on capital or purchase price at the rate of 15% per annum and making payments into a sinking fund zvhich at 4% compounded annually will provide for the return of capital at end of %-year life. The above table is calculated for the investment of a sinking fund at 4%. the variables being the rate of discount on capital and the years of life. From the table we find that the present value of each dollar of operating profit accu- mulated during the life is .48350694. Present zvorth therefore is $4,923,013 X .483507 = $2,380,311 Deduct cost of plant (actual or prospective) 1,000,000 The Treasury deducts the full cost (actual or prospective) of the plant from the March i, 1913, present value of the mine on the assumption that the plant must be constructed and the full investment therefor made at the beginning of the period during zvhich the ore is to be removed. If the plant had been constructed prior to March i, 1913, its value at that date zvould be deducted. Market value of ore en bloc March i, 1913 $1,380,311 Unit of depletion per ton ($1,380,311 -^ 875,000 tons) $1-5775 "Discovery" value of mines, oil and gas wells. — Ruling. In computing the gain or loss from the sale of mines, oil and gas wells, discovered on or after March i, 1913. the tax- 6o2 INCOME payer is not entitled to set up the value as of date of the discovery or within thirty days thereafter, as the basis of the computation. . . . . (C. B. 3, page 44; Sol. Op. 26.) Such value is permitted, however, for depletion purposes. (See Chapter XXXIII.) Value of claims for infringements, judgments, claims, etc., March i, 1913. — The rules for determination of values of in- tangible assets at March i, 191 3, are in many respects similar to those heretofore discussed. The position of the Treasury is set forth in a recent ruling. The taxpayer in the case secured a perpetual injunction in 191 1 restraining an infringer of its patents. Ruling. Thus, on this date (July 31, 191 1) a definite, assign- able property right vested in the M Company. The case was referred to a master of the court to ascertain and determine subject to the approval of the court the amount of said gains, profits and damages. The master filed a final report with the court on April 18, 1918, measuring the damages to be the loss or profit on the sales lost by the complainant In the latter part of 1918 the case was compromised, and the amount finally agreed upon and received was X Dollars In view of the foregoing it is held that the amount received in 19 1 8 does not constitute taxable income for that year, for the reason that the right to receive this amount existed and was a part of the assets of the M Company on March i, 1913. (Unreported to date.) Value of goodwill at March i, 1913. — The Treasury has indicated the following methods : 1. The difference between the price at which an article is sold under the trade-name and under no trade-name multi- plied by the number of units sold during the year equals profits attributable to goodwill. Capitalize this at 20 per cent. 2. Comparison with businesses having similar sales and profits when such companies have goodwill purchased for cash. Ruling The third method and possibly the one which will most frequently have to be applied as a check in the absence of data necessary for the application of the preceding ones, is to allow EXCHANGES OR SALES OF CAPITAL ASSETS 603 out of average earnings over a period of years prior to March i, 1913, preferably not less than five years, a return of 10 per cent upon the average tangible assets for the period. The surplus earnings will then be the average amount available for return upon the value of the intangible assets, and it is the opinion of the committee that this return should be capitalized upon the basis of not more than five years' purchase — that is to say, five times the amount available as return from intangibles should be the value of the intangibles (C. B. 2, page 31; A. R. M. 34.) Later*^ the Treasury held that the 10 per cent was to be appHed to the net tangible assets. Of course, the smaller the average net tangible assets to be capitalized, the greater will be the earnings to be capitalized at 20 per cent to establish the goodwill value. In businesses that are more or less stable, the Treasury suggests 8 or 9 per cent return on tangibles and capitalizes the earnings applicable to goodwill at 15 per cent. Earnings of predecessor organization may be used. — Ruling. In determining the value of good will as of March i, 1913, in accordance with the third method outlined in A. R. M. 34 (C. B. 2, p. 31), and as a factor in the ascertainment of the value of a share of stock as of that date, a corporation which had not been in existence for a period of five years prior to that date was per- mitted to take the average earnings of the business for five years, thus including a part of the period of the partnership organization that pre- ceded incorporation. (B. 52-21-1990; O. D. 1146. ) It would also be proper to use the earnings of a predecessor corporation. In reorganizations, consideration must be given to any abnormal conditions that may have affected adversely the earnings of the predecessor, such as change in product, need for reducing fixed charges, expansion of facilities, all of which may have prevented the former organization from show- ing large earnings, even though possessing a valuable good- will on which the successor corporation was able to realize excellent profits in subsequent years. C. B. 3, page 43 ; A. R. M. 68. Go4 INCOME Deduction for federal taxes — ascertainment of net i:arnings. — The ruling (juolcd l)el()\v is of particular inter- est not only in holding that federal taxes need not be de- ducted in arriving at net earnings for purposes of goodwill valuation, but because it clearly permits the taxpayer to con- sider only those ordinary expenses and costs which a prospec- tive purchaser would take into account. Any extraordinary expenditures should be restored to income for the purpose of the computation. . A failure to cover sales commitments in a rising market resulted in a loss to one concern which had a very valuable goodwill and sold same for cash the following year at a high figure. The loss in question materially reduced its average earnings for the preceding five years. Such abnormal condi- tions rec[uire that the earnings record be studied with care. \\'hat is necessary is that a value shall be reached, after full consideration of all the factors, that would influence an intel- ligent i)urchaser, who would make due allowance for fluctua- tions in profits, trend of sales, excess plant capacity (if any), management, character of product, etc. Ruling Following the application of A. R. M. 34 em- ployed in A. R. R. 252, the Unit, in the instant case, has determined the value of the intangible assets thus: On Xovember — , 1919, A sold the business of which he was sole owner. It was necessary to report as income the difference between the value of the business on 2\Iarch i, 1913, and the price at which it was sold. An appraisal of the tangible assets was made at or about the time of the sale. Five years' earnings prior to the date of sale — that is, earnings for 1915 to 1919, inclusive — have been averaged and a rate of 8 per cent on the value of the tangible assets determined by the appraisal has been considered a fair return on such tangible assets and the balance divided by the difference between the selling price of the business and the appraised value of the tangible assets, which gives a percentage of 11.33 ^^ the return on the good will. This ratio of 11.33 applied to the average earnings for five years prior to 1913 gave the value of the good will, etc., as of March i, 1913. In computing the earnings for the five years prior to the sale, Federal income taxes were not deducted In this discussion is to be kept constantly in mind that the objective to be attained is the value of the intangible assets as of March i, 1913. EXCHANGES UR SALES OE CAPITAL ASSETS 605 By value is here meant what a wilHng purchaser would be willing- to give and a willing seller would be willing to take for such assets. In the absence of a sale as of the approximate date of March i, 1913, it is recognized that any amount fixed will l)e at best only an approxi- mation. The best method of determining this value yet suggested — and the employment of this method is not questioned by the tax- payer — is the capitalization of the net earnings of the intangibles. For this purpose it is necessary first to determine the net earnings of all the assets. In determining net earnings, both from an accounting standpoint and from a legal standpoint, it is necessary to deduct from the gross receipts cost of materials, cost of labor, cost of burden or overhead, and the amount of any other expenses not covered by these terms but which are not properly included in capital expenditures. In determining the percentage to be used in the capitalization of the net earnings of the intangible assets of the particular business as of March i, 1913, the Unit has tentatively determined the average earnings of intangible asets for the period of five years immediately preceding the date when the value of the intangibles was definitely fixed by an actual sale, but in computing the net earnings did not deduct, and now insists that it should not deduct, Federal income taxes for those years. During the years in question^ I9i'5 to 1919, inclusive, with the exception of the year 1917, no tax was assessed upon an individual's business as such. The only tax which an indi- vidual paid was upon his individual income. This income, during all of the years in question, was, under the terms of the several Acts in force, made up of his receipts from all sources and the tax was levied upon the net income remaining after the allowable deductions had been made. Under no construction of the Revenue Act of 1913, or the Revenue Act of 1916 in its original form or as amended by the Revenue Act of 1917, or of the Revenue Act of 1918, could this tax be held to be an expense of any business in which the taxpayer was engaged during these years. The tax was not computed until all the expenses of such business had been deducted from the gross income, and no room appears for any serious contention that such tax would constitute a proper deduction in determining the earning power of the assets The real consideration presented by the inquiry of the Income Tax Unit, therefore, appears to be whether the war and excess profits taxes imposed upon the business of an individual by section 201 of the Revenue Act of 191 7 should be deducted in determining the earnings for the year 1917 of the intangible assets employed in such business. The value of the intangible assets to be determined, as above pointed out, is the value as of March i, 191 3. At that time no tax was im- posed upon the business of an individual as such, nor was any in con- templation. Any tax not imposed until nearly four years later cer- 6o6 INCOME tainly was too reniole to have been anticipated. Such a tax, there- fore, could not have entered into the consideration of any prospective purchaser of a business in determining upon its worth to him. In de- termining, therefore, the rate per cent to be appHed in capitalizing the net earnings as of March i, 1913, it is beUeved that no other or different factors should enter into the equation than those which would have been used by a prospective seller and a prospective pur- chaser as of that date, even if it be conceded, for the sake of argument, that such taxes constitute expenses which would properly be deducti- ble in determining the net earnings of intangible assets for the pur- pose of computing their value as of a later date. But the tax im- posed by section 201 of the Revenue Act of 1917 is "a tax * * * equal to the following percentages of the net income." It seems rea- sonably clear, therefore, that the tax does not apply until all permis- sible deductions from earnings have been made and that the tax does not itself constitute a deduction in determining such earnings. It is therefore held, in the case of A', that in determining the earn- ings chargeable to good will in accordance with A. R. M. 34 Federal income taxes are not to be deducted. (I-1-13; A. R. M. 145.) The use of the average rate of earnings on intangible value during 1915-1919 as the basis for capitalizing actual earnings assignable to intangibles prior to 191 3, is open to question. Rates of earnings and interest ^vere both abnormally high during a considerable portion of the period of 1915-1919, and this was presumably taken into account by the purchaser of the property in 19 19. He would certainly expect to capitalize abnormal earnings at a higher rate of return than earnings during a period of relative business depression such as some of the years preceding 191 3. When the earnings of the years immediately prior to March i, 19 13, were low, due to any abnormal condition, and the earnings of the years immediately following March i, 1913, reflect a more normal situation, the capitalization of the earnings after March i, 191 3, is permissible. It is admitted that great difficulty arises in determining the goodwill of a business which did not change hands at or about March i, 191 3. Less difficulty arises in the case of a corporation if a considerable number of the shares of its capi- tal stock was sold at or about March i, 191 3. The following ruling is sound: EXCHANGES OR SALES OF CAPITAL ASSETS 607 Ruling. In determining the value of a corporation's assets, in- cluding good will, as at March I, 1913, contemporary sales of stock are held to be of greater weight than values l)ased on appraisal. (C. B. I, page 72>; O. 791.) The foregoing ruling, however, cannot be apphed if only a few shares were sold. Ruling. In applying the third method outlined in A. R. M. 34 (C. B. 2, p. 31), of determining value as of March i, 1913, of in- tangible assets, individuals or partnerships in determining net earnings should deduct a reasonable amount on account of the salaries of owners actively engaged in the business. (C. B. 4, page 43; O. D. 937-) Goodwill in relation to federal taxation. — The following discussion** calls attention to some of the most important points which one should consider when placing a value upon goodwill : Goodwill is an intangible and fluctuating asset which represents the value of a business over and above the money, other tangibles and accumulated profits invested in it In actual sales and purchases the value has been computed in a variety of ways, among which are: (i) the aggregate of the entire earnings of a specified period; (2) a certain number (of years' purchase) times the average earnings in excess of a determined rate on the average tangible investment for several years; and (3) the cap- italization of an average of several years' earnings at a specified rate, deducting therefrom the value of the tangible assets. It is undoubt- edly true that in a number of cases the amount paid for goodwill represents only the difference between the book value and the sales price, which price is the result of a compromise between bid and asked prices with little or no regard to any of the above-mentioned methods of computation. Goodwill has a value as a rule only when a business has earned and it is expected will continue to earn a rate on the invested value of the tangible assets in excess of a certain basic rate of return. The exception to the rule would be, for example, when a large amount of advertising has been done but sufficient time has not elapsed to show the value of this advertising. The excess of earnings arises from a number of factors, such as patents, reputation for in- tegrity, trade-names, publicity from past advertising, location and a partial or complete monopoly ** Goodiuill in licUiliun lo I'cdcnil TdSdlioii, Ity N. J. Lenhart, Chicago office, Lybrand, Ross Bros, and iVlontgomcry. 608 INCOME In general, investors in bonds, preferred stocks or common stock place considerable importance on the past earnings, reputation and the factors of goodwill (although perhaps not to the same degree), because no investor is willing to invest in a business which he does not believe is reasonably assured of continued success. The rate of return (earnings to investment) that will attract investments in common stock in any particular industry cannot be reduced to a definite figure. The factors which affect the yield expected are : 1. A seasoned stock with a long-continued earning and dividend record sells at a lower yield than an unseasoned stock. 2. A business with stable earnings sells at a lower yield than a business in the same industry with unstable earnings. 3. A steady growth in earnings always attracts investors at a lower yield than an unsteady growth or no growth. 4. The liberality of the dividend distribution, marketability and sectional money rates have considerable effect on the yield expected. It, therefore, seems reasonable to assume that there is no gen- eral rate of return necessary to attract investors in any particular industry. If any particular business is in question and a rate of return which will attract an investor is agreed upon, the question arises as to whether the investor desires the agreed return upon his whole investment or if he desires the agreed rate on his investment in tangible assets and a higher rate on the amount invested in goodwill. One method of computation which has been often used is to decide on tlie rate of earnings necessary to attract the investor, which may be 9 per cent, for example, and then to take, say, five times the excess of earnings over the 9 per cent on the investment during a specified period. Under this method the resulting rate of earnings on the new investment figure is always larger than the rate represented by 9 per cent, provided, as is nearly always the case, that the number of years used is less than 100 divided by the rate used, and so it might be concluded that the investor requires a higher rate of return on the amount invested in goodwill than on the balance of his investment. That this is not generally the case is shown by : 1. In many instances a business is purchased in which goodwill is the bulk of the asset bought. This is particularly true when the goodwill consists largely of patents, or in the case of retail stores where the location is particularly favorable. 2. The purchaser expects to continue the business and further develop the goodwill. The various elements of goodwill, such as location, patents and trade-names, are no more likely to depreciate EXCHANGES OR SALES OF CAPITAL ASSETS 609 than are the physical assets through misuse, obsolescence and poor management. 3. The Treasury Department lias consistently refused to allow depreciation on goodwill purchased, which attitude assumes goodwill to be of a more permanent nature than the physical assets. It is consequently reasonable to assume that a rate of return which will attract the investor is a rate on his entire investment including goodwill. In view of the foregoing discussion there are two methods of goodwill computation at March i, 1913, which seem desirable in two situations, namely: (i) when the business is sold and a price paid for the goodwill, and (2) in case there has been no sale and when the value at which goodwill is paid in for stock is to be determined or in the case of liquor interests in which the goodwill has been lost through enactments by Congress. The procedure to be used in the first instance can best be shown by an illustration of an actual case. The facts are as follows: Income in 1910 $150,000.00 Investment for 1910 $750,000.00 Income in 191 1 160,000.00 Investment for igii 800,000.00 Income in 1912 170,000.00 Investment for 1912 850,000.00 Total $480,000.00 $2,400,000.00 Average... $160,000.00 $ 800,000.00 Per cent of return 20% $425,000.00 Investment 375,000.00 Investment Income in 1919 322,000.00 Investment for 1019.... 2,800,000.00 Income in 19x7 $425,000.00 Investment for 1917. . . .$2,000,000.00 Income in 1918 375,000.00 Investment for 1918.... 2,400,000.00 Total $1,122,000.00 $7,200,000 00 Average $ 374,000.00 $2,400,000.00 * Per cent of return 15.5% In this case the amount actually paid for the goodwill early in 1920 was $1,000,000, which, added to the average investment of $2,400,000 gives a new average of $3,400,000. The earnings for 19 17, 1918 and 1919 were 11 per cent on the $3,400,000, and it is quite evident that the investor expects to get not more than 11 per cent without further development of the business. Now the earnings decreased during the period of 191 7, 1918 and 1919, but increased in the pre-war years. Conditions were stable in 1910, 191 1, 1912, whereas the years 1917, 1918 and 1919 were war- time years and a period of depression could be expected. Since when conditions are stable and the earnings show a steady increase, the risk is considered less and the expected yield is lower than when 6io INCOME the reverse is true, it follows that in 1913 an investor or the same investor would undoubtedly have been satisfied with considerably less than II per cent and certainly not more than 10 per cent. On the basis of $160,000 average earnings in the pre-war years and an expected return of 10 per cent, the business was worth at least $1,600,000 at March i, 1913, and the goodwill then was worth $800,000. Due to the nature of the business, patents, location, repu- tation, etc., the earnings could be expected to continue for a minimum of seven years and probably longer without additional development. Seven times the average earnings over 10 per cent in the pre-war years shows a goodwill of $560,000, which is obviously low (this is demonstrated in the actual case just cited), and this method admits of more argument than the one used in the illustration. In case there are factors which make the pre-war period entirely different from the years preceding the date of sale, this method based on the actual sales price as illustrated above may be open to criticism, but as a rule it seems to be the fairest and least open to attack in case there has been an actual sale of goodwill. In case there has been no sale of the goodwill a more or less arbitrary method must be adopted. Any method used will be open to discussion and it is of the highest importance to get as many com- paratively definite factors as possible. It has been demonstrated in the published Treasury Department's reports that in the pre-war years the great majority of industries earned less than 10 per cent upon the invested capital. It follows, therefore, that in most industries the rate which could be expected by the investor willing to pay an amount equal to or greater than the invested value of the tangible assets was less than 10 per cent. The variations in the rates expected by an investor between industries as a whole depend upon the risk involved. This risk varies directly ■with the number of years the profits of the industry can be expected to continue according to the character of the business. The preferred stock rate expected in an industry varies much less between the various businesses in the industry than does the rate on common stocks; and the preferred stock rate is, therefore, much easier to obtain and less open to question. If the expected rate of return on the investment in a business were known it would be easy to capitalize the average earnings at that rate and call the difference between the book value of the net tangible assets and the figure so found goodwill. But this rate is unknown and certainly could never be satisfactorily agreed upon. However, since the expected rate varies directly with the risk, the rate would seem to be about the rate of the average earnings to an investment figure made up of the book value plus a number of years times the average excess of earnings over the preferred stock rate. The number of years will be determined according to the risk. EXCHANGES OR SALES OF CAPITAL ASSETS 6ll The manner in which this method is used is as follows: Income in 1910 $150,000.00 Investment for 1910. . . .$75o,ooo.oo Income in 191 1 160,000.00 Investment for 191 1 800,000.00 Income in 1912 170,000.00 Investment for 1912 850,000.00 Total $480,000.00 $2,400,000.00 Average $160,000.00 $800,000.00 Preferred stock rate was about 6% during 1912: 6% on average investment $ 48,000.00 Average earnings 160,000.00 Excess over 6% $112,000.00 Seven times excess over 6% $784,000.00 The goodwill, as computed above, amounts to $784,000 as com- pared with $800,000 under the metliod previously discussed. The preferred stock rate should be the rate in the industry in the locality of the particular business. This rate can be found with some degree of accuracy, and at least with a much greater degree of accuracy than the rate necessary to attract investors to the pur- chase of common stock. The rate should be the average over a period of not more than a few years prior to the date at which goodwill is to be computed. If a standard line of industry is decided upon and the number of years' purchase to be used in that industry is agreed upon, the relative degree of risk and the number of years to be used in some other industry should result in no wide divergence of opinion. The number of years to be used in finding the average return on the in- vestment need not be the same as the number of years' purchase used, since cognizance must be taken of any special features present and facts which make certain years abnormal. The conclusion to be drawn from the foregoing discussion is that a set formula cannot be developed for the computation of good- will, but each case should be considered on its merits. If there has been a sale of the goodwill the first-mentioned illustration or an adap- tation of it would give the most accurate result. If there has been no sale some variation of the second illustration should be issued. In valuing shares of stock as at March i, 191 3, when there was no market vakie determinable, the Treasury appHed a formula for fixing the vahie of goodwill : Ruling The Committee is of the opinion that the market value of shares of stock was what they would bring, and that the 6i2 INCOME best evidence of what they would bring is what sucli shares did in fact bring when offered for sale about that time in a free and open market. How^ever, in the present instance, it is understood that there were no sales, and it is necessary to apply other tests, the market value in such case being deemed to be what a willing buyer might reasonably have been expected to pay or a willing seller to accept for the stock A prudent investor contemplating an investment, usually takes into consideration primarily two factors; first, the safety of his capital, and second, th'e return on it which he may reasonably expect ( C. P.. 3. page 47; A. R. R. 252.) The formula set forth in the foregoing ruling is sum- marized below, using the figures given in the ruling: 1916 Tangible assets 6io.t- Average tangible assets (3^ Selling price of entire com- j-ears prior to sale) 586.r mon stock i,200.r Average net income (same Paid tor goodwill 590;tr period) i I2.i- - 8% of 586.1- = (approx.) 46.r Balance applicable to good- will 66x Percentage 66.v to 590.1- = i\% (approx.) ^ percentage to be used in capitalizing average earnings at March i, 1913, applicable to good- will. Average tangibles (5 years prior to March i, 1913) 258.1- Average earnings 30jr 8% of 258.1- = (approx.) 20.r Earnings attributable to goodwill lox Capitalizing lox at 11.13% = (approx.) 92,1- =^ value of goodwill March i. 1913. Add, Book value of tangibles at March i, 1913 232.r Value of total assets, March i. 1913 324.1- Deduct, Par value of preferred stock 50.r Value of common stock. March i. 1913 274.1- Adjustment by appraisals of various dates. — ]\Iost a])- praisals made either by taxpayers or disinterested third EXCHANGES OR SALES OF CAPITAL ASSETS 613 parties are of some date other than March i, 191 3. If made within a short time before or after that date the books of account should afford sufficient data upon which adjustments could be based. When the date of the appraisals is more than a year before or after March i, 1913, the application of book adjustments is not of itself evidence that the result would represent fair market value as of that date. Actual conditions at the date of the appraisals would have to be compared with conditions existing March i, 1913. If it could be shown that building materials, labor and other elements of cost were substantially the same, and if normal depreciation were ap- plied, there is no good reason why an appraisal of a date more than a year before or after should not form the foundation for an adjustment of book figures to conform to fair mar- ket value at A'larch i, 191 3. The Treasury in a recent ruling (1-5-60; A. R. R. 747) has held that "retrospective" apprais- als will be accepted "when the facts upon which the appraisals are based have been established l)y proof." The proof need be only such "as is ordinarily accepted in important business transactions of like character." The acceptance of such ap- praisals is an important departure from the Treasury's previous procedure. (For text of A. R. R. 747, see Appendix A, Chap- ter Vm.) The purpose for which an appraisal was made should always be stated, since it may be the controlling factor in its acceptance or rejection. When the actual surplus at March t. 1913, does not ap- pear on the books of the individual, firm or corporation, the difficulty of the case is apparent, but the mere absence of defi- nite recorded figures compiled and stated on that exact date does not preclude a legitimate inquiry at a later time and an endeavor to ascertain accurate data as of that date.'*^ Much "Doyle V. Mitchell Brothers Company, 247 U. S. 179, 38 S. Ct. 467, 62 L. Ed. 1054 (May 20, 1918). Case decided under tlie 1909 law: "Nor is the result altered by the mere fact that the increment of value had not been entered upon plaintiff's books of account. Such books are no more than evidential, being neither indispensable nor conclusive. The decision must rest upon the actual facts." 6i4 INCOME of the work of public accountants consists in stating accounts as of a past date, and their findings are almost invariably sus- tained by the courts. Therefore, if a corporation, say, in 191 7, sets up in its books certain assets acquired before March I, 19 1 3 (but not carried on its books at any valuation, or at a low valuation), credits surplus and declares a large special dividend, it cannot be contended that there is there a distri- bution of taxable income, unless the undistributed earnings ac- cumulated since March i, 19 13, are sufficient to cover the payment. Comparative values of similar property. — Ruling. In general, value as at March i, 1913, of property, real, personal, or mixed, may be established by consideration of bona fide transactions in like property occurring on or about March i, 1913) together with all other facts pertaining to such value. (C. B. I, page 37; O. D. 7.) Prorating land and crop values. — Ruling. A purchased for a certain price land together with crops growing thereon. The basis for determining gain or loss upon subsequent sale of the crops is the difference between the cost, or if no part of the purchase price was assigned to the crops, the fair market value thereof at the time of purchase, and the selling price less cost of harvesting and marketing. (C. B. 3, page 49; O. D. 714.) Average of stock quotations on March i, 1913. — The ques- tion has arisen as to which price shall be accepted in case of the sale of stock listed on an exchange, which was sold at varying prices on March i, 1913. A ruling has been issued covering this point as follows : Ruling. 'The fair market price or value of March i"' is held to be the fair market price or value as of the entire day of March i, which, in the case of variation between "opening and closing price" for the day, would mean the average price for the day. This, how- ever, would be conditioned upon showing that the exchange quota- tion represented the fair market price or value of the stock, as it is this "fair market price or value" which is to control, however that fact may be ascertained. (Letter to the Corporation Trust Company, signed by Commissioner W. H. Osborn, and dated November 21, 1916.) EXCHANGES OR SALES OF CAPITAL ASSETS 615 In view of frequent references to the March i, 19 13, date it is worth while to note that in legal and commercial usage this refers to facts as they existed at the commencement of business on March i, 1913. In the regulations the date Jan- uary I, 1909, is often used. In commenting thereon the Supreme Court of the United States has said "December 31. 1908, would have been more precise,"'"' meaning that as the date from which to measure changes in values, December 31, 1908, should have been selected instead of January i, 1909. It may safely be assumed that if called upon to pass upon a case where there was a difference between prices at the close of business February 28, 191 3, and the average of prices dur- ing the entire day of March i, 19 13, the Supreme Court would doubtless uphold the closing prices of February 28, 1913- New York Stock Exchange prices on March i, 19 13, were substantially the same as on February 28, 19 13, so the point probably is of little importance. Ruling. The value of shares of stock as at March i, 1913, should be determined on the basis of market quotations as at that date instead of book vakies. (C. B. 2, page 30; A. R. R. 33.) When only a few shares were sold before and after March I, 19 1 3, taxpayers may claim that such sales were not repre- sentative nor controlling. The Treasury itself supports the statement.*^ Valuation of closely held stocks. — Decision. In appraising shares of stock held in a corporation whose sole property was an office building, the shares having always been held in one family and never sold, the contention of the execu- tors was that the value of the shares should be determined by the earnings of the property, which were shown to have been from 2.18^ to 4.i5>4 per cent over a period of six years. The value was claimed not to exceed $50 per share and the federal authorities had valued it at $39 per share. [The par was $100.] '"Hays V. Gaulcy Mnuiitahi Coal Co.. 247 U. S. 189, 38 S. Ct. 470, 62 L. Ed. 1 06 1, May 20, 19 18. " See Excess Profits Tax Procedure, 1921. 6i6 INCOME The court held that capital stock representing a building in good condition must be considered as worth the amount originally contrib- uted by the shareholders ; that the stock represented the assets, sug- gesting this to be the foundation of the stock dividend decision {Eisner v. Macombcr) ; that while earning power was of very con- siderable influence upon market value, it was but one of the elements and not the most important one ; that the argument advanced would lead to the conclusion that where a corporation had been running at a loss, the stock would be worthless. The fact that the stock in question represented a minority interest was held not material under the circumstances where the corporation owed no debts and where its property consisted of a large ofifice building, well located in the heart of a growing city and where there had been no dissension among the stockholders. The shares were held worth par, one judge dissenting.'*'^ Value fixed by appraisers of state court may be rebutted. — Ruling. The appraised value of stock as at the time of the creation of a trust estate, by appraisers of a State court, creates a presumption only that the stock is of the appraised value; this pre- sumption may be rebutted by competent evidence to the effect that the stock was of another value than that appraised. ( C. B. i, page 38; A. R. M. 7.) In one case the executrix was the residuary legatee. There was no direct inheritance tax in the state at that time; no question of commissions was involved; the real value of the stock did not seem to be a vital one to the appraisers, who in 1 9 14 valued stock at $100 a share. The real value was over $500 a share. The Treasury allowed a reappraisal in this case because the value of $100 a share was merely nominal. Pro rata method — how far valid. — The early regulations under both the 1909 and the 1913 laws*' laid down the rule that in the case of certain appreciations in values extend- ing through a period which began before the effective date of the law, the appreciations should be considered to have ac- crued evenly throughout the period. The taxable portion, con- sequently, should be determined by a prorating process which ■** Note on Succession of Coleman, 85 Southern 43 (La.) appearing in the Bulletin of the National Tax .Issocialion. November, 1020, page 57. "1909 law, Reg. 31, 1909; 1913 law, T. D. 2291, February 8, 1916. EXCHANGES OR SALES OF CAPITAL ASSETS 617 would make the amount taxable depend upon the relative length of the period elapsed before and after the act took effect. The Supreme Court has made it plain that this method, while in itself not illegal as a method, must be considered merely one way of ascertaining the value of the property at March i, 1913. In certain cases it may be the best or the only way of estimating that value and in such cases the court has indicated its acceptability. In the presence of some less arbitrary and more accurate method of valuing property at the effective date of the law, the pro rata method is not to be con- sidered valid. In a case under the 1909 law, Hays v. Gaiiley Moun- tain Coal Company (decided by the Supreme Court of the United States, May 20, 1918),'^° the court pointed out the necessity of establishing the value of the capital assets on December 31, 1908, and commented as follows on methods of determining that valuation: Decision. Whether this should be done by taking an inventory upon the basis of market values then existing, or whether the entire increment accruing between the time of acquiring and the time of disposing of the assets should be prorated as if it had arisen through a series of gradual and imperceptible augmentations, is a matter of detail, to be settled according to the best evidence obtainable, and in accordance with valid departmental regulations. Treasury Regula- tions 31, December 3, 1909, provided for inventories at the beginning and end of each year with respect to manufacturing and mercantile companies ; and with regard to a sale of capital assets acquired prior to January i, 1909, and sold thereafter, required that the amount of increment or depreciation representing the difference between the selling and buying prices should be adjusted so as fairly to determine the proportion of the loss or gain arising subse- quent to the date mentioned ; but without prescribing any particular method of doing this. Subsequent rulings required that sales of stocks and bonds should be regarded as sales of capital assets and accounted for accordingly under Regulations 31, and while still requiring inven- tories, resorted to the prorating method with respect to real estate, apparently on the ground that increases and decreases in the value of this class of property during particular periods could not be accu- rately determined "'247 U. S. 189, 38 S. Ct. 470, 62 L. Ed. 1061. 5i8 INCOME The present case was heard upon an agreed statement of facts which contains nothing from whicli the value of the stock at the time the act took effect may be deduced, otherwise than by the pro- rating method that was adopted; nor is any objection made by the respondent to the application of that method. Hence there is no lawful ground for overthrowing the tax. Again, in the case of U. S. v. C. C. C. & St. L. Railway Co./^ decided by the same court on the same day, the court remarked : Decision. Just how this part (the portion taxable because ac- crued after the effective date of the law) is to be separated from that which previously accrued is a matter of some nicety, as we have shown in the Hays v. Gauley Mountain Coal Co., supra case, The circuit court of appeals adopted the theory of an inventory taken as of the time the act went into effect; and although the assets here under consideration were not acquired for the purpose of sale in the manner of merchandise, but were bought for investment, and hence were not inventoried on December 31, 1908, it accepted the stipulated fact that the stock had a regular market value of $57 per share on that date as supplying the lack of an inventory. This result accords with the vie\ys we have expressed in the cases referred to. The Treasury has pointed out that the Gauley Mountain Coal Company case merely approved the prorating method when there is no better way of determining fair "value." Ruling. In the year 1900 a taxpayer purchased two shares of corporate stock for an aggregate amount of 52 x dollars, and in 1915 sold the same shares for 36 x dollars. On March i, 1913, this stock was quoted at 24 x dollars. The taxpayer claims that he is entitled to a deduction for loss upon the sale of stock to the extent of the pro rata part of the reduction from cost to sale price attributable to the period after March i, 1913. The excess of the proceeds of a sale in the year 1915 of stock acquired by the taxpayer prior to March i, 1913, over the market value of such stock on March i, 1913, determined according to "the best evidence obtainable,'" is income for such taxpayer for the year 191 5, regardless of the fact that the sale price of such stock was less than the cost of such stock to the taxpaver. (C. B. i, page 35; T. B. M. 72>-) In this case the Treasury held that the vahie of the stock on March i, 1913, was "fairly shown by the market quota- "247 U. S. 195, 38 S. Ct. 472, 62 L. Ed. 1064. EXCHANGES OR SALES OF CAPITAL ASSETS 619 tions on that date," wliich was a better measure than pro- rating, and therefore must he used. In view, however, of the Supreme Court decision in Goodrich z-. Edziurds (advance opinions, 65 L. Ed. 450), there is no taxable gain in this case as original cost exceeded the selling- price. Under the 1921 law, also, there would l)e neither taxa])le gain nor deductible loss in this case. Income Derived from Sale or Exchange of Property Acquired by Gift and Inheritance A new provision has been inserted into the 1921 law where- by appreciation of gifts in the hands of the donor is taxable to the donee when the latter subsequently disposes of the gifts. Law. Section 202. (a) .... (2) In the case of such property, acquired by gift after December 31, 1920, the basis shall be the same as that which it would have in the hands of the donor or the last pre- ceding owner by whom it was not acquired by gift. If the facts neces- sary to determine such basis are unknown to the donee, the Com- missioner shall, if possible, obtain such facts from such donor or last preceding owner, or any other person cognizant thereof. If the Com- missioner finds it impossible to obtain such facts, the basis shall be the value of such property as found by the Commissioner as of the date or approximate date at which, according to the best information the Commissioner is able to obtain, such property was acquired by such donor or last preceding owner. In the case of such property ac- quired by gift on or before December 31, 1920, the basis for ascertain- ing gain or loss from a sale or other disposition thereof shall be the fair market price or value of such property at the time of such acquisi- tion; .... Gifts after December 31, 1920. — Regulation. In computing the gain or loss from the sale or other disposition of property acquired by gift subsequent to December 31, 1920, the basis shall be the same as it would have in the hands of the donor or the last i)rece(ling owner by whom it was not acquired by gift. This basis in the hands of the donor or last preceding owner by whom it was not acquired by gift shall be determined under the provisions of article 1561 and the taxable gain or deductible loss from the sale or exchange shall be computed in accordance therewith. If the donee is unable to ascertain the facts necessary to determine such basis, he shall so state upon his return, and the Commissioner 620 INCOME shall if possil)le obtain such facts from such donor or last pre- ceding owner or any other person cognizant thereof. If the Com- missioner finds it impossible to obtain such facts, the basis shall be the value of such property as found by the Commissioner as of the date or approximate date such property was acquired by said donor or last preceding owner. In order to insure a fair and. adequate appraisal or determination of the proper basis, donors making gifts of property on or after January i, 1921, should leave an accessible record of the facts necessary to determine the cost of such property (and its fair market value as of March i, 1913, where pertinent). (Art. 1562.) Gifts before January i, 1921 — bequests, devises or in- heritances. — Regulation. In computing the gain or loss from the sale or other disposition of property acquired by gift on or before December 31, 1920, or by bequest, devise, or inheritance, the basis shall be the fair market price or value of such property at the time of acquisition. The term "property acquired by bequest, devise, or inheritance" as used herein included (a) such property interests as the taxpayer has re- ceived as the result of a transfer, or creation of a trust, in contempla- tion of or intended to take effect in possession or enjoyment at or after death and, (b) such property interests as the taxpayer has re- ceived as the result of the exercise by a person of a general power of appointment (i) by will, or (2) by deed executed in contemplation of or intended to take effect in possession or enjoyment at or after his death In the case of property acquired by gift, bequest, de vise, or inheritance, prior to March i, 1913, the taxable gain or de- ductible loss from the sale or other disposition thereof shall be com- puted in accordance with article 1561. In the case of property acquired by bequest, devise, or inheritance, its value as appraised for the pur- pose of the Federal estate tax or in the case of estates not subject to that tax its value as appraised in the State court for the purpose of State inheritance taxes shall be deemed to be its fair market value when acquired. (Art. 1563.) The accepted principle of law is that property acquired from donors or decedents is capital in the hands of the recip- ients, and that under the sixteenth amendment to the Federal C\)nstitution no taxable income can be imposed thereon. This principle was adopted in the 1913, 191 6, 1917 and 191 8 fed- eral income tax laws. As to property acquired from dece- dents, the rule is followed in the 192 1 law. As to gifts other EXCHANGES OR SALES OF CAPITAL ASSETS 621 than from decedents, an attempt is made in the 192 1 law to tax appreciation in the value of gifts made after December 31, 1920, when, as and if realized by donees. Income from sale of property acquired by gift. '^ — Early in 1 92 1, the House of Representatives passed an act"^ amending the existing law and ascribing to donees upon realization the same measure of gain as would have been realized by donors if the gift had not been made. The Act did not pass the Senate. The act was meritorious so far as it reached palpable eva- sion of taxes upon actual profits. Taxpayers owned property which had increased tremendously in value since 191 3. The taxpayers having received very favorable cash offers for their properties and being unwilling to pay any tax on the prospec- tive profit, conveyed the property to their wives. Immediately after the conveyance the wives would sell the properties and under the 1918 and prior laws no tax could be assessed thereon. It was agreed that something should be done to reach this species of evasion. Prior to January i, 192 1, if the recipient of a gift disposed of it during his lifetime, he reported as taxable income (if a profit was realized) the difference between the value of the gift the day it was received, or if it was received before March I, 19 1 3, its value on that date, and the amount realized. If the proceeds of the sale were less than the value on the date of receipt of the gift or on March i, 1913, the resulting loss was an allowable deduction. The state of New York attempted to tax donors at the time of making gifts,^* on the gain measured by the difference between the cost to the donor and the value of the gift when made. The Appellate Division of the Supreme Court of the °^' Section 202 (a-2). "H. R. 14198, passed House of Representatives May 27, 1921. " New York State Comptroller's Regulations, Art. 91 ; amended No- vember, 1921. 622 INCOME state of New York held the act to be unconstitutional on the ground that no taxable income was realized.'"' The 1921 federal law is as follows: Law. Section 202. (a) . . . . (2) In the case of such property, acquired by gift after December i, 1920, the basis shall be the same as that which it would have in the hands of the donor or the last preceding owner by whom it was not acquired by gift. If the facts necessary to determine such basis are unknown to the donee, the Commissioner shall, if possible, obtain such facts from such donor or last preceding owner, or any other person cognizant thereof. If the Commissioner finds it impossible to obtain such facts, the basis shall be the value of such property as found by the Commissioner as of the date or approxi- mate date at which, according to the best information the Commis- sioner is able to obtain, such property was acquired by such donor or last preceding owner. In the case of such property acquired by gift on or before December 31, 1920, the basis for ascertaining gain or loss from a sale or other disposition thereof shall be the fair market price or value of such property at the time of such acquisition; .... The 192 1 law''' does not fall into the error of taxing the gift itself. The tax is only imposed upon actual realization by the donee of a gain measured by cost to the donor. As a means of reaching gains which should properly be taxed, the new provision is meritorious. A limit of time, however, should have been fixed. Palpable evasions of tax usually arose when sales were made immediately after transfers of property. In other words, the sales, in effect, were transac- tions by and for the ostensible donors. The gifts were not bona fide. When sufficient time elapses between the date of a gift and realization by donees, it may be assumed that the gift is bona fide. Undoubtedly the legality of the new provision will be at- tacked. Donees in receipt of bona fide gifts cannot be held to realize "income" except to the extent of appreciation after the date of the gift. It is recognized in the 192 1 and prior laws that property acquired from a decedent is capital in the hands "'People ex rcl. JVilsou v. Wendell, 188 N. Y. Supp. 273; People ex rel. Brewster v. Wendell, 188 X. Y. Supp. 510. °* [Former Procedure] Under 1918 and prior laws, the basis of gain or loss regarding property acquired by gift was value at the date of the gift. EXCHANGES OR SALES OF CAPITAL ASSETS 623 of recipients. It is difficult to discern any difference between bona fide gifts and bequests. The obligations imposed upon donees may be found to be unreasonable. In the case of hus- bands and wives or children it may be reasonable to require a statement of cost or value March i, 19 13, to accompany a gift. In many other cases the obligations are too onerous. Gifts to employees and servants frequently consist of shares of stock of closely held corporations or real estate or other property the cost of which to donors is uncertain and difficult to determine. Often there will be hesitancy to divulge the actual cost. In such cases the donee is unduly penalized. The new provision works two ways. If constitutional it imposes on donees liability for tax when the donor would have realized a profit, but it opens up two opportunities to donors of which they will not be slow to take advantage. Here- tofore, in order to transfer possible tax liability it was nec- essary to make irrevocable gifts. In many cases securities or other property declined in value after the date of the gift. The donor was unable to take advantage of the loss in case of sale. Under the present law donors will be able to wait almost indefinitely in the case of non-income bearing property before deciding whether or not to make the gift. If the prop- erty declines in value and the donor decides to sell it, he may deduct the loss. If it increases in value and the gift is made, the donee will pay the same tax as if the gift had been made earlier. Furthermore, donees may now make new gifts to former donors in which case the latter may deduct losses which under the 1918 and prior laws would only have been deductible by donees, i.e., the loss accrued after the first gift. No income tax is imposed upon an estate for any appre- ciation in values which may exist at the date of death, but inheritance taxes are based on actual values. Appreciation in value of gift is not income to donor. — The following ruling applies to the determination of taxable profit upon sale of any gift received prior to January i, 1921. It 624 INCOME is immaterial wliether the sale took place before, or takes place after, January i, 192 1, as the provision of the 192 1 law taxing profits from property sold or otherwise disposed of on the same basis as though the property were in the hands of the donor or last preceding owner who did not acquire it by gift, applied only to gifts made after December 31, 1920. Ruling In the case of a real and actual gift of property which has appreciated in value between the time of acquisition and the time the gift is made, the appreciation will not be the subject of income taxation, and the donee who sells it will return as income only any appreciation realized over its value when the donee actually became the owner of it. On the other hand, a mere colorable gift is not to be treated as a gift at all, and an attempt by such colorable gift to evade taxation is fraud for which either party who participates therein may be punished. (C. B. i, page 83; S. 1022.) In view of section 202 (a-2) of the 1921 law, the Treas- ury will doubtless hold that this ruling does not apply to gifts made after December 31, 1920. Homestead — value at date of acquisition. — Ruling. The basis for determining gain or loss from the sale of a homestead acquired from the Government will be the fair mar- ket value of the homestead at the date of its acquisition or the value at March i, 1913, if acquired prior to that date. The date of acquisition of a homestead acquired by public grant is the date of entry upon the land. The taxpayer will not be entitled to add to the value of the homestead the amount expended for relinquishment in order to clear the Land Office records, nor any fees paid to the Government, but the cost of improvements may be added to the value as of the date of acquisition. (C. B. 2, page 33: O. D. 386.) The foregoing is based on the theory that a "public grant" is in the nature of a gift from the government.''' Therefore the value used to compute profit or loss on sale is the same as that used in the case of any gift, viz., the value at date of acquisition if after March i, 1913. and before Tanu- " Letter to the Corporation Trust Company, signed bj- Acting Commis- sioner Paul F. Myers, dated July 8, 1920. EXCHANGES OR SALES OF CAPITAL ASSETS 625 ary i, 1921. The procedure regarding such gifts after De- cember 31, 1920, is a good test of one's imagination. Income from sale of property acquired by inheritance. — Law. Section 202. (a) . . . . (3) In the case of such property, acquired by bequest, devise, or inheritance, the basis shall be the fair market price or value of such property at the time of such acquisition.'''^ The provisions of this paragraph shall apply to the acquisition of such property interests as are specified in subdivision (c) or (e) of section 402. s^ .... Value at date of testator's death must be used. — Ruling. In computing gain or loss on a sale of stock by trustees under a will, the value of the stock at the date of the testator's death should be used as the starting point rather than the value of such stock at the date of distribution to the trustees. Any gain realized on such a sale must be reported as taxable income by the trustees, who will also be required to pay the tax due thereon. The fact that at some uncertain date in the future the corpus of the estate, including the accumulation of income of a certain character will, if it is then in existence be paid over to exempt corporations, does not relieve the trustees from the obliga- tion of paying the tax (C. B. 2, page 34; O. 1012.) The last paragraph of the foregoing ruHng is contrary to a recent court decision based on the 19 16 and 191 7 laws. {Ledercr v. Stockton, 266 Fed. 173, writ of certiorari was granted by the Supreme Court October 25. 1920, 254 U.S. 625.) Ruling. Under the terms of a will the residue of the estate was bequeathed to the testator's three sons, to be divided equally among them. This residue consisting of cash and a number of securities was in accordance with mutual agreement divided upon the basis of the market price of the securities at the time of distribution, which was in excess of their value at the date of decedent's death, as appraised for Federal estate tax purposes. Following this arrange- ment one of the residuary legatees received no cash, another less cash than the third, but all received an equal share of the residue in '^^ [Former Procedure] Reg. 45, Art. 1562, provided that the value at time of acquisition should be the basis for property acquired by gift as well as by bequest, devise or descent. ''"Section 402 (c) and (e) .deals with tlie determination of the gross estate of a decedent for estate tax i)urposes. For details see Chapter XL. 626 INCOME accordance with the terms of the will. The question presented is whether the estate derived any taxable gain from the transfer of the securities to the residuary legatees and whether on a subsequent sale by the legatees the basis for determining gain or loss is the fair market value of such securities at the time they w^ere received by the legatees in the distribution or at their appraised value as at the date of the death of the testator. Held, that the estate of the decedent derived no taxable gain from the transfer to the residuary legatees of the securities forming a part of the residue of such estate. The basis for determining gain or loss upon a sale of securities received by legatees is the value of such securities at the date of the testator's death, as appraised for the purpose of the Federal estate tax, whether the devise or bequest be specific or residuary. (C. B. 3, page 53; O. D. 667.) ^^'here securities held in trust for the beneficiaries are sub- secjuently distributed together with other securities represent- ing investments by the executors, it is necessary to segregate the securities for purpose of determining any profit on sale l^y the beneficiaries. Ruling. Held, that the basis to be used in determining the gain or loss resulting" from the sale of those securities which were part of the estate of the testator at the time of his death is the value of the beneficiary's vested interest in such securities as at the date of the decedent's death ; that the basis to be used in determining the gain or loss resulting from the sale of those securities representing an invest- ment made by the trustees after the death of the decedent is the cost of such securities to the trustees. (I-3-28; 1. T. 1165.) Securities are to be valued at date they are avail- able, IRRESPECTIVE OF DATE RECEIVED. Ruling. On the date of her divorce in 1919 a beneficiary under a trust instrument executed by her father became entitled to the delivery by the trustee of securities. Their value on this date is the basis for determining gain or loss from a sale, notwithstanding the fact that by mistake she did not receive them till two years subsequently. (B. Digest 51-21-1976; O. D. 1136.) Value as between life tenant and remainderman. — Ruling. Where in a bequest of property the remaindermen have only a contingent interest prior to the death of the life tenant, the basis for determining gain or loss from a sale of such property by the remaindermen is its value as of the date of death of the life tenant. ( C. B. 3, page 53; O. D. '/2/.) EXCHANGES OR SALES OF CAPITAL ASSETS 627 When interest is not contingent. — Ruling. Where real estate is devised by a testator to his widow for Hfe with a direction that upon her death the property shall be sold and the proceeds divided among the testator's children, the basis for ascertaining the gain or loss on a sale of such real estate and distribution of the proceeds to the children is the value of their rights at the time they vested, or on March i, 1913, if they vested prior thereto The possession of land devised to the children of a testator sub- ject to a life estate in their mother, which vested in fact on the death of the life tenant, was acquired by the children in right on the death of the testator. The provision of the income tax law exempting from tax the value of property acquired by a devise or bequest merely exempts the value of the right at the time it was acquired and not any value which subsequently may attach to it pending actual or anticipated arrival of the period of enjoyment (C. B. 3, page 50; Sol. Op. 35.) In the detailed opinion the soHcitor said : Section 2(c) of the Revenue Act of 1916, in so far as the pres- ent question is concerned, is substantially the same as the provisions of section 202 of the Revenue Act of 1918, here involved. Law Opinion 649, upon a consideration and application of the former section, held that the basis for determining the profit from a sale of real estate by a remainderman after the termination of a life estate is the value of the property upon the date when the remainder vested in possession. That opinion is inconsistent with the view here enter- tained and is hereby overruled. Capital Gains Prior to January i, 1922, the rates of tax imposed under all federal income and profits tax laws were the same upon capital gains''" as upon ordinary net income. Under the 192 1 law the maximum rate of tax upon net capital gains realized after January i, 1922, is 12^/2 per cent.*^^ As the rate includes °° "There are capital profits and revenue profits. Thus, for instance, part of a tract of land upon which a factory has been erected is sold for an amount equal to the original cost of the entire undertaking. This is realized income, but it does not fall within the ordinary definition, therefore it is not wise to rely upon any one definition. The net income from a man's voca- tion is revenue profit ; the net profit realized from an outside venture is capital profit." [Auditing Theory and Practice, by R. H. Montgomery (1921 edition), page 309.] "' For computations, etc., see page 631. 628 INCOME the normal tax of 8 per cent, the niaxinunn surtax is 4^2 per cent. The provision does not ai)ply to corporations, but as the tlat tax upon corporations is 12 J/2 per cent the inhibition is of no importance for the year 1922. The law contains the following definitions : Law. Section 206. (a) That for the purpose of this title: (i) The term "capital gain" means taxable gain from the sale or exchange of capital assets consummated after December 31, 1921; (2) The term "capital loss" means deductible loss resulting from the sale or exchange of capital assets consummated after December 31. 1921; (3) The term "capital deductions" means such deductions as are allowed under this title for the purpose of computing net income and are properly allocable to or chargeable against items of capital gain as defined in this section; (4) The term "capital net gain" means the excess of the total amount of capital gain over the sum of the capital deductions and capital losses; (5) The term "ordinary net income" means the net income, com- puted in accordance with the provisions of this title, after excluding all items of capital gain, capital loss, and capital deductions; and (6) The term "capital assets" as used in this section means prop- erty acquired and held by the taxpayer for profit or investment for more than two years (whether or not connected with his trade or busi- ness), but does not include property held for the personal use or con- sumption of the taxpayer or his family, or stock in trade of the tax- payer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year The provisions of the 192 1 law with respect to the method and rate of taxation to be applied to capital gains realized after December 31, 192 1, are as follows: Law. Section 206 (b) In the case of any taxpayer (other than a corporation) who for any taxable year derives a capital net gain, there shall (at the election of the taxpayer) be levied, collected and paid, in lieu of the taxes imposed by sections 210 and 211 of this title, a tax determined as follows: A partial tax shall first be computed upon the basis of the ordinary net income at the rates and in the manner provided in sections 210 and 211, and the total tax shall be this amount plus 121^ per centum of the capital net gain; but if the taxpayer elects to be taxed under this section the total tax shall in no such case be less than 12^ per EXCHANGES OR SALES OF CAPITAL ASSETS 629 centum of the total net income. The total tax thus determined shall be computed, collected and paid in the same manner, at the same time and subject to the same provisions of law, including penalties, as other taxes under this title. Although the courts and economists do not agree on the distinction between capital and income, the language of the law is not ambiguous and there should be little difficulty in computing net capital gains. In large part the regulations pertaining to the capital gain provisions of the law merely repeat in slightly different phrase- ology the language of the law itself and present a few illus- trative figures to show the application of the provisions to con- crete cases. The regulations do, however, touch specifically on. two points which are not mentioned in the law itself. One is with reference to the case of a taxpayer who has a net capital gain and a net loss in ordinary income account. The regula- tions hold that the net loss in ''ordinary net income" cannot be applied against net capital gain if the benefit of the I2)'2 per cent rate of tax on the capital gain is to be availed of. The other point is with res])ect to the question of whether the two-year period runs from the inception of an investment, the form (but not the substance) of which has changed but from which change under section 202 (c) no taxable profit or deductible loss is deemed yet to have arisen, or whether the two-year period runs from the time the investment took the form it had at the time of sale. Article 1561 (see page 570) holds that in such case the time during which the invest- ment was in its previous form is included in the two-year period. Regulation, (a) Section 206 applies only to sales or exchanges of capital assets consummated after December 31, 1921. It provides that any taxpayer other than a corporation may, if he so desires, state separately in his return his net gain on sales or exchanges of capital assets and pay on such capital net gain (as defined and limited in the section) a fiat tax of 12^2 per cent in lieu of the tax he would other- wise pay on such income under sections 210 and 211. On his net income from other sources, termed "ordinary net income" in this section, . he would be taxed under those sections. If, however, he elects thus 630 INCOME to segregate his capital net gain, his total tax on the aggregate amount of both kinds of income must be at least 12^ per cent thereof. Definitions: "capital as.sets." — The term "capital assets" is defined to mean property of any kind whatever acquired and held by the taxpayer for profit or investment for more than two years, whether or not connected with his trade or business, not including property ( for example, a dwelling) held for the personal use or consumption of the taxpayer or his family, or stock in trade of the taxpayer or other property of a kind properly in- cluded in an inventory. The specific property sold or exchanged must have been held for more than two years, but in the case of a stock dividend the prescribed period applies to the original stock and the stock received as a dividend considered as a unit and where property is exchanged for other property and no gain or loss recognized under the provisions of section 202, the prescribed period applies to the property exchanged and the property received in exchange con- sidered as a unit. "Capital gain" and "capital loss." — - "Capital gain" is taxable gain from the sale or exchange of capital as- sets, while "capital loss" is deductilile loss resulting from the sale of capital assets. As to the basis for determining such gain or loss (in- cluding adjustment for depreciation) see article 1561 ; as to better- ments and repairs, see articles 24 (3) and 103. Ordinary repairs and taxes are annual charges against income, and do not enter into the computation of such gain or loss. "Capital deductions" and "capital net gain." — "Capital deductions" are deductions properly allocable to or chargeable against items of capital gain, including items of expense connected with the sale or exchange of a capital asset ( for example, commissions paid brokers or agents). While interest, taxes, and other carrying charges are usually annual charges against income, they may be al- located to capital gain derived from the sale or exchange of a capital asset for the taxable year in which such asset is sold or exchanged to the extent that such current charges exceed the income directly derived from such asset. "Capital net gain" is the excess of the total amount of the capital gain over the sum of the capital deductions and capital losses. Computation of capital net gain and tax. — For illustration: A in K)22 sold li) an ofiice building for $1,000,000 which he had bought in 1915 for $500,000 and on which EXCHANGES OR SALES OF CAPITAL ASSETS 631 there was depreciation aggregating $100,000; and (2) stock in a mining company for $10,000 which he had purchased in 1919 for $20,000. Taking no account of capital deductions (for example, commissions paid on these sales), his capital gain would be $600,000, his capital loss $10,000, and his capital net gain $590,000. Sup- pose that his other net income ("ordinary net income") in 1922 was $50,000. Instead of paying normal tax and surtax on his total net income of $640,000, he may segregate these capital transactions in his return and pay a tax of 12^2 per cent on his capital net gain of $590,000, plus the normal tax and surtax upon his ordinary net in- come of $50,000. Suppose, on the other hand, that A, with capital net gain of $590,000, not only had no "ordinary net income," but actually sustained a net loss of $50,000 in his business. He may not deduct such net loss in "ordinary net income" from his capital net gain if he elects to be taxed under section 206, but must pay 12J/2 per cent of $590,000 (Art. 1651.) The illustration in article 1651 quoted above may be stated in tabular form as follows : 1922 Selling price of office building $1,000,000 191 5 Cost price of office building $500,000 Less: Depreciation 100,000 400,000 Capital gain $600,000 1919 Cost of mining stock $ 20,000 1922 Selling price of mining stock 10,000 Capital loss 10,000 Capital net gain $590,000 Other income ("ordinary net income") 50,000 Total net income ' $640,000 Tax A pays 125^% on $590,000 $ 73,750 Plus: Normal tax: Ordinary net income $ 50,000 Less: Exemption (if married and having no dependents) $ 2,000 $ 48,000 Taxable at 4% 4,000 160 Taxable at 8% $ 44,000 3.520 Surtax (1922 rates) on $50,000 4,960 Total tax $ 82,390 632 INCOME The tax computed without benefit of the capital gains provision would be : Normal tax : Normal income $ 640,000 Less : Exemption 2,000 $ 638,000 Taxable at 4% 4.000 $ 160 Taxable at 8% : $ 634,000 50.720 Surtax on $640,000 290,960 Total tax $341,840 Difference $259,450 In the second case assumed in the illustration Capital net gain is the same as before $590,000 But instead of other income ("ordinary net in- come") of $50,000, A sustained a net loss in business of $ 50,000 Such net loss is not deductible from the $590,000 capital net gain which is taxed at i2i/2%. The net loss of $50,000 from business, mentioned in the illustration, should not be confused with the "net loss" de- scribed in section 204 (see Chapter XXIX), which may be carried forward to the succeeding year. The $50,000 net loss shown in the illustration is merely a factor in the alternative computation under the capital gains provisions Section 206. On the other hand, assume that A's capital gain is $100,000 and that A's net loss from business, as before, is. . . . $50,000 If A computed the tax under the capital gains provision, the tax would be i2j/2% of $100,000, or $ 12,500 If A does not elect to be taxed under the capital gains provision, the tax will be computed as follows : Normal tax : Net income ($100,000 — $50,000) $50,000 Less: Personal exemption 2,000 $48,000 Taxable at 4% 4,000 $ 160 Taxable at 8% $44,000 3,250 Surtax on $50,000 4,960 Total tax $ 8,640 EXCHANGES OR SALES OF CAPITAL ASSETS 633 It is obvious that A in the ilkistration just given would not invoke the capital gains section of the law. The point is that losses which may not be deductible in computing capital gains may be taken in computing net income in the regular way. Alternative computations will have to be made so the taxpayer can determine which yields the lower tax. Application of credits and exemptions in alternative com- putations. — Regulation (b) The credit allowed by section 222^- .... is a credit against the total tax, however compnted, but the creeh'ts allowed l\v section 216'''' are allowed "for the purpose of the nor- mal tax only" and may not l)e taken against capital net gain, although they may be deducted from ordinary "net income." For example, if B, a married person, had capital net gain of $30,000 and ordinary net income of $2,000, his $2,500 personal exemption would more than offset his ordinary net income, but he may not apply any part of it to reduce his capital net gain (Art. 1651.) Tax not less than 12^ per cent of total net income. — Regulation Section 206 (b) provides that if the tax- payer elects to be taxed under that section his total tax shall in no case be less than 12^ per cent of his total net income. In the ex- ample just given, the tax on B's capital net gain of $30,000 at I2j^ per cent would be $3,750, but the corrected amount of his total tax under this limitation is 12^ per cent of his total net income of $32,000, or $4,000. It will be found, hoA'ever, that B, with ordinary net income of $2,000 and capital net gain of $30,000, would not elect to be taxed under section 206 because under the surtax rates for 1922 his total tax computed in the usual way would be only $3,940 (normal tax $2,240 plus surtax $1,700), or $60 less than if computed under section 206 (Art. 1651.) The tax in the foregoing illustration is computed thus : (i) On basis of capital gains $3,75o (2) On basis of applying the limitation of 12^% to total net in- come $4,000 (3) On ordinary basis, disregarding capital gains provision $3,940 B pays the last of the three taxes. •'""Section 222 refers to credit for foreign income and profits taxes. °' Section 216 provides for credit of certain dividends and interest, and tor the personal exemptions and credits for dependents. 634 INCOME Effective date. — The law refers to transactions "consum- mated after December 31, 192 1." It is clear that sales or exchanges which were entirely completed before January i, 1922, cannot be reported in 1922, but are subject to the rates in force prior to 1922. Irrespective of the new regulations, the attitude of the Treasury must be that the word "consum- mated" as applied to the taxation of income, means actual realization and not a "paper" closing of a transaction. There will be cases in which doubts will arise as to the actual con- summation of a transaction, and in some cases the decision will throw the gain back of 1922 and in almost similar cases the gain will be held to be realized in 1922. Generally speaking, transactions prior to January i, 1922, which did not result in the receipt of cash or property of a readily realizable mar- ket value, were not consummated on the effective date, and the gains arising from such transactions should not be reported until they are actually consummated. Meaning of term "capital assets." — Upon the interpreta- tion given to the term "capital assets" will depend the classi- fication of items which heretofore have not been carefully earmarked as capital items because no necessity existed for a correct classification. It is immaterial what terminology may have been used by taxpayers in the past. The sole test here- after will be the true designation of items. The law clearly sets forth three negative tests which permit easy classification : 1. Capital assets must have been owned for at least two years. 2. Stock-in-trade must be excluded. 3. Property held for personal use or consumption must be excluded. Meaning of two-year requirement. — In imposing a low rate of tax it was the intention of Congress to encourage the transfer of investments. It had been claimed that property held for a long period of years could not profitably be disposed of EXCHANGES OR SALES OF CAPITAL ASSETS 635 under the high rates of tax. The argument did not extend to gains arising from property recently acquired. With this in mind it should not be difficult to follow the two-year limitation. Taxpayers who claim the benefits of the special rate must show that the assets from which the taxable gains arise have been "acquired and held by the taxpayer" for more than two years prior to date of sale. The property disposed of must be the identical property acquired more than two years previously, unless the existing property is held for income tax purposes to take the place of other property. In all cases which are held not to be closed transactions the two-year period runs from the date the original property was acquired. There are difficulties in applying this prin- ciple. \/Vhen real estate which is real property has been exchanged for shares of stock which are personal property, it can hardly be held that the capital asset disposed of is the real estate even though one is held to take the place of the other and no tax was imposed upon the exchange. It may be held that capital assets disposed of must have been held for two years in their identical form although the basis of tax may go back to the original cost of property for which the property sold was exchanged. The section must be reasonably construed. A building is a capital asset. Sup- pose it is substantially rebuilt within two years prior to sale. The building as sold has not been held for two years but the capital asset has been held for two years. In other words, a mere change in form should make no difference. Assets (other than stock-in-trade) owned by partnerships and distributed to partners at book values, are capital assets in the hands of the partners. The two-year period runs from the time the assets were acquired by the partnership. Meaning of term stock-in-trade. — Without going into refinements of terms it is sufficient to state for income tax pur- poses that stock-in-trade is that which the Bureau of Internal Revenue has held to be stock-in-trade. There have been many 636 INCOME exclusions of what might have l)eeii called stock-in-trade under commercial practice. For instance, dealers in real estate do not own stock-in-trade. All of their assets are capital assets. Taxpayers engaged in business should be careful hereafter to analyze their income statements. It is not considered good accounting practice to credit to current income gains arising from sales of capital assets ; but it is quite easy for a book- keeper to make such entries. In the past it has made little difference. In the future it may make a substantial difference. The Treasury has ruled that inventories ma}- be taken only of merchandise and of securities; in the case of securities per- mission to inventory is strictly limited to dealers in securities. Many who have called themselves dealers in securities have been refused the classification by the Treasury.''* Article 1585 of Regulations 43 made a distinction between corporations and partnerships which were dealers in securities and "officers of (such) corporations and members of (such) I)artnerships, who in their individual capacities buy and sell securities," holding that the officers and individual partners were not dealers in securities. They were not permitted to inventory their securities and obviously therefore their secur- ities could not be considered "stock-in-trade." The Treasury recently has ruled''' that "a taxpayer, engaged in the real estate business, is not permitted to inventory real estate which is held for sale for the purpose of calculating net income subject to federal income tax." Under this ruling the gain on real estate owned for more than two vears will carry the 12^ per cent rate. In the case of bankers and others who have carried securities for more than two years and which have not been inventoried, for federal tax purposes, they may sell them and the gain, if any, will be taxed at 12^/2 per cent. In any event, accounting jjractice determines which assets should be inventoried. Those which should not be, are capital assets, irrespective of erroneous methods of accounting. Income Tax Procedure. 1921, page ^59. C. B. 4, page 47; O. D. 848 (March 2^. 1921). EXCHANGES OR SALES OF CAPITAL ASSETS 637 In some cases inventories of stock-in-trade improperly in- clude capital items such as machinery parts, building materials, etc. In case of resale at a gain the items should be segregated; otherwise the practice has no effect on the computation of capi- tal gains. Former definitions of term "capital assets" not BINDING. — The Treasury in the following case has defined the term "capital assets." Ruling. In the case of a bank the term "Capital Assets" as used in article 545 of Regulations 45 includes bonds and other securities in which it has invested money received on deposit. Any gain de- rived by the bank from the sale of such securities must be reported in its gross income and the amount of the gain is to be ascertained in accordance with the rules laid down in that article. (C. B. 4, page 276; O. D. 832.) Ordinarily definitions such as the foregoing will not affect the specific definitions contained in the law. In the case of banks all of their investments are capital assets unless they were permitted by the Treasury to inventory their securities, having first qualified as dealers in securities. The mere act of calculating depreciation or depletion has much to do with the determination of stock-in-trade. The latter is periodically revalued for income tax purposes. Under the regulations assets which could not be inventoried, auto- matically become capital assets. Meaning of term "personal use or consumption." — Taxpayers are not permitted to deduct as losses, nor permitted to return as capital gains, the losses or gains arising from the sale of residences occupied by the taxpayers, automobiles, jewels and similar items (article 1651, see page 570). The in- hibition is fair so far as losses are concerned, but not fair regarding gains; if such gains are taxable at all they certainly should be taxed as capital gains. All property, including residences leased to others, and in- • 638 INCOME vestments of every description, excluding only assets for per- sonal use or consumption, are classed as capital assets. Determination of "net" capital gains. — The law states that "net" capital gains consist of capital gains minus capital losses. Having decided which assets are capital assets, the calculation of the net gain or net loss is comparatively simple, and being fully discussed elsewhere, need not be repeated.*"^ A short formula is the following : Debit an account with value of asset at March i, 191 3, or cost if acquired since; add capital expenditures such as carrying charges if capitalized (that is, if not deducted in tax returns since 191 3) ; credit depreciation or depletion to date of sale; credit net sales price. The balance of the account will be the capital gain or capital loss. Net capital losses. — The law does not impose the limitation of I'zYz per cent upon net capital losses. Taxpayers who seek to secure the maximum benefit under the new law will endeavor to bunch their capital gains in one taxable year and their capi- tal losses in another taxable year. For discussion see page 627. Statement of capital transactions to be attached to return. — Regulation. Segregation of capital transactions for the purposes of section 206 is required only where the taxpayer elects to be taxed under that section. Where his total income tax for any taxable year does not exceed 12^ per cent of his net income he will not elect to be so taxed for that year When a taxpayer elects to be taxed under this section for any taxable year, he shall attach to his return of income for such year an accurate statement under oath showing all items of capital gain, capital loss, and capital de- ductions in such manner as will clearly show the exact amount of his capital net gain for the taxable year. Each capital transaction must be separately shown and the capital items with respect thereto grouped °* See page 573, where effect of depreciation on sales is discussed, and computations on page 577 showing effect of depreciated March I, 1913, value, and depreciated cost, respectively EXCHANGES OR SALES OF CAPITAL ASSETS 639 together in order that the capital gain derived or the capital loss sustained from each capital transaction will readily appear. In the case of sales or exchanges of real estate, the statement must show whether or not it was held as a residence by the taxpayer or his family. In the case of sales or exchanges of securities or any other property, the statement must show how long the property was held by the tax- payer immediately preceding the sale or exchange. (Art. 1652.) CHAPTER XVIII INCOME FROM ROYALTIES AND PATENTS Income from royalties and similar sources is not specifically named in the definition of income in the law, but it is clearly included within its terms. Law. .Section 213 the term "gross income" — .... (a) Includes .... gains, profits and income derived from any source whatever. Regulation gross income .... embraces .... income .... such as ... . royalties .... (Art. 541.) The law provides that the profit which arises from the sale of patents and copyrights must be included as income for the year in which it is received. It has been pointed out on many occasions that this procedure works an unwarranted hardship on inventors and others who have spent considerable time and money in the development of ideas or devices, only to find that on selling them the whole of the increased value must be returned for tax purposes in a given year. While it is admitted that proration of the increment over the develop- ment period w ould l)e extremely difficult, nevertheless the pres- ent procedure burdens the unfortunate inventor or author. Under the 1918 and prior laws no relief is granted, nor is any ettective for the taxable year 192 1 ; but for 1922 and subsequent years the ''capital net gain'' provision of the law (section 206) will limit the tax payable to 12^% of the profit, if the patent or cop}right has been held for at least two years. ^ Royalties from Mines, Oil Wells, etc. Royalties from mines, oil wells, etc., must be included in iiross income for the vear in which thev are received. Tliis See further Chapter XVII. 640 FROM ROYALTIES AND PATENTS 641 procedure applies even if the title to the producing land is in question. Rulings. Income from oil royalties must be returned in the tax- able year received, even though the title to the producing land is in litigation. If any p^rt of the royalty income is ordered by the court to be paid over to another, any tax previously paid thereon will be credited against any income tax then due under any other return of the taxpayer, and any balance of the excess tax paid will be re- funded if proper claim for such refund is made. (C. B. 4, page 95; O. D. 825.) This ruling was later explained as follows : In the case of a dispute as to the title of oil-producing land, the royalties belong to the true owner. They follow the land and come into existence regardless of the person or activities of the owner. If one collects the royalties thinking he is the owner and then by judgment of court finds that another is the owner, he must surrender the royalties received not as damages but simply because they belong, and belonged from the beginning to the true owner. The one who first received the royalty did so because he thought the land, and therefore, the royalties were his. Where a patentee obtains a judgment against the infringer of a patent by virtue of which the infringer must account for all profits made through the infringement, the situation is materially different. The infringer of a patent directly creates by his activities the profits made; but for him they might not have come into existence. These profits as earned belong to him and are properly returned as in- come in the years earned. Hut having conmiitted a wrong in infring- ing the patent he is compelled to compensate the owner for the dam- age done him and the measure of such damage in equity is tlie profit derived by such infringement and such further amount as the Master may find. A judgment requiring an accounting of profits, in such a case, is the equivalent or substitute for legal damages. It does not mean that the profits made by the infringer belong to the owner of the patent from the time such profits are made and that the infringer is converted into a trustee for the owner with respect to such profit. (Tilghinaii v. Proctor, 125 U. S. 136; Root v. R. Ry. Co., 105 U. S. 214.) With this understanding of the nature of judg- ments requiring an accounting of profits in patent infringement cases it is clear that the loss sustained by the infringer must be taken in the year judgment is rendered. (B. 51-21-1981; O. D. 1141.) Royalties subject to depletion charges. — The owner of a mine, an oil well or other similar property operated on a 642 INCOME royalty basis must return as income his royalties received, but he is permitted to deduct expenses and to charge against re- ceipts depletion allowances based on the full value of his property as at March i, 191 3, if purchased before that date, or on the basis of the capital originally invested if purchased thereafter,^ except in the case of mines and oil wells discovered by the taxpayer, in which case the value of the property at the date of discovery or within thirty days thereafter is the basis prescribed by law." For a full discussion of the topic of deple- tion as an allowable deduction, consult Chapter XXXIII, ''De- pletion." After the value as at March i, 1913, is determined, a proper calculation must be made as to how much of the royalties re- ceived is capital and how much is income. The part which is capital cannot be taxed, but all royalties which accrue must ' Foil Banmbach z: Sargoit Land Co., 242 U. S. 503, 61 L. Ed. 460, 37 S. Ct. 201. [Former Procedure] Full depletion allowances have been per- missible deductions only since 1916. The 1913 law contained a provision restricting such charges to 5 per cent of the gross value of the output of the mine, and in spite of the fact that this worked inequitaljly in some cases the courts decided that it was constitutional. The 1909 law per- mitted no deduction at all for depletion. As it is still frequently neces- sary to pass upon returns made under the 1913 law, the following deci- sion issued February 12, 1915, is of interest: "In the case of mines operated by a lessee on a royalty basis, it is held that the lessor in disposing of his ores or natural deposits on the basis of royalties has a measure of profit in every ton of ore disposed of in this way, and that so much of the gross receipts on account of royalties as is in excess of depletion, not exceeding 5 per cent of the gross value of the output at the mine, plus any incidental expenses to which the corporation may be subject, is income within the meaning of the federal income tax law and should be so returned by the lessor." (T. D. 2152.) The above ruling was obviously defective because it ignored the fact that there are many cases where royalties received have no "measure of profit" in them. Every purchaser or owner of a mine or oil well does not have a bonanza. He may have paid a high price for his property, hoping to secure royalty returns which would show a handsome profit, but his hopes may fade and disappear and he may be glad to get his original capital back without interest. " Section 214 (a-io). . FROM ROYALTIES AND PATENTS 643 be reported as gross income and the depletion allowance must be deducted in order to ascertain the taxable or net income. In the Manual for the Oil and Gas Industry the Treasury states (page 29) that "if a certain proportionate part of the lessee's capital returnable through depletion deductions is de- ducted in a given year the same proportion of the lessor's capital sum returnable through depletion will be deducted." This rule may or may not be equitable. No general rule can deprive the lessor or lessee of the right to a depletion allowance which will return his capital free of tax. Ruling. Land was purchased in 19 14. At the time of the pur- chase the mineral rights in the land had no market value, that is, no part of the purchase price of the land was paid as consideration for the mineral rights therein. Subsequently the land was leased on a royalty basis for oil and gas development and in 1919, amounts were received from the sale of interests in such royalty. Held, that inasmuch as the oil and gas rights had no market value at the time the land was purchased the entire amount received from the sale of the royalty interests is income for the year of its receipt, subject, however, to proper adjustment on account of depletion sus- tained. (C. B. 3, page 89; O. D. 644.) The ruling is inconsistent. It first states that there is no capital investment, and then that an adjustment is to be made for "depletion sustained." The amount of depletion, when there is no capital sum to be depleted, must be rather difficult to determine. The following ruling deals with a participating lease of oil lands. Ruling. B acquired a lease of oil land, agreeing that the lessors should receive a one-sixth royalty interest in the lease. Tn considera- tion of the lease he also agreed to pay x dollars to the lessors from one-half the proceeds of all sales of oil and gas produced by the five- sixths working interest belonging to him in the lease and one-fourth and one-twelfth of the proceeds of the sales of oil and gas produced by him upon two other leases he owned. Under the agreement he was obligated to pay Federal income tax upon the sums payable, together with interest, the taxes and interest being payable in the same manner as the X dollars. The oil is piped direct to the purchasing company, which remits to C, who places to the credit of the less^ rs amounts properly payable 644 INCOME to them. Upon forfeiture of the lease B is bound to pay the x dollars taxes and interest, and he may not sell the lease without paying these amounts. Held, that all income received from the five-sixths interest belong- ing to B and the one-fourth and one-twelfth interest in the two other leases represent income to B for the year in which received or accrued, proper deductions being taken for depletion each year. The .r dollars may not be amortized over the period required for its payment, but so much of each payment as represents a payment on such principal amount, income tax payable, and interest upon the payments, should be claimed as a deduction for the year in which paid. (B. 28-21-1723: O. D. 971.) Royalties from coal lands. — In the anthracite fields man}'- owners of coal lands have granted perpetual "mining leases" to operators. The Supreme Court of Pennsylvania has held these transfers to be "sales. "^ In all cases the rev- enue therefrom (usually a fixed rate per ton mined) is known as "royalties." Under the 19 16 and subsequent laws, the owners of coal lands, or those to whom a "royalty" is being paid, are entitled to receive in cash, free from income tax, an amount equal to the fair value of the property on March i, 191 3, if the property had been acquired prior to that date. This valuation is assumed to be capital. After such principal sum is provided for, the balance of the collections is income and is subject to the income tax. If the rate of royalties is a substantial one. it is probable that, of the royalties received each year, part is capital and part is taxable income. A lease to mine coal in Pennsylvania provided that the lessor should retain the privilege of selling the property at the expiration of ten years. The Treasury held^ that such a lease was not a sale of the coal in place, but the deduction for de- pletion was held to be the same as if the lease were a per- petual one. Mining royalties (minimum) received in advance. — In most mining districts it is customary for owners of the lands * Hosack V. Crill, 204 Pa. St. 97, 53 Atl. 640. °C. B. 2, page 143; S. 1365. FROM ROYALTIES AND PATENTS 645 to execute contracts or leases under which the lessees are re- quired to make annual payments representing a fixed per-ton compensation or royalty for a definite number of tons of ore or coal. These payments are made to the owners and are clearly understood by both parties concerned to be in full pay- ment of royalties for an equivalent amount of ore or coal whenever it may be removed thereafter. These payments are usually designated as advance minimum royalties, and may be paid for several successive years in which no ore or coal is mined.'' In many cases the property is surrendered to the lessors before the quantities paid for have been removed. Depletion applicable to royalties. — Regulation. ... (b) Where the owner has leased a mineral property for a term of years with a requirement in the lease that the lessee shall extract and pay for, annually, a specified number of tons, or other agreed units of measurement, of such mineral, or shall pay, annually, a specified sum of money which shall be applied in payment of the purchase price or royalty per unit of such mineral whenever the same shall thereafter be extracted and removed from the leased premises, the value in the ground to the lessor, for purposes of deple- tion, of the number of units so paid for in advance of extraction will constitute an allowable deduction from the gross income of the year in which such payment or payments shall be made; but no deduction for depletion by the lessor shall be claimed or allowed in any subsequent year on account of the extraction or removal in sucli year of any mineral so paid for in advance and for which deduction has once been made. Both capital and income accounts must be ad- justed. — (c) If, for any reason, any such mineral lease shall be termi- nated or abandoned before the mineral which has been paid for in advance has been extracted and removed, and the lessor repossesses the leased property, the lessor shall adjust his capital accounts by restoring to the capital sum of the property the depletion deductions made in prior years on account of royalties on mineral paid for but not removed, and his income account shall be adjusted so as to include the amount so restored to capital sum as income of the year such lease is terminated or the property repossessed, and the tax thereon paid. (Art. 215.) '[Former Procedure] See Income Tax Procedure, 1919, page 288. 646 INCOME The foregoing regulation properly holds that when a lessor has claimed annual depletion equal to the quantity covered by the advance royalties, no further deduction shall be made when the ore is subsequently removed. The regulation further provides that when a lessor re- possesses the property, and part of the ore or mineral, in re- spect of which depletion was deducted, has not been removed by the lessee, the aggregate of the excessive deductions will be deemed income to the lessor "and his income account shall be adjusted so as to include the amount .... as income of the year such lease is terminated or the property repossessed, and the tax thereon paid." This latter provision may work great hardship. A lessor may lease coal lands for a period of thirty years at a stated royalty per ton for coal removed, the minimum royalty being fixed at $25,000 per annum. If the proper depletion based on the minimum royalty is $10,000 per annum, there is re- turned as net income $15,000 annually. If the lessee should mine only one-half of the coal paid for (and in many cases the proportion is less), in the thirty-first year the lessor would be presumed to have realized a net income of $150,000 and the tax thereon might be $50,000. Tlieoretically, excessive depletion, to the extent of $5,000 per annum for thirty years, has been claimed; but the tax saved by the excessive deduction may not have amounted to more than one-half of the tax which would be payable if the adjustment were made in the year of repos- session. Furthermore, the taxpayer probably would have no means of pa)'ing the tax, because a repossessed coal mine has little, if any, sale value. In most cases the apparently excessive deductions would not be excessive at all. Depletion could only be charged from year to year on the basis of the original value of the lease. The lessee would nut relinquish possession and lose his ad- vanced royalties if the mine retained its value. Therefore, at the end of the period the lessor would have merely charged FROM ROYALTIES AND PATENTS 647 off an aggregate sum equal to the depletion of the coal re- moved plus the depreciation in the value of his property. In any event the actual value of the property repossessed is the maximum amount which can be deemed to be income. If amended returns for prior years are not accepted, the au- thor ventures the prediction that no court would deem the value of the property repossessed to be income taxable solely in the year of repossession. When the failure to recoup the advanced royalties or the lapse of the lease is due to inefficient operation, inadequate capital owned by the lessee, or for similar reasons other than the content, availability, etc., of the mine, and when the allow- ance in previ(jus years for depletion, which never actually accrued, has resulted in real income not yet rc])orted, amended returns should be made by the lessor. Also, if advanced roy- alties become unrecoverable because minerals have not been removed during a definite period stipulated in the lease, within which advanced or minimum royalties may be recovered, there may be some additional income of the lessor for previous years for which amended returns should be made. Royalties waived for several years — received in one year. — Ruling. A lessor of mining property who waived his right to royalties for several years on account of the fact that the mine was operated at a loss, and received all of the royalties in the year 1917, may, if he has submitted returns for those years on a cash receipts and payments basis, deduct from the income received in 1917 such depletion allowance as appertains to that income. (C. B. 2, page 144; A. R. M. 17.) Royalties from Copyrights An author should report as gross income all sums received from copyright privileges. He is entitled to claim as deduc- tions all expenses, except ordinary living expenses, incurred in producing such income. The argument which appears on page 640 for a more equitable tax upon the earnings of inventors applies with 648 INCOME equal force to the earnings of authors. It must be admitted, however, that there will be great difficulty in framing and administering a remedial provision. A lawyer who works for ten years and finally wins an important case has an equal claim to consideration. Regulation xA.mounts expended for securing a copyright and plates, which remain the property of the person making the pay- ments, are investments of capital (Art. 293.) However, deductions can be made for depreciation^ and conservative accounting calls for rates of depreciation on assets of this kind up to 100 per cent per annum. The method prescribed for computing the profit, if any, from the sale of copyrights, is the same as that for patents.* The British [)ractice as to copyrights is as follows: British practice. (1) Annual payments of fixed amount, or being a fixed share of profits, are assessed on the person making the payment in the same way as interest. (2) An author, playwriter, or artist selling copyrights, etc., to publishers is chargeable on the amount received less his expenses; if sold on royalty, the whole amount of the royalty is chargeable. (3) No charge is made upon a person who has an isolated trans- action of such a nature ; the profit is looked upon as capital. [Murray and Carter, Income Tax Practice (1919 edition), page 219.] Royalties and Profits from Patents Income from the sale of patents above cost, or from royalties when such royalties include profit over and above the return of capital, is taxable.^ The general principle of a return of capital must be followed, however. No tax can be imposed on receipts from the sale of patents or patent rights unless the owner has made full provision to reimburse himself for the cost or value of them. If the patents were applied for or owned on or before March i, 19 13, their actual value at ' See Chapter XXXI, "Depreciation." * Art. 40, page 652. ' [Former Procedure] For a short time the Treasury in taxing royalties ignored Alarch i, 1913, values. For rulings in 1916, see Income Tax Procedure, 1920, page 395. FROM ROYALTIES AND PATENTS 649 that date is their capital value. If they were acquired after that date, the cost is considered the capital value/" A payment to bind an option to purchase an interest in the royalties to be received from certain patents has been held to be income to the recipient/^ Damages received from infringements of patents. — Collec- tions of damages arising from infringements may be income or capital or both, depending on the fair value as at March I, 1913, and the nature of the damages collected. If no injury to the capital value has resulted, the entire collection, less ex- penses, is income. If the capital value has been diminished by the infringe- ment, the amount collected, or an appropriate part thereof, should be applied in reduction of the book value of the patents. Regulation A person may sue in one year on a pecu- niary claim or for property, but money or property recovered on a judgment therefor rendered in a later year would be income in that year, assuming that it would have been income in the earlier year if then received. This is true of a recovery for patent infringement. .... (Art. 51; Reg. 45, Art. 52.) The foregoing regulation may be applicable to most cases of recoveries arising from judgments, but there are many ex- ceptional cases which must be decided according to other sec- tions of the law and according to the decisions of the courts which define taxable income. As stated above, the fair value of a claim as of March i, 191 3,'" is an important consideration. If a taxpayer was en- titled to property in 1912, but did not recover it until 1921, it cannot be held, and the Treasury does not hold, that he re- ceived any taxable income in 1921. If he became entitled to property in 1914, but did not re- turn it in that year because he did not know its actual value, it is not reasonable to claim that if he collected the claim or '"Reg. 45, Art. 1561, page 570. "Bulletin 37-21-1813; O. D. 1028. ''For method of establishing value at March t, 1913, see page 596. 650 INCOME received the property in 1921, the entire amount would be income in 192 1. The courts might hold that the income arose in 1914 and give the taxpayer the privilege of filing an amended return for that year, l3ut there is little in the trend of recent decisions to support such a belief. The courts are more likely to hold that when a taxpayer could have adopted the accrual basis of reporting, but did not do so, the election must stand. As late as 191 7 (see Chapter XXVI) the Treasury held that when a corporation was compelled, in 1916, to pay dam- ages arising out of an infringement case and the period of in- fringement ended in 19 12, no part of the sum paid was de- ductible as an expense in 19 16, but that it should all be de- ducted (by amended returns) in the period prior to 1912. Patent development costs. — The cost of developing a pat- ent is of the same nature as carrying charges on real estate. One has the option of capitalizing the items or of charging them off as current expenses. Frequently it is difficult to determine which course should be pursued, even at the time. It may be obvious, after a period, that the experiments under way are not yielding satisfactory results. In such an event the cost is a clear expense. More often the result is doubtful, in which case it is permissible to elect whether to capitalize or to charge off the amount. Conservative accounting methods call for charging off, but the owner may be penalized for so doing if current profits are not large. The subsequent sale of the patent for a con- siderable profit would result in a tax on the entire sale price, if the development costs had all been claimed as deductions and written off. Regulation The cost of defending or perfecting title to property constitutes a part of the cost of the property and is not a deductible expense (Art. 293.) The foregoing regulation cannot always be applied to pat- ent litigation. If the litigation does not clearly add to the FROM ROYALTIES AND PATENTS 65 1 value of the patent, the expenses should be charged off as they are incurred. This view is adopted by the Treasury in the following : Expense of patent litigation not added to cost.— Ruling. The M Company expended a certain amount in litigation defending its right, title, and interest in a patent after the patent had been issued by the Government. Held, that this amount may be deducted as an ordinary and neces- sary operating expense. The actual cost of the patent represented by various Government fees, cost of drawings, experimental models, attorney's fees, etc., paid before the patent was issued, will be re- turned to the company through annual depreciation deductions. . . . . (C. B. 2, page 105; A. R. R. 98.) Method of valuing patents. — Owing to the great uncer- tainty which often exists regarding the commercial (that is, the market or income-producing) value of a patent, it is difihcult to arrive at a fair taxable value when a sale or transfer is made for a consideration other than cash before the patent is fully developed. In ascertaining the net taxable income of an inventor or owner to be assessed as of the year in which a transfer takes place, there should be taken into consideration the stage of the patent's commercial development, the degree of prosperity attained by the concern manufacturing it, and any other facts which serve to fix a fair value. Some of the information may appear to be of a later date, but it is valuable nevertheless. Value of patents March i, 1913. — In the 191 7 law^^ patents were included among tangible assets. In the 19 18 law^^ pat- ents are included among intangible assets. Generally speaking the rules for valuing tangible and intangible property, hereto- fore discussed, govern the valuation of patents. The distinc- tive features which exist in regard to patents will now be dis- cussed. Section 207 (a-3-a). Section 325 (a). 652 INCOME X'alucs of patents must be established (a) to arrive at the basis for the eomputation of depreciation allowable as a deduc- tion from gross income, and (b) for the purpose of report- ing gains or losses resulting from their sale or disposition. Regulation. A taxpayer disposing of patents or copyrights by sale should determine the profit or loss arising therefrom by comput- ing the difference between the selling price and the cost. The taxable income in the case of patents or copyrights ac(|uircd prior to March i, 1913, should be ascertained in accordance with the provisions of article 1561. The profit or loss thus ascertained should be increased or de- creased, as the case may be, by the amounts deducted on account of depreciation of such patents or copyrights since February 28, 1913, or since the date of acquisition if subsequent thereto. (Art. 40.) A patent is valuable for a limited period. It can never be treated as of permanent value per sc. Rights and privi- leges permanent in their nature may develop from patents, but such rights should not be classified as patents. The mo- nopoly granted by the government is for a specific period. Patents, therefore, come within the category of depreciable assets. At times it is difficult to distinguish between patents and goodwill. ^^ Except for the year 191 7 (when patents were tangibles), the only difference of importance between patents and goodwill is the element of depreciation. Under the Treasury regulations a deduction for deprecia- tion of patents is made at the election of the taxpayer. It is not obligatory. However, if depreciation has been taken the amounts so deducted must be considered when patents are sold or disposed of in the same manner as in the sale of tangible assets.'" Depreciation is such an important element that the correct valuation of patents as at March i, 1913, may make a tre- mendous difference in the amount of taxes payable after Jan- uary I, 191 7. Prior to that date the rate of tax was so low that it made little difference how much was claimed for de- ' See article 843. ' Art. 843. FROM ROYALTIES AND PATENTS 653 preciation of patents. Taxpayers who practically disregarded patent values and depreciation of patents prior to 19 17, are not barred from reopening their accounts and tax returns and making proper adjustments/' Tlie mere failure to assert one's rights does not operate as a waiver. ^"^ The Commissioner is powerless to enforce any regulation or rule which limits the right of a taxpayer to correct his tax returns for previous years, except only in case of fraud. It has not been, and cannot be, urged that the opening of tax returns arising from properly supported revaluations can be considered fraudulent. There is, of course, one very practical objection to the reopening of tax returns for the years 1916 and prior. Sec- tion 252 of the 192 1 law provides that no claims for refund will be allowed (including those under the 1909 and subse- quent laws) unless the claim is filed within five years from the day when the return was due. If, however, invested capi- tal under the 1917 or 1918 laws is decreased by the Commis- sioner as the result of insufficient deductions in prior years, which afifect the returns of earlier years and so result in a credit for taxes in the earlier years, such amount may be cred- ited or refunded regardless of the expiration, of the five-year period. ^^ Returns for the calendar year 1916 were due March i, 191 7. If claims in respect thereof are not filed before March I, 1922, the Commissioner will have no power to grant them. To determine the actual value of patents at March i, 19 13, is in many cases a difficult task. Each case must be decided on its own merits. There existed at that date instances in which taxpayers had in the dim past merged patents and other in- " For table of terms of patents and copyrights in various countries, see C. B. 3, page 169. " .... Mere delay in asserting a right does not ipso facto bar its enforcement in equity, by the great weight of authority, unless the case is barred by the statute of limitations." (21 C. J. 221.) '"Law, section 252. See page 255. 654 INCOME tangible such as goodwill, in their accounts. In other in- stances a number of patents were acquired without a value being placed on each distinct patent. Intercompany book transactions also frequently tended to render the value of patents obscure. Numerous other complications exist. Nev- ertheless, in order that the taxpayers' interests may be pro- tected and in order that the government may receive the proper amount of tax, patent values must be established. Where the amounts involved are large, it is a problem upon which sound judgment and experience should be employed. Patents accjuired subsequent to March i, 1913, and later disposed of, do not differ from other assets in so far as the method of treatment for the purpose of determining gain or loss on the transaction is concerned.^" If patents were acquired solely for cash prior to March I, 191 3, and if the payments can be readily traced through the accounts, the tax laws presume that the cash payments rep- resent the actual value of the patents at the time acquired. Unless the purchase was made immediately before March i, 19 1 3, the cash payment would not be an important factor in fixing the value as of that date. If the consideration for the patents was stocks, bonds or notes which had, a marketable value at the time of acquisition, it is presumed by the Treasury that the value of the patents was equal to the market value of the securities received there- for. If the securities were not marketable but were in the nature of investm^t securities having a fixed rate of return, their appraisal is usually a comparatively simple matter. Cases have arisen in which the nominal value of stock issued for patents was considerably less than the known cash value. Such cases occur when, for some particular reason, it is desired to keep the capitalization of the purchasing cor- poration at a low figure. If the profit on sale be based on the nominal value of the stock, substantial injustice will be done to the taxpayer. The profit must be based on the real cash See Chapter XVII. FROM ROYALTIES AND PATENTS 655 value as of the time of acquisition, little or no attention being paid to the nominal value of stock issued for the patents. The foregoing applies particularly to common stock which usually receives the greatest benefit from a successful patent. Actual value may be determined by earnings, past or pros- pective, which are attributable to the ownership of patents. If it can be shown that, after providing for a return on the net tangible assets, the excess is due to the ownership of pat- ents, such excess earnings may be used in fixing the value of the patents. Royalties paid by licensees is another factor to be consid- ered in establishing patent valuations. Royalty agreements and schedules of receipts (herefrom arc valuable supporting evi- dence. Furthermore, the value in many cases may be demonstrated by the opinions of those who, by reason of their technical knowledge and experience, are familiar with the value of the patents in question. This method of valuation meets with the approval of the Treasury. Ruling., .... Where there is no established market to serve as a guide the question of value, even of tangible assets, is one largely of judgment and opinion, and the same thing is even more true of intangible assets: (C. B. 2, page 31 ; A. R. M. 34.) In rare cases the value of patents can be established by sales of the particular patents at or about March i, 1913. It is obvious that the value cannot be established by sales of similar property, because we are dealing with a monopoly. The law does not attempt to limit the 191 3 value to its "mar- ket" price at that time. Section 202 (a) reads "the fair market price or value of such property." There is no pos- sibility, in 99 out of 100 cases, of ascertaining a "market price" as at March i, 19 13, and it is useless to attempt it, because the law intends and authorizes taxpayers to deter- mine the "value" of the patents as at that date.^^ -'Reg. 45, Art. 1561. Sec page 570. 656 INCOME Regulation. No method of determining this value (March i, 1913) can be stated by the Department which will adequately meet all circumstances. What that value was is a question of fact to be established by any evidence which will reasonably and adequately make it appear. (Reg. 33, paragraph 6^.) In general, the Commissioner is required to adopt the standards and definitions of value which have been approved by the United States Supreme Court. The Treasury, while not perhaps applying strict technical rules of evidence in mat- ters of this kind, necessarily receives and gives the same weight to evidence admissible in court as would be accorded to such evidence by a court. It therefore becomes important to con- sider what attitude the courts may take with respect to the establishment of value of property having no technical mar- ket value. The courts not only permit, but require, that per- sons should be brought before the court who, from their tech- nical experience and knowledge, are better qualified to form a judgment concerning the real value of such property than is the ordinary citizen ; they require such person to detail his expe- rience and means of knowledge to the jury, and then they permit him to express his opinion as to the actual value of the property in question, based upon his knowledge of that property in particular and upon his experience in general. The follow- ing decisions bear upon this subject : Decisions. This question of damages, under the rule given in the statute, is always attended with difficulty and embarrassment both to the court and jury. There being no established patent or license fee in the case, in order to get a fair measure of damages, or even an approximation to it, general evidence must necessarily be re- sorted to. And what evidence could be more appropriate and perti- nent than that of the utility and advantage of the invention over the old modes or devices that had been used for working out similar results? With a knowledge of these benefits to the persons who have used the invention, and the extent of the use by the infringer, a jury will be in possession of material and controlling facts that may enable them, in the exercise of a sound judgment, to ascertain the damages, or, in other words, the loss to the patentee or owner, by the piracy, instead of the purchase of the use of the invention. (Suffolk Co. V. Hayden, 3 Wall. 315-320.) FROM ROYALTIES AND PATENTS 657 There remains for consideration but a single point-that there was admitted in evidence on the trial the opinions of witnesses as to the value of the land, which were not based upon the sale of the same or similar property, and were not, therefore, the opinions of persons competent to so testify. It appears that the land taken was a strip running through a mining claim, which had been patented and belonged to the defendants in error And yet, uncertain and speculative as it is, such "prospect" has a market value; and the absence of certainty is not a matter of which the railroad company can take advantage, when it seeks to enforce a sale. Contiguous to a valuable mine, with indications that the vein within such mine ex- tends into this claim, the railroad company may not plead the un- certainty in respect to such extension as a ground for refusing to pay the full value which it has acquired in the market by reason of its surroundings and possibilities. In respect to such value, the opinions of witnesses familiar with the territory and its surroundings are competent. At best, evidence of value is largely a matter of opinion, especially as to real estate. True, in large cities, where articles of personal property are subject to frequent sales, and where market quotations are daily published, the value of such personal property can ordinarily be determined with accuracy; but even there, where real estate in lots is frequently sold, where prices are generally known, where the possibility of rental and other cir- cumstances affecting values are readily ascertainable, common ex- perience discloses that witnesses the most competent often widely differ as to the value of any particular lot; and there is no fixed or certain standard by which the real value can be ascertained. The jury is compelled to reach its conclusion by comparison of various estimates. Much more so is this true when the effort is to ascertain the value of real estate in the country, where sales are few, and where the elements which enter into and determine the value are so varied in character. And this uncertainty increases as we go out into the newer portions of our land, where settlements are recent and values formative and speculative. Here, as elsewhere, we are driven to ask the opinions of those having superior knowledge in respect thereto. It is not questioned by the counsel for plaintiff in error that the general rule is that value may be proved by the opinion of any witness who possesses sufficient knowledge on the subject; but their contention is, that the witnesses permitted to testify had no such sufficient knowledge. It is difficult to lay down any exact rule in respect to the amount of knowledge a witness must possess; and the determination of this matter rests largely in the discretion of the trial judge. Stillwell Manufacturing Co. v. Phelps, 130 U. S., 520; Lawrence v. Boston, 119 Mass., 126; Chandler v. Jamaica Pond Aqueduct Corporation, 125 Mass., 544. The witnesses whose testi- mony is complained of, all testified that they knew the land and its 658 INCOME surroundings; and many of them that they had dealt in mining claims situated in the district, and had opinions as to the value of the property. It is true, some of them did not claim to be familiar with sales of other property in the immediate vicinity; and the want of that means of knowledge is the specific objection made in the Su- preme Court of the Territory to the competency of those witnesses. But the possession of that means of knowledge is not essential. It has often been held that farmers living in the vicinity of a farm whose value is in question, may testify as to its value although no sales have been made to their knowledge of that or similar property. Indeed, if the rule were as stringent as contended, no value could be estab- lished in a community until there had been sales of the property in question, or similar property. After a witness has testified that he knows the property and its value, he may be called upon to state such value. The means and extent of his information, and therefore the worth of his opinion, may be developed at length on cross-exam- ination. And it is fully open to the adverse party, if not satisfied with the values thus given, to call witnesses in the extent of whose knowledge and the weight of whose opinions it has confidence. (Mon- tana Railway Co. v. Warren, 137 U. S. 348, 352, 353, 354.) Inventions are of all sorts, and it is very difficult for a jury to estimate the value of the use of any invention either before or after the issue of letters patent. We are of opinion that, in the discretion of the court, a witness with the qualifications shown in this case might be permitted to give an opinion of the value of the use of inventions relating to stock and cattle cars. Sturgis v. Knapp, 33 Vt, 486, 531; Butler V. Mehrling, 15 111., 488; Brady v. Brady, 8 Allen, loi ; Vandine v. Burpee, 13 Mete. (Mass.), 288; Beale v. City of Boston, 166 Mass., 53, 56, 43 N. E., 1029. {Burton v. Burton Stock Car Co., 50 N. E. Rep. 1029, 103 1.) Where there is no evidence to show that any license fee has ever been paid or demanded, the jury, in estimating the damages, should consider the utility and advantage to the defendant of the use of the patented device, as compared with any other means of obtaining similar results whose use was open to it, and may compare the cost of using the one to the cost and saving in the use of the other. (Syllabus, Brickill ct al. v. Mayor, etc., of Baltimore, 60 Fed. 98, 8 C. C.'a. 500.) In the last case cited, the Circuit Court of Appeals for the Fourth Circuit approved the following charge to the jury: This is an action at law for the damages sustained by the plain- tiffs for the alleged infringement, and in such actions, when there has been proved an established royalty or license fee, which has FROM ROYALTIES AND PATENTS 659 been customarily paid to the owner of the patent by those who desired to use it, such regular price for a license is the primary and true criterion of the plaintiff's damage; but in this case there is no evidence of any license fee ever having been demanded or paid by any one; and so, if you find in favor of the plaintiff's, you should consider the utility and advantage to the defendant of the use of the patented device, as compared to any other means of obtaining similar results which were open to the defendant to use, and you may consider the cost of using one as compared with the cost and savings to the defendant of using the other; and from these data, if proven to you, you should ascertain, in the exercise of a sound judgment, what would be a fair compensation to the plain- tiffs for the damage which they have sustained by reason of the defendant having infringed, instead of having purchased the right to use, the invention. Ruling. The Committee has considered the question of provid- ing some practical formula for determining value as of March i, 1913, or of any other date, which might be considered as applying to intangible assets, but finds itself unable to lay down any specific rule of guidance for determining the value of intangibles which would be applicable in all cases and under all circumstances. Where there is no established market to serve as a guide the question of value, even of tangible assets, is one largely of judgment and opinion, and the same thing is even more true of intangible assets such as good will, trade-mark, trade brands, etc (C. B. 2, page 31; A. R. M. 34.) Also see cases cited in discussion regarding fair value of services, page 871. Patents not issued March i, 1913, may be valued. — The Treasury very properly permits applications for patents to rank with those issued in ascertaining values as of March i, 1913.^^ This is on the theory that there is an assignable prop- erty right in an application for a patent. Obviously, if no patent is subsequently issued there can be no value at March I, 1913- The method of depreciation, when a patent was not issued until after March i, 1913, necessarily differs from that appli- cable to patents issued prior to March i, 1913. For a discus- sion of this point, see Chapter XXXI. 'X. B. 3, page 342; A. R. R. 328. 66o INCOME Royalties subject to depreciation charges. — The following ruling explains the extent to which royalties subject to depre- ciation charges are taxable. ^^ Ruling. A invented certain apparatus and secured United States patents thereon. The patents were assigned to a foreign corporation under an agreement by which he retained 40 per cent interest in profits therefrom. Legal title to the patents passed to the company subject to the agreement mentioned. A's interest was recognized by the company and by the United States licensees under the patents. The committee is of the opinion that the agreement should be recog- nized as giving A a depreciable interest in the patents. The value of each patent as at March i, 1913, should be segre- gated and the depreciation allowable thereon determined on the bdsis of its own life instead of using as a basis the average life of all the patents and the value of all the patents in bulk. Of the total depre- ciation allowable for any year, 60 per cent is deductible in the return of the company and 40 per cent in A's return. (C. B. 2, page 142; A. R. M. 35.) °' See Chapter XXXI for a full discussion of the depreciation of patents. CHAPTER XIX INCOME FROM INTEREST— GENERAL All interest, except on slate, municipal and certain United States securities, is to be included in gross income, whether on notes, bank deposits, securities, bonds, mortgages or deeds of trust or other similar obligations of domestic corporations and insurance companies, bonds issued in foreign countries or upon foreign mortgages or like obligations (not payable in the United States). Interest on tax-exempt securities is not to be reported as a part of gross income. The statement showing the number and amount of such securities and the income therefrom which was required to be submitted with the annual income tax re- turn'- under the 1918 law, is not required- under the 1921 law. Subject to the exceptions stated, not only is all interest re- ceived by residents and domestic corporations taxable, but in- terest received by non-resident aliens and foreign corporations from sources w^ithin this country^ is also taxable — a fact which raises an interesting cjuestion of international double taxation.' The law and procedure regarding interest derived from United States obligations, including farm loans, will be found in the following chapter. Interest from all other sources will be discussed in this chapter. Interest subject to tax. — Law. Section 213. That for the purposes of this title .... the term "gross income" — (a) Includes gains, profits, and income derived from .... in- terest .... ' Prior to 1918, interest which was entirely exempt from taxation did not have to be reported at all. ""As defined in section 217 (a-i) of the 1921 law. See Chapter XXXVI. 'For discussion of the principles involved in the taxation of non- resident aliens, see Chapter XXXVI. 661 662 INCOME In order to exclude all exempt interest from taxation, taxpayers, particularly banks and other financial institutions, should keep separate ledger accounts for interest from various sources. Interest accrued but not collected. — So far as possible tax- payers are expected to keep their accounts on an accrual basis and return as income all interest which accrues to them. Regulation. When interest coupons have matured, and are pay- ahle, but have not been cashed, such interest payment, though not col- lected when due and payable, is nevertheless available to the taxpayer and should therefore be included in his gross income for the year dur- ing which the coupons matured. This is true if the coupons are ex- changed for other property instead of eventualyl being cashed. De- faulted coupons are income for the year in which paid (Art. 53; Reg. 45, Art. 54.) Unless the foregoing regulation is intended to refer only to cases where payment can be secured upon presentation of the coupons, it is too optimistic. It states without reserva- tion that when interest is due it "is nevertheless available to the taxpayer." Owners of public utility bonds which have been made worthless, or nearly so, by the hostile action of municipal authorities, as in New York City, or by confiscatory legis- lation in other places, should not accrue the interest until there is a reasonable chance of collecting it. Of course, if the taxpayer could collect, but does not, there is no excuse for not reporting the amount accrued. Accrued interest returned as income which is not subse- quently collected. — Taxpayers reporting upon the accrual basis should report as taxable income accruals from real estate mortgages, loans and other obligations when there is a reason- able expectation that such interest will be received in due course. In cases where it develops that the debtor is unable to pay the interest previously entered as income, this interest should be charged off on the taxpayer's books as soon as it FROM INTEREST— GENERAL 663 is known to be worthless, and proper credit should be taken therefor in making the next succeeding income tax return.* Interest accrued prior to March i, 1913, not taxable.^ — The regulations provide that interest which fell due on or before March i, 191 3, and was subsequently collected, is not taxable. " Regulation. Any claim existing unconditionally on March i, 1913, whether presently payable or not and held by a taxpayer prior to March i, 1913, whether evidenced by writing or not, and all in- terest which had accrued thereon before that date, do not con- stitute taxable income, although actually recovered or received subsequent to such date. Interest accruing on or after that date is taxable income. Where an interest-bearing claim held on February 28, 1913, is paid in whole or in part after that date, any gain derived from the payment of the claim is taxable. The amount of such gain is the excess of the proceeds of the claim (both princi- pal and interest) exclusive of any interest accrued since February 28, 1913, already returned as income, over the cost thereof (both principal and interest then accrued). However, the gain to be in- cluded in gross income where the fair market value of the claim as of March i, 1913, is greater than the cost thereof, is the excess of the amount received over such value. No gain results where the amount received from the claim is more than the cost thereof but less than its fair market value as of A'larch i, 1913 (y\rt. 90, Reg. 45, Art. 87.) Interest accrued prior to January i, igog, not taxable. — Ruling. Interest which accrued prior to 1909, and was paid in 191 1, was not income within the provisions of the excise tax law of 1909." (C. B. 3, page 243; T. D. 3048.) * [Former Procedure] Where interest on loans made by a parent corporation to its subsidiary accrued from year to year, but was not paid, the amount thus accrued during a taxable year cannot be considered income to the parent company within the meaning of the Act of August 5, 1909. (T. D. 3133, dated February 25, 1921.) ° [Former Procedure] It was held that interest which became due and payable after March i, 191 3, was all taxable even though part accrued prior to March i, 1913. The instance mentioned concerned an interest coupon due April i, 1913, covering six months' interest to that date. There was an attempt to tax five months' interest which accrued prior to March i, 1913. The proposed assessment could not be supported by the law and was not insisted upon. • See Chapter XXII. 'Northern Pacific Ry. v. Lynch, Collector (U. S. D. C. Minn., March 22, 1920, not reported; see T. D. 3048) ; also see Walker v. Gulf & Inter- state Ry. Co. of Texas, 269 Fed. 885 (quoted in T. D. 3133). 664 INCOME The Treasury had imposed a tax on interest accrued prior to January i, 1909, collected in 191 1, although the decisions of the courts should have been sufficient notice to the Treasury that its position was untenable. The case was defended by the government when it was heard, March 22, 1920, but the court directed that the tax be refunded, with interest from the date of its collection. Interest on Obligations of States and Political Subdivisions It will be recalled that the law exempts interest upon "the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia." [Section 213 (b-4)]^ Definition of a political subdivision, — The interpretation of the phrase "interest upon the obligations of a state .... or any political subdivision thereof" has raised the question as to whether certain special assessment districts are political sub- divisions. The present regulations, in addition to defining obligations of a state, give a broad, inclusive definition of a political subdivision which results in the exemption of interest on the securities of special assessment districts (drainage, irrigation, school, etc).^ Irrigation districts. — Ruling. In some of the Western States irrigation districts are created by an election duly called for the purpose. The county assessor of the county in which the land benefited is located assesses all such property on the assessment rolls of the county and a tax is levied and collected in the same manner as other taxes are levied and collected. Held, the district is a political subdivision of the State and inter- est on its bonds is exempt from income tax. (C. B. 2, page 93; O. D. 544-) ^ For text of section 213 (b-4) and Art. 74. sre page 359. "Infra (Art. 74). [Former Procedure] For conflicting regulations prior to 1919, see Income Tax Procedure, 1920, page 403. FROM INTEREST— GENERAL ^ 665 Mortgage indebtedness assumed by municipality. — Regulation The^ purchase by a State of property sub- ject to a mortgage executed to secure an issue of bonds does not render the bonds obligations of the State, and the interest upon them does not become exempt from taxation, whether or not the State assumes the payment of the bonds. (Art. 74.) Land sold for non-payment of taxes. — Ruling., Certificates of sale issued by the county treasurers of counties of Wisconsin to purchasers of land sold for the nonpayment of taxes are not obligations of political subdivisions of the State of Wisconsin. Such certificates do not place any obligation upon the county to pay any sum of money to such purchasers. The statute provides that the owner or occupant of such land may at any time within three years from the date of the certificate redeem the same or any part thereof by paying to the county treasurer for the use of the purchaser the amount for which such land was sold, together with subsequent charges thereon authorized by law, but does not pro- vide that the county is either directly or indirectly liable for .the re- deniption thereof. It is held, therefore, that tiie interest on the tax certificates issued by county treasurers of counties of Wisconsin is not exempt from tax. (B. 48-21-1944; O. D. 1 1 14.) Interest on awards by state or municipality. — When a state or city takes property under the power of eminent domain, or when other awards of a state or city are paid with in- terest, the question arises as to whether or not interest on an award is equivalent to interest on an obligation and therefore is exempt from federal taxes. The liability of a city to pay for property taken under the power of eminent domain is certainly an obligation. State constitutions provide that private property shall not be taken for public use except upon just compensation paid or secured. A city is allowed to give its own bond and under the obliga- tion of this bond it is compelled to pay just compensation. Such just compensation is due as of the date of the taking, and when not paid immediately the citizen is placed in the same position by the payment of interest as such, or by the payment of an additional amount, which in some cases is 666 ^ INCOME spoken of as "damages for detention" not exceeding legal interest, but it is in substance interest. It is, of course, of im- portance to the recipient that any part of the award which actually is tax-exempt interest should be properly designated. Rulings. Bonds were issued by a municipality of Wisconsin, in accordance with the general city charter law of that State, to cover deferred installments of assessments against real estate for the cost of certain public improvements. Each bond was a lien upon all the property benefited to the extent of unpaid assessments and interest thereon. The bonds contained recitals that they were chargeable only to the particular prupcrty described therein, and that they should in no event constitute a general city liability. Notwithstanding the bonds were not a general liability of the city, they were issued l>y the city for public purposes and are obliga- tions of a political subdivision of a State within the meaning of section 213(b) 4 of the Revenue Act of 1918, and the interest upon such bonds is accordingly exempt from tax. (C. B. 2, page 93; O. D, 447-) Interest received by a contractor on paving assessments issued to him by a municipality in payment for work under the provisions of the statutes of a certain State is exempt income under section 213 (b) 4 of the Revenue Act of 1918 (B. 34-21-1778; O. D. 999-) ] Interest on l)onds issued by agricultural and horticultural societies under authority of section 7852, compiled laws of Michigan, is not exempt from tax under section 213 (b) 4 of the Revenue Act of 1918. (B. 31-21-1751: O. D. 983.) Sale of municipal bonds issued at a discount. — Ruling. The M bank purchased certain 10 year 4I/2 per cent municipal bonds at 96.10 which had been originally issued and sold by the municipality at 94.50. The question is presented as to whether in case the bank sells the bonds before maturity at 98, the profit realized will be exempt in its hands. Held, that inasmuch as no person other than the municipality can pay the interest borne by the obligations of the municipality (whether such interest is paid at the specified rate or in the form of realized discount) any person selling municipal bonds for an amount in ex- cess of the cost of the bonds to him realizes a taxable profit to the extent of such excess amount even though the bonds were issued at a discount. If, therefore, the bank sells at $98 the municipal bonds issued at FROM INTEREST— GENERAL 667 $94.50 and purchased by it at $96.10, it will derive a taxable profit of $1.90 on each bond sold. If, however, it holds the bonds to maturity and receives $100 the difference between the purchase price of the bonds and the amount received, or $3.90, will represent exempt in- come to it. (C. B. 4, page 31; O. D. 762.) Interest from Miscellaneous Sources The law and the regulations do not enumerate all the sources from which taxable interest may be derived, but as with other items of income, the question of taxability de- pends on whether or not the amount received or accrued is in fact income. Interest on bank deposits.'" — Regulation Interest credited on savings bank deposits, even though the bank nominally have a rule, seldom or never en- forced, that it may require so many days' notice in advance of cash- ing depositors' checks, is income to the depositor when credited. .... (Reg. 45, Art. 54.) As to non-resident aliens see Chapter XXXVI. Interest on loans to Liberty bond subscribers. — Ruling. Interest received by a bank on loans to subscribers for Liberty bonds is not interest received on obligations of the United States, and is therefore subject to tax. (C. B. i, page 67; O. D. 16.) Interest on Food Administration Grain Corporation notes. — Ruling. Interest on Food Administration Grain Corporation notes is not exempt from income and excess profits taxes. (Telegram '" [Former Procedure] Regulation. "Interest on bank deposits or on certificates of de- posit, whether paid or accrued and unpaid, must be included in the annual income return of the person entitled to receive such interest, whether on open account or on the certificate of deposit." (Reg. 22, 1914, Art. 67.) This regulation ignored the "cash" basis, and required a return on the accrual basis. If the taxpayer did not receive notice of the interest until after his cash account for the year was closed, and if he were report- ing upon a cash as distinguished from an accrual basis, he would, how- ever, not have been required to include the interest until the following year. 668 INCOME to The Corporation Trust Compari}', signed by Commissioner Roper, April 13, 1919.) Interest charged to construction. — Ruling. No taxable income accrues to a public utility corpora- tion from a mere book entry charging construction account and crediting income account due to charging interest on the company's own funds used temporarily for construction purposes, as permitted under the Interstate Commerce Commission's classification ; neither will the company be allowed to include in its assets such amount of interest charged to capital account for the purpose of determining invested capital. (C. B. i, page 212; O. D. 246.) By O. D. 1061 (B. 41-21-1862) this ruhng was extended to apply to the Revenue Acts of 1916 and 191 7. Income from bonds paid at maturity or before. — When bonds are purchased at a discount from their face vahie or when they are purchased at par and paid ofT at a premium, the excess received above cost or value March i, 191 3, (and interest periodically collected) is taxable income. If a taxpayer keeps his accounts on an accrual basis it would be good accounting practice to enter annually as in- come a proportional part of the difference between cost and par, and return such accruals for income tax purposes. When the bonds are paid at maturity or called, the amount to be returned will be only the difference between cost, or value March i, 1913, plus the amounts previously returned (ex- cept interest actually collected) and the amount received. When the amount received is less than cost or value March I, 1913, plus the amounts returned as income, the difference is an allowable deduction as a loss. (See ('hapter XXIX.) The rule, in effect, is disapproved by the Treasury in the following ruling. Ruling. Interest received or accrued on bonds purchased at a premium, according to the method employed in keeping books, rep- resents income for the year in which received or accrued at the FROM INTEREST— GENERAL 669 rate carried by the bonds and not at the rate which would be reahzed after amortizing the premium.'^ (C. B. 3, page 89; O. D. 622.) It is not believed, however, that a taxpayer who keeps his accounts according to well-recognized accounting principles would be required to make any change therein in order to conform to the foregoing ruling, which conflicts with good practice. The author consistently has held that disanint on bonds or like securities is, in effect, an increased rate of interest. The Treasury, with equal consistency, holds that the discount is a profit to the recipient and a loss to the payer. '- It may be expected that non-interest bearing notes and bonds will become popular. Taxpayers in receipt of large in- comes loaning money for more than two years, will be able to btiy the obligations at a discount and report their gross returns thereon as capital gains. Income from redemption of bonds — amortization of pre- mium. — The following regulation summarizes the cases in which income is deemed to arise upon the redemption by a corporation of its own bonds or from the amortization of the premium on its bonds sold above par. Regulation, (i) (a) If bonds are issued by a corporation at their face value, the corporation realizes no gain or loss (c) If, however, the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year. (2) (o) If bonds are issued by a cnrpuration at a premium, the net amount of such premium is gain or income which should be pro- rated or amortized over the life of the bonds (c) If, how- ever, the corporation purchases and retires any of such bonds at a price less than the issuing price minus any amount of premium al- ready returned as income, the excess of the issuing price minus any amount of premium already returned as income (or of the face value ';See Chapter XXVII. "Income Tax Procedure, 1921, pages 510, 734; Andifing, Theory and Practice, by R. H. Montgomery (1921 edition), page 531. 670 INCOME plus any amount of premium not yet returned as income) over the purchase price is gain or income for the taxable year. (3) (a) If bonds are issued by a corporation at a discount, [and] .... (c) If, however, the corporation purchases and retires any of such bonds at a price less than the issuing price plus any amount of discount already deducted, the excess of the issuing price plus any amount of discount already deducted (or of the face value minus any amount of discount not yet deducted) over the purchase price is gain or income for the taxable year. (Art. 545. Reg. 45, Art. 544.) The subject of deductible loss because of the purchase and retirement by a corporation of its bonds is discussed in Chap- ter XXIX. Interest received by stock-brokers and others. — Interest charged by stock-brokers and others, who in the ordinary course of business make regular interest entries against cus- tomers' accounts, should be reported in income tax returns at the gross amount so accrued or collected, and not at the net amount ascertained by deducting interest paid. Under the 1 91 7 and prior laws, reporting the net amount was held to be illegal.^^ Sinking fund increment. — Under the earlier laws the ques- tion arose as to whether or not interest on a corporation's own bonds held in its own sinking fund should be reported as in- come. Under the 1918 and 192 1 laws, it is immaterial how the interest is reported. The limitation on the interest deduc- tion no longer exists. '■* Regulation. If a corporation, in order solely to secure the pay- ment of its bonds or other indebtedness, places property in trust, or sets aside certain amounts in a sinking fund under the control of a trustee, vv'ho may be authorized to invest and reinvest such sums from time to time, the property or fund thus set aside by the corporation "This point was decided in the case of Altheimer & Rowlings Imrst- vient Co. V. Alien, Collector (248 Fed. 688, 160 C. C. A. 588, 248 U. S. 578; certiorari denied, 63 L. E. 430, 39 S._ Ct. 20. '* [Former Procedure] For criticisms of regulations under former laws, see Income Tax Procedure, 1920, page 407. FROM INTEREST— GENERAL 671 and held by the trustee is an asset of the corporation, and any gain arising therefrom is income of the corporation and shall be included as such in its annual return. The trustee, however, is not taxable as such on account of the property or fund so held. (Art. 542, Reg. 45, Art. 541.) Income from building and loan associations.^^ — A new pro- vision has been written into the law exempting dividends or interest from building and loan associations up to an amount of $300 per annum, effective for the years 1922- 1926, inclu- sive. Law. Section 213 (b) . . . . (10) So much of the amount received by an individual after December 31, 1921, and before January i, 1927, as dividends or interest from domestic building and loan associations, operated exclusively for the purpose of making loans to members, as does not exceed $300; .... Although a literal interpretation of this provision^*^ would indicate an exemption aggregating $300 over the period, Jan- uary I, 1922, to December 31, 1926, the author is of the opinion that the intention of Congress was to exempt from taxation interest from building and loan associations up to a maximum of $300 each year. The author's interpretation is confirmed by a study of the original House provision and of the conferees' report. The House bill contained the fol- lowing : So much of the amount received by an individual as dividends or interest from Domestic Building & Loan Associations, operated ex- clusively for the purpose of making loans to members, as does not exceed $500. The conference report makes the following explanation of the change made in the final act : Amendment No. 152: The House bill provides that individuals should not be required to include in their gross income so much of the '° [Former Procedure] l^ir prior regulations see Incouic l\tx Pro- cedure, ig2i, pages 511-512. '"Such an interpretation lias not been made by the Treasury in Art. 89 (2). This regulation accords with the intent of Congress, even if the draftsmen of the law failed tu express the thought accurately. 672 INCOME amount received by them as dividends or interest from Domestic Building & Loan Associations operated exclusively for the purpose of making loans to members, as does not exceed $500. The Senate amendment strikes out the provision of the House bill. The House recedes with an amendment permitting the exclusion from gross in- come of an amount of such dividends or interest not in excess of 5j^300 and providing- that this exclusion from gross income shall only be in effect from January i, 1922, until January i, 1927. The author's contention is confirmed by the following ex- tracts from the Congressional Record, 192 1. Congressman Treadway : Perhaps Mr. Average Man may become fairly well to do and wishes to save in expectation of owning his own home. He has the opportunity under the new bill of investing his savings in a mutual building and loan association and up to $500 his income from this source will be exempted — another evidence of the interest this bill is showing in the home life of the man of moderate means. (Page 5624.) Congressman Longworth : This bill carries this provision : We make the first $500 of in- come received from capital invested in the stock of building associa- tions exempt from any tax at all. We put it on tlie same basis to the extent of $500 as all otlier nontaxable investments. There is no ques- tion now but that the stock in a building association amounting to $10,000 will be a reasonably attractive investment and will result in a great increase of capital available for the building of small homes throughout the country. This is a small thing on paper, perhaps, but I believe it is a big thing in the interest of the plain people of this country, and Democrats propose to vote against it. ( Page 5704.) The conferees intended merely to reduce the exemption of $500 per annum to $300 per annum, not to $300 spread over five years, otherwise the reference to $10,000 of principal would have been absurd. The foregoing interpretation has been accepted by the Treasury, as indicated in in the following: Regulation The following additional exclusions from gross income .... are allowed .... (2) So much of the amount received by an individual after De- cember 31, 1921, and before January i, 1927, as dividends or interest from domestic building and loan associations operated exclusively for the purpose of making loans to members as does not exceed $300 per year; .... (Art. 89.) FROM INTEREST— GENERAL 673 Amount to be reported. — Ruling An amount credited to shareholders of a building and loan association, when such credit passes without re- striction to the shareholder, has a taxable status as income for the year of the credit. Where the amount of such accumulations does not become available to the shareholder until the maturity of a share, the amount of any share in excess of the aggregate amount paid in by the shareholder is income for the year of the maturity of the share. (Art. 53. Reg. 45, Art. 54.) Ruling. A taxpayer is deemed to have received items of gross income which have been credited to or set apart for him without re- striction. Therefore an amount credited to shareholders of a building and loan association, when such credit passes without restriction to the shareholder, has a taxable status as income for the year of the credit and should be so reported by the shareholder. In cases, however, where the amount paid in by the shareholder and the accumulative profits do not become available to the shareholder until the maturity of a share, the proceeds of any share subscribed for subsequent to March i, 1913, in excess of the aggregate amount paid in by the shareholder is income for the year of the maturity of the share. If the subscription was made prior to March i, 1913, and under the rules of the association the share subscribed for had a cash sur- render value on March i, 1913, and any year thereafter in excess of the amount paid in by the shareholder, the determination of any profit realized at the time of cash surrender or for the year of the maturity of the share will be based on the proceeds in excess of the cash surrender value as of March i, 1913, plus the aggregate amount paid in subsequent thereto. (C B. 2, page 87; O. D. 446.) Stockholders in btiilding and loan associations may desire to set up on their books annually the interest or earnings allotted to their particular shares. In such cases the only income to report in the year of maturity would be the differ- ence between income already taxed and final profit received. Shares in many building and loan associations are not of the same nature as shares in corporations. No dividends are declared, but earnings are ascertained and are fully ap- portioned pro rata to the outstanding stock. So far as the books of the associations are concerned, an actual distribution is made and no surplus account is carried. The accruing annual income from building and loan asso- ciation shares and from life insurance policies is in the nature 674 INCOME of interest earnings, as the funds are invested almost entirely in bonds and mortgages. They are formed on the mutual plan so that each stockholder or policyholder is in effect real- izing annually his pro rata share of the entire net income. If under any tax law the net income of the association or company should be taxed, the proportion accruing to its mem- bers would be free from the normal tax. Interest on securities acquired between interest dates. — When securities are purchased between interest dates and the buyer pays to the seller an amount equal to the accrued interest between the last interest date and the date of sale, each should enter as income the portion of the interest assignable to the period during which he owned the security. Ruling. Interest accrued on bonds and other interest-bearing obligations sold between interest dates is income as such to the vendor when the agreement of sale specifies a division between the price of the obHgation and the accrued interest. The vendee of such securities may exclude from interest income a sum equal to the amounts advanced by him to the vendor on ac- count of accrued interest. Capital gain or loss resulting from a sale of interest-bearing obli- gations sold between dates at a stipulated price plus accrued interest is computed upon a basis of capital investment, and without regard to amounts paid or received on account of accrued interest. The burden is on the taxpayer to show what part of moneys paid or received by him on accoi^mt of a transaction involving the sale or purchase between interest dates of interest-bearing obligations should be allocated to capital investment and what part to accrued interest. In the absence of such showing the construction most favorable to the Government should be adopted. (C. B. 3, page 90; Sol. Op. 46.) Interest received by legatee. — T, D. 2570 (November 6, 191 7) holds that: Ruling. A legatee is required to return as income the full amount of interest received by him on a bond, notwithstanding the fact that a part of the first coupon, payable after he had received it, had been added to the bond and included in the gross estate of the decedent, thereby becoming subject to the estate tax law. If the estate was assessed for the income tax on the accrued FROM INTEREST— GENERAL 675 interest to the date of the death of the decedent the legatee should not pay again on the same amount, since property re- ceived by legatees is capital and includes accrued interest. The 191 7 regulation is unsound and probably will not now be en- forced. Coupons used as purchase price for other securities. — Regulation. Coui)ons from bonds for interest thereon, ex- changed for other bonds, are held to lie the equivalent of payment of the interest coupons and purchase of the new bonds with the cash. The amount of the coupons is to be accounted for as income for the calendar year in which the exchange is made. (Reg. 33, 1918, Art. 4.) If coupons and new securities were exchanged "par for par," the interest represented by the coupons would be reduced by an amount equal to the difference between the par value of the new securities and their fair market value. Income from hfe insurance policies. — The law exempts from income taxation^' the entire proceeds of life insurance policies (see page 352) upon the death of the assured when paid to individual beneficiaries, to the estate of the assured or to a corporation beneficiary.^* The total amount paid in premi- " The taxability of the proceeds of life insurance under the estate tax law is discussed in Chapter XL. '' [Former Procedure] 1913 Law. Section IIA. Subdivision 2 B. ". . . . the proceeds of life insurance policies paid upon the death of the person insured or payments made by or credited to the insured, on life insurance, endowment or an- nuity contracts, upon the return thereof to the insured at the maturity of the term mentioned in the contract, or upon surrender of contract, shall not be included as income." Under the 1916 and 1917 laws (section 4) insurance payable to the estate of the insured was taxable. Regulation. "Proceeds of life insurance policies payable to the estate of a decedent, when received by an executor or administrator, are, in the amount of which such proceeds exceed the premium or premiums paid by the decedent, income of the estate to be accounted for by the exec- utor or administrator under the provisions of section 2 (b), act of Sep- tember 8, 1916." (Reg. 33, 1918, Art. 29.) This regulation was based on section 2 (b) of the law. Until the question is judicially settled an estate is entitled to claim that a policy should be valued as of March i, 1913, as a basis for taxation under the 1916 or 1917 law. Under the 1918 law insurance paid to a corporation beneficiary was taxable. 676 INCOME unis may be less than the amount eventually received from the proceeds of a policy, but the difference is not treated as taxable income. The law''' expressly limits the exemption. When there is a return of principal to the assured during his life, that \ydrt, if any, of such return which is in excess of the premiums paid is taxable. The basis of this provision is that the amount received in excess of the premiums paid represents interest on the premiums. The purpose of the law in mentioning the exemption from taxation of premiums returned or the equivalent of premiums returned evidently was to leave no doubt about the matter. When premiums are paid they do not in this country^" con- stitute an allowable deduction, but are treated as capital pay- ments. Therefore the return of all or any part of such capital could not be taxed under an income tax law. However, the law covers the point, even if unnecessarily, and there can be no controversy about it. If the assured receives at the maturity of a policy on the endowment plan, or from its cancellation, any amount in excess of premiums paid, such receipts are taxable income and must be returned."^ As provided, in article 47, any dividends received would be subject only to the surtaxes. In view of the uncertainty of such income it would hardly be practicable to accrue it annually on the books of the assured. This means that the entire excess above premiums paid must be included in the returns for the year of its receipt. Regulations In the case of an insurance policy its sur- render value as of March i, 1913, may be used as a basis for the purpose of ascertaining the gain derived from the sale or other dis- position of such property (Art. 90.) .... Where an insured receives under life insurance, endow- ment, or annuity contracts sums in excess of the premiums paid therefor, such excess is income for the year of its receipt Distributions on paid-up policies which are made out of earnings of "Section 213 (b-2). " For British practice, see Chapter XXVI. " See "Paid-iip Policies," Chapter XXVI. FROM INTEREST— GENERAL 677 the insurance company subject to tax are in the nature of corporate dividends and are income of an individual only for the purpose of the surtax. (Art. 47.) Cash surrender value of policy at March i, 19 13. — Ruling. The basis for ascertaining the taxable income resulting from the disposition of a life insurance policy acquired prior to March i, 1913, where the insured transfers the policy to some one other than the insurance company, which wrote the policy, is the cash surrender value of the policy as at March i, 1913. However, if the insured surrenders his policy and all his rights thereunder to the insurance company, which wrote the policy, the aggregate amount of the premiums paid during the period the policy was held, or the cash surrender value of the policy as at March i, 1913, whichever is greater in amount, is to be taken as the basis in computing the taxable income derived by the insured. (C. B. 2, page y'] ; O. D. 379.) Annuities. — Regulation. Annuities paid by religious, charitable, and educa- tional corporations under an annuity contract are subject to tax to the extent that the aggregate amount of the payments to the annui- tant exceeds any amounts paid by him as consideration for the con- tract. An annuity charged upon devised land is income taxable to the annuitant, whether paid by the devisee out of the rents of the land or from other sources. The devisee is not required to return as tax- able income the amount of rent paid to the annuitant, and he is not entitled to deduct from his taxable income any sums paid to the annui- tant (Art. 47.) Many annuities are gifts. In such cases this ruHng strictly interpreted would not apply. The amounts received by the beneficiary would be taxable income only to the extent of the excess of the aggregate receipts above the capital value of the annuity at the date of the gift. Ruling. An individual who receives income from an annuity which has been purchased for his benefit by another person is not liable for tax thereon until the payments received under the terms of the annuity have equaled the amount paid or set aside to purchase or establish same. (C. B. 2, page y(y\ O. D. 170.) Deduction in case of tax-free covenant bonds. — It has been the custom for certain corporations to issue bonds containing 678 INCOME a covenant binding the corporation to pay the interest free of all taxes which it may be required to withhold at the source.^' Tax paid by obligor not income to obligee. — The 192 1 law provides that the rcipient of income from securities con- taining a tax-free covenant does not include in gross income the tax of 2 per cent paid by the obligor (payer of the income). ~ [Former Procedure] The 1913 law, by establishing the system of collection at the source, threw upon such corporations the burden of pay- ing the normal tax applicable to the interest payable to their bondholders. The rate under this law was i per cent. The requirement was continued under the 1916 law, which raised the rate to 2 per cent. 1916 Law. Section 5. " . . . . (c) For the purpose of the normal tax only, the income embraced in a personal return shall be credited with .... the amount of income, the normal tax upon which has been paid or withheld for payment at the source of the income under the provisions of this title." In 1917, when the system of collection at source was almost completely abandoned and the rates of the normal tax were increased to 4 per cent on individuals and 6 per cent on corporations, collection at the source was retained to the extent of 2 per cent only in the case of these tax-free covenant bonds. In the 1918 law the same provision is made. 1918 Law. Section 221. " . . . . (d) Income upon which any tax is required to be withheld at the source under this section shall be included in the return of the recipient of such income, but any amount of tax so withheld shall be credited against the amount of income tax as computed in such return." Under the 1918 law, the recipient of income from securities having a tax-free covenant was required to include in gross income not only the income actually received, but also the tax paid by the obligor, which the Treasury held was constructively received. Ever since the issue of the second edition (jf Reg. 45 (April, 1919), the author has contended that the tax of 2 per cent paid by the obligor was not income of the obligee. That the author was justified in his criticism oi the rulings and regulations is proven b_s' the new provision in thf KjJi law. For a full dlNCussion see Incciiiir Tax I'ruccditre, 1921, pages 516-52J. The Treasury's position has been upheld in a recent decision by the United States District Court for the Eastern District of Pennsylvania {Massey v. Lederer, Collector) . In that case, however, the court did not have presented to it and did not consider what the author considers to be the chief factor, viz., the attempt of Congress to make the deduction effec- tive by permitting it to be deducted from the amount of tax payable. Such action precludes the inference that it should be dealt with as constructive income. FROM INTEREST— GENERAL 679 Law. Section 234. (a) .... (3) .... In the case of ob- ligors specified in sub-division (b) of section 221- ■ no deduction for the payment of the tax imposed by this title, or any other tax paid pur- suant to the contract or provision referred to in that subdivision, shall be allowed, nor shall such tax be included in the gross income of the obligee This provision is effective January i, 1921; therefore, no tax should be induded by the recipient in 192 1 income. Sec- tion 221 (d) still permits the tax paid by the obligor to be deducted from the tax due by the recipient as shown by his return."* Interest from foreign subsidiaries. — Ruling. A domestic corporation owning a majority of the stock of foreign corporations should include in its income tax return any amounts of interest debited to its foreign subsidiaries, but it may claim as a deduction any amount of interest credited to such sub- sidiaries (C. B. I, page 239; O. D. 330.) See page 323. See page 333- CHAPTER XX INCOME FROM INTEREST ON OBLIGATIONS OF THE UNITED STATES (Including Interest on Bonds Issued Under the Fed- eral Farm Loan Act and on Bonds of the War Finance Corporation) The obligations of the United States, interest upon which is subject to special treatment in tax returns, are so many and so large in amount that it is deemed advisable to devote an entire chapter to the income from such obligations. At the outset it should be noted that there are two broad statements which can be made in reference to interest re- ceived by all taxpayers (except non-resident aliens and for- eign corporations, partnerships and associations not engaged in business in the United States)^ upon obligations of the United States and obligations issued under the Federal Farm Loan Act of July 17, 19 16, and the War Finance Corporation Act, approved April 5, 1918. 1. No part of such interest is subject to normal income tax upon individuals or income tax upon corporations. 2. Such interest is subject to surtaxes and excess profits and war profits taxes" only in the case of obligations issued after September i, 1917, and as to these, only so far as such in- terest is not exempt under provisions of the several Liberty bond acts and other acts under which these obligations are issued. By authority of one of these acts the 3^ per cent Victory notes, although issued after September i, 191 7, are not subject to any surtax, excess profits or war profits taxes. All the Farm Loan bonds are wholly tax-exempt. ' See page 692. 'All Lilierty bonds are subject to the estate tax. See Cliapter XL, 680 FROM INTEREST ON U. S. OBLIGATIONS 68l Interest which is wholly exempt from tax is excluded from "gross income" as defined in the 192 1 law. If the income of a taxpayer is wholly from exempt sources, or if his income from other sources is less than $1,000 (single) or $2,000 (married or head of a family), he need not make an income tax return unless his gross income exceeds $5,000.^ Law. Section 213. That for the purposes of this title .... the term "gross income" — .... (b) Does not include the following items, which shall be exempt from taxation under this title: (4) Interest upon (a) the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia; or (b) se- curities issued under the provisions of the Federal Farm Loan Act of July 17, 1916; or (c) the obligations of the United States or its pos- sessions; or (d) bonds issued by the War Finance Corporation. In the case of obligations of the United States issued after September i, 1917 (other than postal savings certificates of deposit), and in the case of bonds issued by the War Finance Corporation, the interest shall be exempt only if and to the extent provided in the respective Acts author- izing the issue thereof as amended and supplemented, and shall be ex- cluded from gross income only if and to the extent it is wholly exempt to the taxpayer from income, war-profits and excess-profits taxes; The return of tax-exempt securities required under the old law is no longer necessary.^ Interest wholly exempt. — The obligations, interest upon which is wholly exempt, for all taxpayers, from surtaxes and excess profits and war profits taxes are : I. The following bonds, certificates and notes issued under the Liberty Bond Acts and all United States obligations issued before September i, 1917:^ (a) The 3^ per cent First Liberty bonds, original issue, unconverted. * See page 52. * The 1918 law required wholly tax-exempt interest to be shown in the tax return only for information of the Treasury and not as a part of taxable income. ° Issued under the First Liberty Bond Act, approved April 24, 1917. Certificates- of indebtedness issued under this act were also exempt. 682 INCOME (b) The 3^ per cent Victory Loan notes issued under the Victory Liberty Loan Act, ap- proved March 3, 19 19. These bonds have been called for redemption June 15, 1922. (c) Postal Savings deposits.^ 2, Obligations issued under the Federal Farm Loan Act of July 17, 1916/ Interest in no part exempt from surtax and excess profits tax. — The interest on 4^ Victory Loan notes is subject to surtax and excess profits tax.* Treasury notes issued under Victory Liberty Act are essen- tially different from Treasury certificates and are placed in the same class with \'ictory 4}i's in so far as relates to ex- emption ; in other words, there is no exemption on Treasury notes. Interest subject to special exemption.^ — The special exemp- tions in force under the 19 18 law have been materially changed by the 192 1 law. No longer does the original subscription to certain issues play a part in determining exempt interest; nor are there now any interrelated exemptions. ° [Former Procedure] Only the interest credited on postal savings deposits prior to September i, 1917, was exempt (Reg. 45, Art. 77). The 1918 law did not specifically exempt the interest from postal savings certifi- cates of deposits as does the 1921 law [section 213 (b-4-c)]. ' The constitntionality of these obligations was affirmed by the U. S. Supreme Court in Smith v. Kansas Cily Titfe & Trust Co. et al., February 28, 1921 ; advance opinions, 65 L. Ed. 360. * Under the provisions of the Victory Liberty Loan Act the Treasury made the following conditions applicable to issue of the Fifth Loan, in announcement made April 14, 1919. "The Victory Liberty Loan, which will be offered for popular sub- scription on April 21, 1919, will take the form of 4J4 Per cent three/four year convertible gold notes of the. United States, exempt from state and local taxes, except estate and inheritance taxes, and from normal federal income taxes. The notes will be convertible, at the option of the holder, throughout their life into 3^ per cent three/four year convertible gold notes of the United States, exempt from all federal, state and local taxes, except estate and inheritance taxes. In like manner the 3J4 Per cent notes will be convertible into the 4^ per cent notes." " [Former Procedure] For details as to procedure under the 1918 law, see Income Tax Procedure, 1921, page 524 et seq. FROM INTEREST ON U. S. OBLIGATIONS 683 The exemptions now applical)le are indicated in the following : Law. Section 1328 (a) On and after January i, 1921, 4 per centum and 4]/^ per centum Liberty bonds shall be exempt from graduated additional income taxes, commonly known as surtaxes, and excess-profits and war-profits taxes, now or hereafter imposed by the United States upon the income or profits of individuals, partnerships, corporations or associations, in respect to the interest on aggregate principal amounts thereof as follows: Until the expiration of two years after the date of the termination of the war between the United States and the German Government, as fixed by proclamation of the President, on $125,000 aggregate principal amount; and for three years more on $50,000 aggregate principal amount. (b) The exemptions provided in subdivision (a) shall be in addi- tion to the exemptions provided in section 7 of the Second Liberty Bond Act, and in addition to the exemption provided in subdivision (3) of section i of the Supplement to the Second Liberty Bond Act in re- spect to bonds issued upon conversion of 35^ per centum bonds, but shall be in lieu of the exemptions provided and free from the condi- tions and limitations imposed in subdivisions (i) and (2) of section i of the Supplement to Second Liberty Bond Act and in section 2 of the Victory Liberty Loan Act. Regulation (3) 4 per cent and 4I4 per cent Liberty bonds (but not 4^ per cent Victory notes), Treasury certificates of indebtedness, and Treasury (war) savings certificates are entitled to certain limited exemptions from surtaxes and excess-profits taxes now or hereafter imposed by the United States For the period from January i, 1921, to July 2, 1923, the total possible exemption from surtaxes and profits taxes amounts to $160,000, while for the period from July 3, 1923, to July 2, 1926, the total possible exemption amounts to $55,000, as follcTws: Period Jan. i, 1921, to July 2, 1923: $5,000 in the aggrcgateof first 4s, first 4y4S, first second 434s, second 48 and 434^, third 434s, fourth 434s, Treasury certificates of indebtedness, and Treasury (war) savings certificates. 30,000 of first second 434s. 125,000 in the aggregate of first 4s, first 4%s, first second 434s, second 4s and 4%^, third 434s, and fourth 4^/48. $160,000 total possible exemptions for this period. Period July 3, 1923, to July 2, 1926: $5,000 in the aggregate of first 4s, first 434s, first second 434s, second 4s and 434s, third 434s, fourth 4%^, Treasury certificates of indebtedness and Treasury (war) savings certificates. 684 INCOME 50.000 in the aggregate of first 4s, first 4^As, first second 4/4s, second 4s and 4J4s, third 4/4 s, and fourth 4^4 s. $50,000 total possible exemptions for this period. (Art. 84.) The changes are effective as of January i, 1921. The Treasury, in administering the 1918 law, permitted tlie capitalization of the interest received on each issue at the appropriate rate and applied the exemption to the principal sum so obtained. As indicated by the new forms (schedule E, form 1040, for individuals; schedule A-4, form 1120, for corporations), the Treasury has abandoned this practice. For example, as- sume the following : 4%% Liberty bonds held for 6 months, January i to June 30, 1921, (par) $200,000 6 months' interest on $200,000 at 4%% is $4,250 Total maximum exemption 160,000 Principal amount in excess of exemption $ 40,000 6 months' interest on $40,000 at 4%% is the amount of taxable interest, viz $ 850 Under the previous procedure the total interest received ($4,250) would be capitalized at 434 per cent, resulting in an "average principal" of $100,000, which is less than the $160,000 of exempt principal, so that none of the interest received ($4,250) would be taxable. Exemptions not limited as to time. — It will be noted that tlie partial exemptions which are unlimited as to the time they remain in force are only of interest on $5,000 of the Second, Third and Fourth^" Liberty Loans and on $5,000 of bonds of the War Finance Corporation. These two exemptions are entirely separate and a single taxpayer may have the benefit of both. ^"This $5,000 exemption applies also to certificates of indebtedness and War Savings and Treasury Savings certificates, and War Savings Stamps. i FROM INTEREST ON U. S. OBLIGATIONS 685 $125,000 unconditionally exempt until 1923. — The 1921 law'^ consolidated the various exemptions granted under the several Liberty Bond Acts and supplements thereto, some of which were conditional, in order to simplify the computation of tax-exempt interest. By eliminating the conditions orig- inally attached to some of the exemptions, the 192 1 law has liberalized them. July 2, 192 1, has been officially proclaimed as the date of the termination of the war with Germany, and thus the exemption periods referred to in section 1328 (a) expire on July 2, 1923, and on July 2, 1926, respectively. Therefore, in addition to the $5,000 exemptions referred to in the preceding paragraph, the interest on 4 or 4)4 per cent Liberty bonds is exempt up to a principal sum of $125,000 until July 2, 1923. $50,000 unconditionally exempt 1923-1926. — x\fter July 2, 1923, Liberty bonds of any issue bearing interest at 4 or 4^ per cent are for a further period of three years, i.e., until July 2, 1926, exempt up to a principal sum of $50,000. This exemp- tion is also in addition to the $5,000 exemptions already referred to. Interest accrued upon conversion of Victory notes. ^" — Regulation. All interest accrued on 4%, per cent Victory notes at the date of any conversion by the taxpayer into 3% per cent Vic- tory notes shall, for the purpose of computing net income, be deemed to be interest upon 4% per cent Victory notes, and subject to sur- taxes and excess-profits and war-profits taxes, now or hereafter im- posed by the United States upon the income or profits of individuals, partnerships, associations, or corporations. Any and all amounts re- ceived by any taxpayer from the United States by way of adjustment of accrued interest upon the conversion of 4% per cent Victory notes into 3% per cent Victory notes shall be deemed to be interest upon 4% per cent Victory notes. All interest accrued on 3% per cent Victory notes at date of any conversion by the taxpayer into 4% per cent Victory notes shall, for " Section 1328. See page 683. "For procedure on conversion of other issues of Liberty bonds, see Income Tax Procedure, \g-ii, page S40. 686 INCOME the purpose of computing net income, be deemed to be interest upon 3^ per cent Victory notes and shall be entitled to the exemptions from taxation to which interest on 3% per cent Victory notes is entitled. (Art. 82.) Exemption in case of fiscal years ending in 192 1, — Due to the change in the exemption requirements, the interest accrued up to December 31, 1920, is exempted under the conditions imposed by the 191 8 law, while that accruing after January I, 1 92 1, is stibject to the 1921 law. Regulation. In the case of a return rendered for a fiscal year beginning in 1920 and ending in 1921, the interest received from ob- Hgations of the United States issued after September i, 1917, is, in respect to the amount received prior to January i, 1921, exempt only if and to the extent provided in the acts authorizing the issue there- of. See article 80, Regulations 45. The interest received on and after January i, 1921, is exempt in accordance with the acts authorizing the issue thereof as amended and supplemented by section 1328 of the Revenue Act of 192 1. See article 83. Since the basis of the exemp- tions is the principal amount of bonds held rather than the amount of interest received, where the holdings are not constant during the tax- able period, if at any time the holdings of any issue or issues are less than the maximum exempted principal, then the exempted interest for such time shall be only the amount of interest received or accrued upon the principal actually held. (Art. 85.) Exemptions when return is for period less than full year. — When return is made for a period less than one year, the 1921 law [section 226 (c)] provides that the net income "shall be placed on an annual basis. "^" The amount of taxable interest should be first computed before the net income is placed on an annual basis because such taxable interest is part of "net income." Interest is income of year when due. — Under the present ruling of the Treasury all interest on bonds is income of the year when it becomes due, whether then collected or not. Even when matured coupons have not been collected, '^ See page 167. FROM INTEREST ON U. S. OBLIGATIONS 687 they should, nevertheless, be included in the return. (Reg. 62, Art. 53.) Ruling. An owner of nontax-free Liberty bonds who has made an absolute gift of the coupons attached to the bonds covering inter- est due for a number of years will be required to include in his income tax return the interest which accrues each year on the bonds, and to pay any tax that may be due thereon. If the gift of the coupons is to an institution under section 214(a) 11, a deduction of such gift would be allowed in the annual income tax return. (C. B. i, page 84; O. D. 120.) Separate ledger accounts for interest. — The taxpayer should keep a separate ledger account for "interest received from Liberty bonds" to facilitate segregation of such parts thereof as are taxable and non-taxable. He should also keep a separate ledger account for "interest paid to carry non- taxable bonds" because such interest is not deductible from gross income. This account will not include any interest paid to carry obligations of the United States issued after Septem- ber 24, 19 1 7, including the 3% per cent Victory notes (if original subscriptions are by the taxpayer), because such inter- est is deductible.^* Accrual of interest on Liberty bonds. — The practice is common among business concerns to accrue other items of income and at the same time not to accrue Liberty bond in- terest. There is, however, no logical reason for not accruing such interest when other items of income and expense are ac- crued. The law requires that accounts be kept so as to reflect the actual net income of the taxpayer. The accrual method has been prescribed to accomplish this for business concerns. For manner of treating interest on bonds purchased and sold between interest dates, see page 674. Of the aggregate of possibly exempt principal of $160,000, all but $5,000 represents temporary exemptions; and if the taxpayer is to secure over a period of years the maximum "Sections 214 (a-2) and 234 (a-2). 688 INCOME amoniit of cxciniitiun, he must make his return of income on the accrual basis. Returns on the cash basis would not entitle the taxpayer to the exemption of interest received on these issues after the temporary exemptions expire. Discount on certificates of indebtedness. — Ruling. In the case of Treasury certificates of indebtedness which are offered by the Government at par and accrued interest and not at a discount, only the coupon interest can be considered exempt from normal tax, and from surtax to the extent provided by the Act approved September 24, 191 7. Where such certificates are subsequently purchased at a discount, the difference between the pur- chase price and the par value of the certificates received at maturity is profit subject to both normal tax and surtax. The subscriber for Treasury certificates who sells them at a discount sustains a deductible loss, which is the difference between the par value of the certificates and the selling price. Any gain or loss on the sale of Treasury certificates of indebtedness prior to maturity should be determined in accordance with section 202 of the Revenue Act of 191 8. (C. B. 3, page 123 ;0. D. 729.) Individuals The foregoing portion of this chapter applies to indi- viduals as well as to other taxpayers, but the following points are applicable particularly to individuals. Under the law individuals are taxed as such upon their income from partnerships in which they are members, from personal service corporations in which they are stockholders^' and from estates and trusts of which they are beneficiaries. It is necessary, therefore, for the individual receiving Liberty bond interest from a partnership, a personal ser- vice corporation or a fiduciary to group all such interest received by issues and to calculate his exempt interest on the basis of his combined holdings of principal as an indi- vidual, as a partner, as a stockholder in a personal service corporation and as a beneficiary of an estate or trust. The various regulations of the Treasury do not specifically de- scribe the manner in which the principal of Liberty bonds Up to December 31, 192:. FROM INTEREST ON U. S. OBLIGATIONS 68g held by partnerships, personal service corporations, estates and trusts shall be apportioned among the individuals receiv- ing the income therefrom other than to say that each partner, etc., is to be regarded as owning a "proportionate part" of the bonds. The assignment of holdings, hov^ever, should ordinarily be made on the basis of the share in profits or income received from the partnership, corporation or fiduciary. The instructions on form 1040 for 1921 read: Enter in column 5 on the proper lines the principal amounts of the various obligations owned in excess of the exemptions specified, during the taxable period, including your share of these obligations held by partnerships, personal service corporations and fiduciaries. In case of a net loss for the year by the partnership, per- sonal service corporation or estate, although the individual will show his share of Liberty bond interest received from the part- nership, personal service corporation or estate, any undue in- crease of the taxable income of the individual thus apparently created will, in the case of partners and stockholders in per- sonal service corporations, but not usually in the case of bene- ficiaries of trusts,^** be offset by the share of the loss of the partnership or personal service corporation which the individ- ual will also show in his return. The regulations covering exemptions of Liberty bond in- terest received from partnerships, personal service corpora- tions and fiduciaries are as follows : Regulation, (o) When income is taxable to beneficiaries, as in the case of a trust the income of which is to be distributed to the beneficiaries periodically, each beneficiary is regarded as the owner of a proportionate part of the bonds held in trust and is entitled to exemption on account of such ownership as if he owned such propor- tionate part of the bonds directly. When, on the other hand, income is taxable to the trustee, as in the case of a trust the income of which is accumulated for the benefit of unborn or unascertained persons, the trustee is regarded as the owner of all the bonds held in trust and the trust is entitled to exemption on account of such ownership. As to exemptions in the case of bonds beneficially owned by nonresident aliens, see article 94. "Sec Chapter XXXVII. 690 INCOME (b) As the income of a partnership is taxable to the individual partners, each partner is treated as the owner of a proportionate part of the bonds lield by the partnership and is entitled to exemption on account of such ownership as if he owned such proportionate part of the bonds directly. This principle also applies to stockholders in per- sonal service corporations during the calendar year 192 1. (Art. 84.) Partnerships Since partnerships are not taxed as such, the question of Liberty bond interest received by a partnership is really a qitestion for the individual partner in his separate return. The partnersliip return merely indicates the share of each partner in the Liberty b(jnd interest received by the partner- ship.^' Stockholders in Personal Service Corporations The question of taxable interest received by personal ser- vice corporations affects the income of the stockholders, as until January i, 1922, they, not the corporation, are taxable on income received by or from it.^^ The exemptions of such stockholders are determined in the same inanner as members of a partnership.^^ Fiduciaries Liberty bond interest received by executors, administra- tors, guardians, trustees and other fiduciaries is taxable to them only in case it is not distributable to the beneficiaries of the estate or trust.^" If the fiduciary is liable to tax, he is entitled to the same exemptif ns of Liberty bond interest as an individual. " [Former Procedure] Under the 1917 law partnerships as such were subject to the excess profits tax. T. D. 2762, dated October 21, 1918, provides that in calculating Liberty bond interest received by a partnership, which may be subject to excess profits tax, the part- nership shall be deemed to be the owner of the bonds upon which the interest is received. '' See Chapter XXIV. '" See Art. 84, quoted above. ^ See Chapter XXXVII, "Fiduciaries," for discussion of the cases in which fiduciaries must make a return and pay a tax. See also Art. 84, quoted above. FROM INTEREST ON U. S. OBLIGATIONS 691 Corporations The general statements on pages 680 and 684 in this chap- ter apply to interest on Liberty bonds received by corpora- tions other than personal service corporations. Exemptions of affiliated corporations. — Ruling. Each of several affiliated corporations included in a consolidated return under section 240 of the Revenue Act of 1918 is entitled to the same full benefits under the exemption provisions of the several Liberty bond acts to which it would be entitled if not affiliated. (C. B. i, page 87; T. B. R. 7.) Parent corporation may not apportion Liberty bonds held to its subsidiaries. — A parent corporation may not apportion Liberty bonds held by it among the affiliated corporations. If the parent corporation should make a bona fide sale of bonds to the subsidiary corporations, then such corporations would be entitled to the exemptions consequent on the holding of the bonds purchased, except that the status"^ of "original subscriber," heretofore discussed, would be lost. Federal Land Bank bonds exempt. — The income from obligations issued under the l<>deral Farm Loan Act of July 17, 19 16, is exempt from normal and surtax (includhig excess profits tax). Regulation. As section 26 of the Federal Farm Loan Act of July 17, 1916, provides that every Federal land bank and every national farm loan association, including the capital and reserve or surplus therein and the income derived therefrom, shall be exempt from taxa- tion, except taxes upon real estate, and that farm loan bonds, with the income therefrom, shall be exempt from taxation, the income de- rived from dividends on stock of Federal land banks and national farm loan associations and from interest on such farm loan bontls is not subject to the income tax. (Art. 75.) '' In view of the consolidation of the Liberty bond tax exemptions effected by section 1328 of the 1921 law, the status of "original subscriber" no longer has any importance, excepting with respect to the deductibility of interest paid to carry 3% per cent Victory notes. 692 INCOME United States Obligations Owned by Non-Resident Aliens, Foreign Corporations, etc.^^ In order to encourage foreign investors to buy and hold Liberty bonds, Congress provided in the Victory Liberty Loan Act that obhgations of the United States shall be exempt from federal, state and local taxes while beneficially owned by non- resident aliens and foreign corporations, partnerships and associations not engaged in business in the United States. Law. Section 4. That section 3 of the Fourth Liberty Bond Act is hereby amended to read as follows: "Section 3. That, notwithstanding the provisions of the Second Liberty Bond Act or of the War Finance Corporation Act or of any other Act, bonds, notes, and certificates of indebtedness of the United States and bonds of the War Finance Corporation shall, while bene- ficially owned by a nonresident alien individual, or a foreign corporation, partnership, or association, not engaged in business in the United States, be exempt both as to principal and interest from any and all taxation now or hereafter imposed by the United States, any State, or any of the possessions of the United States, or by any local taxing authority."-^ "See Chapter XXXVL "^Victory Liberty Loan Act, approved March 3, 1919, section 4. CHAPTER XXI INCOME FROM RENTS Under each of the successive income tax acts rent has, in all cases, been made returnable as income subject to taxation. Law. Section 213 the term "gross income" — (a) Includes .... income derived from .... rent .... Income from rents may be reported on the accrual basis or on the actual receipt basis. If books of account are kept, all rents accrued, and believed to be collectible, should be reported. Any items found to be uncollectible may be de- ducted as losses in subsequent returns. If reporting on the accrual basis is not practicable or convenient, it is sufficient to return all rents received in cash during the tax year.^ No taxable income accrues where corporations, through book entries, have charged rental to construction accounts and credited an income account." Permanent improvements by lessees. — In several decisions the courts have held that title to improvements paid for by lessees vests in lessors as soon as made.^ Prior to these de- cisions the Treasury held that the lessor was taxable on the value of improvements at the end of the lease.* Since these decisions the Treasury holds that the lessor may be taxable at the time when the improvements are made. In the opinion of the author the decisions merely reiterate many other court decisions and restrict the Treasury in its attempt to tax what is not income. 'Rentals from "ground rents" as existing under laws of the state of Maryland should be returned each year as rent and are subject to tax as such. (B. 45-21-1905; O. D. 1089.) -'C. B. 4, page 276; O. D. 811. ^ See page 697 et seq. * [Former Procedure] For text of regulations in force prior to 1922 and criticism thereof, see Income Tax Procedure, 1920, pages 441-443, and Income Tax Procedure, 1921, pages 549-553. 693 694 INCOME The new regulations give the lessor the option of reporting any income derived from the making of improvements by the lessee either in one amount upon completion of the improve- ments or of s])reading such income over the period of the lease. The new regulations are as follows : Recti. ATioNs. When I)uil(liny,s arc erected or iiuprovenienls made by a lessee in pursuance of an agreement with the lessor, and such buildings or improvements are not subject to removal by the lessee, the lessor may at his option report the income therefrom upon cither of the following bases: (a) 'J"he lessor may report as income at the time when such build- ings or improvements are completed the fair market value of such buildings or improvements subject to the lease. This amount would ordinarily be the difference betw^een the value of the land free from the lease without such improvements and the value of the land sub- ject to the lease with such improvements. (&) The lessor may spread over the life of the lease the estimated depreciated value of such buildings or improvements at the termin- ation of the lease and report as income for each year of the lease an aliquot part thereof. If for any other reason than a bona fide purchase from the lessee ])y the lessor the lease is terminated, so that the lessor comes into pos- session or control of the property prior to the time originally fixed for the termination of the lease, the lessor receives additional income for the year in which the lease is so terminated to the extent that the value of such buildings or improvements when he became entitled to such possession exceeds the amount already reported as income on account of the erection of such buildings or improvements. No appreciation in value due to causes other than the premature termin- ation of the lease shall be included. Conversely, if the buildings or improvements are destroyed prior to the expiration of the lease, the lessor is entitled to deduct as a loss for the year when such destruc- tion takes place the amount previously reported as income because of the erection of such buildings or improvements, less any salvage value subject to the lease to the extent that such loss was not compensated for by insurance. If the buildings or improvements destroyed were ac- quired prior to March i, 1913, the deduction shall be based on the cost or the value subject to the lease as of that date, whichever is lower, less any salvage value subject to the lease to the extent that such loss was not compensated for by insurance. (Art. 48.) The Treasury's interpretation of the earlier regulation illus- trates the application of option (a) of the new regulation above quoted, as follows : FROM RENTS 695 Ruling. A, in 1915, leases certain land to B for 20 years. B agrees, in part consideration for the lease, to erect on the leased ground a building, specifications agreed upon, of an estimated life of 25 years and to cost $50,000, which building is not to be subject to removal by B. The building is completed in 1920. A realizes income in 1920, the year in which title to the building passes. The measure of the income is the present value to A of the building, of an estimated life of 25 years and cost of $50,000, the use and enjoyment of which is postponed for 15 years. The depre- ciated value of the building at the termination of the period of the lease will be approximately $20,000 — that is, cost less depreciation sustained. The income of A, then, is the discounted value of $20,000 receivable at the end of 15 years. If market value reflects intrinsic value, this amount should equal the difference between the value of the land free from the lease without the buildings and the value of the land subject to the lease with the building. However, any other evidence available should be considered in determining this present worth to the taxpayer of the legal title to the encumbered building. Since A has included in income only the depreciated value of the building, he is entitled to a depreciation deduction with respect to such building only for the years after the termination of the period of the lease when A has come into possession. This depreciation de- duction to which A is entitled for 1935 and subsequent years should be computed on a basis of the estimated remaining life of the build- ing and a "cost" value equal to the market value placed on the en- cumbered building by A in the year of its erection, i. e., the annual depreciation deduction for 1935 and subsequent years will be the quotient obtained by dividing (a) the value of the improvements to A as determined by him when the same completed became part of the realty, by (b) the number of years in the estimated remaining life of the improvements from the termination of the lease. In any case in which the term of the lease is greater than the estimated life of the improvement no income should be accounted for by the lessor at the time of the passage of title. Also if the improvements will have no value at the termination of the lease, as is often the case in mining leases, no income is realized by the lessor. (C. B. 4, page 90; Mim. 2714.) Option (b) in Regulations 62 is a reasonable basis if it can fairly be assumed that income arises annually out to the improvements paid for by the lessee. Regtilations 45, article 48, and the interpretation assumed several factors which reduced their value to nil. Unimproved land upon which lessees erect buildings rarely increases in fair market value because of the improvements. 696 INCOME The maximum benefit which the lessor can reahze during the lease is the rental reserved in the lease. The lessor will of course return the rent as gross income, but it cannot be claimed in most cases that additional income has been realized. In the illustration it is assumed that a building erected by a lessee has a life of twenty-five years. Experience proves that buildings usually become obsolete within twenty-five years, particularly those erected by lessees for a special purpose. If lessors are required to report upon completion income equal to the estimated present value of the building, which in the illustration would be a substantial sum, where would the cash be found to pay the tax? A building might easily be com- pleted near the close of a taxable year. There would be no income in that year from the lessee and the taxpayer might have no other source of income. How could it be held that he had taxable income to the extent of the present worth of a building in which he has no beneficial interest for fifteen years? The author does not know of any such transaction which would result in taxable income. Article 48 as amended does not attempt to impute income where there is none. It merely states that the lessor may report as income (a) "the fair mar- ket value of such building or improvement subject to the lease," or (b) report as income the estimated depreciated value of the building or improvement over the life of the lease. It leaves to the lessor the fixing of the depreciated value. There may be some appreciation in value on account of the improvements, but any apparent appreciation is decidedly limited by the terms of the lease which, it may be assumed, expressly reserves to the lessee the full benefit and enjoyment of the improvements. The lessor does not pay for the im- provements and it is not intended that he should receive much, if anything, more than the stipulated annual rental. As was said by Mr. Justice Pitney in the stock dividend case :^ Enrichment through increase in value of capital investment is not income in any proper meaning of the term. 'Eisner 7'. Macomhcr, 252 U. S. 189, 40 S. Ct. 189, 64 L. Ed. 521. FROM RENTS 697 In Other words, there must be reahzation before there can be taxable income.'' In the old regulations the Treasury ignored the March i, 1913, factor and attempted to impose income taxes upon prop- erty, which is unconstitutional. The new regulations are equally faulty in ignoring the trend of the decisions of the United States Supreme Court. It will probably be impossible to impose any income tax whatever on a lessor at the time when improvements are made, even though title vests simultaneously ; but it may easily develop that at the end of a lease, when title, possession and enjoyment merge, there may be realized and taxable income equal to the fair market price (equivalent to cash) of the improvements. Decisions. (S}'!.) Where, in 1907, the owner of land leased the same for 23 years, under an agreement requiringthe tenant to construct an expensive brick building, and on the tenant's default the owner retook possession in 1916, the value of the building cannot be deemed income accruing in the year 1917, within income tax law September 8, 1916, section 2 (a), for under the lease the title to the building vested in the owner immediately upon construction, and the lessee's default caused the owner a loss. {Miller v. Gcarin, 258 Fed. 22^^, 169 C. C. A. 293; certiorari denied, 250 U. S. 66y, 63 L. Ed. 1197, 40 S. Ct. 13.) "The net income of a taxable person shall include gains, profits, and income derived from .... sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in real or personal property, also from interest, rent, divi- dends .... or gains .... from any source whatever." Plaintiff is the owner of a lot of land in the city of San Fran- cisco, upon which, under the terms of a lease made by plaintiff in 1908 for a term of 26 years, there was erected by her tenant a class A steel and concrete building, the lease providing that "in no event shall the lessee hereunder have any right to remove any building from said premises." The building was completed in 1910. In 1916, the tenant defaulting in accrued rent, the lease was by mutual ar- rangement canceled and terminated, and possession of the leased premises surrendered to plaintiff. The tax in question was assessed for the year 19 16 upon the then value of the building erected under the lease, upon the theory 'See Income Tax Procedure, 1920, pages 441-443, and Income Tax Pro- cedure, 1921, pages 549-553- 698 INCOME that the structure represented "gains, profits, and income" accruing to plaintiff for that year, under an interpretative rule of the Treasury Department, made for the guidance of taxing officers, that: "Permanent improvements under lease or rental contracts, when improvements become a part of real estate, the difference between cost of the improvements and allowable depreciation during the lease term, is gain or profit to the lessor at the end of the lease term, and is to be accounted for as income at that time." Paragraph 50, Regula- tions 33, Treasury Department. The government claims that under the provisions of the act, and this regulation made thereunder, the tax was properly assessed and collected ; but I am unable to sustain this view. The right to levy the tax turns upon the question: When did the title to this building vest in plaintiff and become a part of her property for the purpose of taxation? I am of opinion that under well-settled principles, aptly expressed in section 1013, Civil Code of California, the moment the building was erected, which the terms of the lease show was to be- come and remain an integral part of the land upon which it was con- structed, the title thereto vested as completely in the plaintiff as though constructed by the plaintiff herself. The terms of the lease clearly disclose that the erection of the building was a part of the con- sideration for the lease, and that it was provided for and taken into consideration in the rent reserved. It therefore became, upon its completion, a part and parcel of plaintiff's income-bearing property, and was subject to taxation in her as of that date. City of Oakland V. Albers Bros. Milling Co. (Cal. App.), 184 Pac. 868. The regulation of the Treasury Department cannot be applied to such a state of facts; if so intended, it must give way, as the depart- ment has no power to abrogate a substantive rule of law. This con- clusion is not affected by the principles stated in Board of Education V. Grant, 118 Cal. 39, 50 Pac. 5; or San Francisco v. McGinn, 67 Cal. no, 7 Pac. 187, relied on by defendant. Nor do the considera- tions urged by defendant as arising from the relation of landlord and tenant, between plaintiff and her lessee, apply to the terms of the lease here involved. It results that whatever accession of value resulted to plaintiff's property from the erection of the building in question accrued and became vested in her in 1910, and not upon the termination of the lease. As this was prior to the enactment under which the tax was levied, the case falls by analogy within the principles of Doyle v. Mitchell Brother's Co., 247 U. S. 179, 38 Sup. Ct. 467, 62 L. Ed. 1054; and Hays v. Gauley Motmtain Coal Co., 247 U. S. 189, 38 Sup. Ct, 470, 62 L. Ed. 1061. Those cases dealt with the act imposing a corporation excise tax, but, like the present act, the tax was imposed on income, and not upon capital invested, or property as such, and it was held that increase in the value of property invested, accruing I<'R0M RENTS 699 before the act took effect, could not be taken into account or treated as income not realized upon until after that fact. (Cryan v. Wardell, 263 Fed. 248.) Guaranteed dividends or interest as rental equivalent. — It frequently happens that where one corporation leases the property of another corporation the lessee pays as rental a sum equal to the interest on certain securities or equal to a fixed dividend upon the capital stock of the lessor. The rent- al paid is a business expense of the lessee corporation and a rental income of the lessor corporation. The latter must so report the income even though the guaranteed dividends or the interest are paid directly to its stockholders. The following ruling and regulation summarize previous rulings : Ruling. A lessee corporation which owns a large part of the stock of the lessor corporation paid the annual rental of 504: dollars not directly to the lessor but as dividends to the stockholders of the lessor, retaining that part of the rental to which as a stockholder it was itself entitled. It is held that the lessor is required to include in its gross income for each of the years 1916, 1917, and 1918 the full annual rental of so.t" dollars. (B. Digest 30-21-1747; A. R. R. 589.) Regulation. Where a corporation has leased its property in consideration that the lessee- shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor's cap- ital stock or the interest on the lessor's outstanding indebtedness, together with taxes, insurance, or other fixed charges, such pay- ments shall be considered rental payments and shall be returned by the lessor corporation as income, notwithstanding the fact that the dividends and interest are paid by the lessee directly to the stockholders and bondholders of the lessor. The fact that a cor- poration has conveyed or let its property and has parted with its management and control, or has ceased to engage in the business for which it was originally organized, will not relieve it from liability to the tax. While the payments made by the lessee directly to the bondholders or stockholders of the lessor are rentals as to both the lessee and lessor (rentals paid in one case and rentals received in the other), to the bondholders and the stockholders such amounts are interest and dividend payments received as from the lessor and as such shall be accounted for in their returns. (Art. 547; Reg. 45, Art. 546.) 700 INCOME The procedure as outlined above is prescribed even in cases where special types of securities are issued in lieu of the cap- ital stock of the lessor corporation. The ruling follows : Regulation. Stock trust certificates or leased line certificates, •as the case may be, issued by the lessee for the purpose of securing or holding control of the stock of the lessor are held to be issued in lieu of the certificates of capital stock, and for the purpose of this tax will be treated as capital stock and the amounts received by the holders of these certificates are dividends to the holders, to be treated as rentals by both lessee and lessor and constitute an allowable de- duction in the one case and an item of income in the other, accord- ingly as they are paid and received. (Reg. 33, 1918, Art. 104.) These regulations have a perceptible effect upon the amount of the tax collected by the Treasury when, as under the 191 7 law, there is a difference between the rate applied to corpora- tions and the normal tax applied to individuals.' Expenditures by lessees for taxes. — Many leases between landlords and tenants stipulate that the latter shall pay taxes or make necessary repairs. Expenditures of this character are considered a part of the rent and must be reported by the landlord.* ' The decision upon which these regulations are based is in the case of Rensselaer & Saratoga Railroad Company v. Irwin, Collector (District Court, N. D., New York), March 5, 1917, 239 Fed. 739, decided under the Act of October 3, 1913; affirmed 249 Fed. 726, 161 C. C. A. 636; writ of certiorari denied by Supreme Court, 246 U. S. 671, 38 S. Ct. 424, 62 L. Ed. 931. The 1918 law also had different 1919 normal rates for corporations and individuals but in case of dividends this makes no real difference as the receiving corporation (lessor) now pays no tax on dividends received. * [Former Procedure] Under the law as it stood prior to October 3, 1917, it was incumbent upon tenants in certain circumstances to with- hold the normal tax upon rentals paid. In such cases questions some- times arose concerning the interpretation of agreements binding teiiapls to pay taxes in addition to a stipulated cash rental, the landlords insisting that income taxes so withheld should be assumed by the tenant, and the tenants contending that they should be deducted from the stipulated cash rental agreed upon. On September 21, 1916, in the case of Suter et al. v. Jordan Marsh Co. (Supreme Judicial Court of Massachusetts. 225 Mass. 34. 113 N. E. 580), the court decided that the tenant could not deduct from its rental the nor- mal federal income tax, having agreed to pay 'all taxes and assessments .... upon or in respect of the rent payable hereunder by the lessee, how- soever and to whomsoever assessed." The court stated that a change in the FROM RENTS 701 Regulation Taxes paid by a tenant to or for a land- lord for business property are additional rent and constitute a de- ductible item to the tenant and taxable income to the landlord, the amount of the tax being deductible by the latter (Art. 109.) Since the net income of the owner is the same whether or not the taxes paid arc inckided as income, many owners do not report as called for by the regulation because they have no personal knowledge of the amount of taxes paid. Decision. A rental contract entered into in 1896 contained the provision that the lessee should pay, among other things : "One-third of all taxes or assessments, special or otherwise, and public charges of every kind and nature that shall or may be taxed or assessed against the (lessor) or its property during the aforesaid term of years." The question at issue was whether the federal income tax and the federal capital stock tax were to be deemed embraced in the con- tract and to be an obligation of the lessee. The court, approaching the question from the standpoint of the circumstances surrounding the parties, in an endeavor to interpret the intent, considered that the fact that the taxes in question were not in force when the con- tract was made was a pertinent circumstance and one which had led the courts in other jurisdictions to limit the meaning to be given to the taxes mentioned in the contract. It passed to the consideration of cases where an income tax was itself involved, concluding that none of them could be held to require the payment of such a tax, and hence it held here that no such obliga- tion was found to be in the contract nor was it necessarily or even reasonably to be implied from the language used. The same reasoning was applied to the consideration of the fed- eral capital stock tax or excise tax, which was also held to be beyond the contemplation of the parties. law as to taxation during the term of the lease is of no consequence. "The covenant is to pay all taxes except betterments." The court held: "The de- fendant seeks to deduct from the rent reserved that which it contends it already has paid as a tax, being obligated to pay all taxes assessed on account of that rent. That it cannot do." In another case, Little Schuylkill Navigation R. R. and Coal Co. v. I'hila. & Reading Ry. Co. (44 Penn. County Court Reports 197), a lessor attempted to hold the lessee liable for the normal tax under a clause in a lease obligating the lessee to pay taxes, but here the provisions as to the kind of taxes the lessee should pay were held by the court to be not inclusive enough to subject it to the federal income tax. The lessee agreed to pay "all taxes, charges, and assessments .... assessed or imposed under any existing or future law on the demised premises .... or on the business there carried on or on the receipts .... derived therefrom, or upon the capital stock .... dividends .... or ... . franchises of the (lessor)." 702 INCOME The court therefore held that tlie lessor was not entitled to recover upon either item of its claim for reimbursement for the taxes paid by it. {Des Moine's Union Ry. Co. v. Chicago Great Western Ry. Co., 177 N. W. 90.)^ Rent received other than in cash. — An owner of property must return for taxation all income therefrom whether re- ceived in cash or in the equivalent of cash. Many farms are leased under agreements which provide that the lessor shall receive as rental a certain portion of the crops. The lessor must return for taxation the fair value, less all expenses in- curred, of the commodities received if consumed or disposed of by gift and must return the net proceeds if sold for cash. Houses, etc., occupied by rent-free tenants. — It may be that neither cash nor produce is collected from the occupants of houses, farms, etc., but the equivalent thereof is realized by the owner in a different form.^*' A taxpayer may own a garage large enough to accommodate the family of a chauf- feur. The wages paid to the chauffeur in such cases will usually be less than if he were obliged to live elsewhere and pay rent. Since the saving in wages is a direct reduction of personal or living expenses, there should be returned for tax- ation by the chauffeur an amount equal to the saving. The same rule apphes to tenants' houses on farms and country places. As heretofore stated, the rental value of a taxpayer's resi- dence, when occupied by himself, is not taxable, but it can- not be assumed that such exemption extends to other resi- dences which are occupied by employees whose services are not of a gainful nature. Should not the decrease in the ex- penses of the employer be deemed to be constructive income? Under the 192 1 Revenue Act, the rental value of a dwelling house furnished to a minister of the gospel as part of his com- pensation is not to be included in taxable income." • Bulletin of The National Tax Association, November, 1920, page 51. '" See page 438. " Section 213 (b-ii). CHAPTER XXII INCOME FROM DIVIDENDS The taxation of dividends presents certain difficulties which do not exist in the taxation of other income. Divi- dends are paid from the surplus earnings of corporations and as corporations have been continuously taxed on net earnings since the incidence of the federal income tax on March i, 1913, taxation of the same earnings when distributed to stockhold- ers would result in double taxation if provision were not made for a proper adjustment. Again, earnings distributed since March i, 1913, out of the surplus accumulated prior to that date are sometimes held to be capital and sometimes taxable income.^ As surtaxes are not imposed upon corporations Con- gress has attempted to devise various methods of compelling corporations to declare dividends, or to penalize the corpora- tions which do not make adequate distributions of profits.* Other complications exist which will be discussed hereinafter. The successive federal income tax laws and the decisions of the Supreme Court of the United States are gradually clearing up disputed points.'* Dividends are taxable. — Law. Section 213. That for the purposes of this title .... the term "gross income" — (a) Includes gains, profits, and income derivedi from .... dividends Dividends are relieved from, normal tax. — Previous federal income tax laws have provided that dividends received by in- ' See page 715. " See Chapter XXXV, "Tax 011 Undistributed Profits." ' In view of many unsettled cases relating to returns going back to 1913, it is deemed necessary to include in this chapter copious references to past regulations and decisions. For full details, however, the reader is referred to Income Tax Procedure, 1918, 1919. 1920 and 1921 editions. 704 INCOME divitluals are not subject to the normal tax.* The 1921 law denies the credit of dividends for normal tax purposes in two cases, i.e., when received from : 1. Corporations entitled to benefits of section 262 (those derivino- most of their income from sources within o United States possessions). 2. Foreign corporations 50 per cent of whose gross income for the preceding three-year period is froi-i sources zvithont the United States. ° Law. Section 216. [Individuals]. That for the purpose of the normal tax only there shall be allowed the foUov/ing credits: (a) The amount received as dividends (i) from a domestic cor- poration other than a corporation entitled to the benefits of section 262, or (2) from a foreign corporation when it is shown to the satis- faction of the Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such psrt of such period as the corporation has been in existence) was derived from sources within the United States as de- termined under the provisions of section 217; .... Section 234 (a-6) provides, in practically identical lan- guage, for the deduction of dividends in computing the net income of corporations.'' * In the case of state income taxes the foregoing provision does not necessarily apply because corporations may not pay a state income tax as such. In New ^'ork State, corporations pay a 4^/2 per cent tax on net in- comes, hut it is imposed as a franchise tax. Consequently an individual taxpayer must pay state income tax on the full amount of dividends re- ceived, with no allowance or credit for the 4j/< per cent already collected on the same net income. ■^ See page 711 for discussion of reason for limitation of credit. " [Former Procedure] Under the 1909 excise tax law corporations were not subject to tax upon dividends. Under the 1913 and 1916 laws they were taxed. Under the 191 7 law they were taxed 2 per cent when out of 1916 or 1917 earnings and i per cent when out of 1913, 1914 or 1915 earnings, and exempt as to the 4 per cent war income tax. The 1918 law relieved corporations from any tax on dividends received from other corporations which were themselves taxable under the federal income tax law. Corporation tax rates were as follows: 1913, 1914, 1915. i per cent; igi6, 2 per cent ; 1917, 2 per cent and 4 per cent war income tax. Dividends from corporations taxed upon their net income in Porto Rico and the Philippine Islands were not allowed as credits, free of tax, in an individual return and were not allowed as a deduction in arriving at net income in a corporation return. (1918 law, section 261.) FROM DIVIDENDS 705 Dividends on stock of federal reserve banks exempt from both normal and surtaxes. — Regulation. As section 7 of the Federal Reserve Act of De- cember 23, 1913, provides that Federal reserve banks, including the capital stock and surplus therein and the income derived therefrom, shall be exempt from taxation, except taxes upon real estate, such exemption attaches to and follows the income derived from dividends on stock of Federal reserve banks in the hands of the stockholders, so that the dividends received on the stock of Federal reserve banks are not subject to the income tax. Dividends paid by member banks, however, are treated like dividends of ordinary corporations. (Art. 76.) The above regulation calls attention to the fact that this exemption of dividends received by member banks does not extend to dividends paid on the stock of member banks. Owners of record liable for tax — Exception. — Many stocks are owned by others than shareholders of record. In such cases the following regulation is of importance -J Regulation. Dividends on stock of domestic corporations or resident foreign corporations are prima facie income of the record owner of the stock, and such record owner will be liable for any addi- tional tax based thereon, unless a disclosure of the actual ownership is made to the Commissioner on Form 1087 which shall show that the record owner is not the actual owner and who the owner is and his address. In all cases where the actual owner is a nonresident alien individual and the record owner is a person in the United States, the record owner will be considered for tax purposes to have the receipt, custody, control, and disposal of the dividend income and will be required to make return for the actual owner, regardless of the amount of the income, and to pay any surtax found by such return to be due. (Art. 405.) "Dividend" Defined The statutory definition of the term "dividend" follows: Law. Section 201. (a) That the term "dividend" when used in this title (except in paragraph (10) of subdivision (a) of section 234s and paragraph (4) of subdivision (a) of section 245"' means any distribution ' See also page 320. 'Refers to distributions by insurance companies (other than life). ' Refers to distributions by life insurance companies. 7o6 INCOME made by a corporation to its shareholders or members, whether in cash or in other property, out of its earnings or profits accumulated since February 28, 1913, except a distribution made by a personal ser- vice corporation out of earnings or profits accumulated since Decem- ber 31, 1917, and prior to January i, 1922 The 1 92 1 law eliminates from the definition a distribution "in stock of the corporation" (stock dividends), as well as distributions from personal service corporation earnings which were accumulated during the period that such earnings were taxed to the individual stockholders. The words ''earnings or profits," which are the same as in the 1918 law, were held to include realizations of appreciation accrued prior to March I, 1913. The ruling is beheved to be illegal.^" The definition given in the regulations limits the meaning of the term still further: Regulation. Dividends for the purpose of the statute comprise any distribution in the ordinary course of business, even though ex- traordinary in amount, made by a domestic or foreign corporation to its shareholders out of its earnings or profits accumulated since Feb- ruary 28, 1913 The term "dividends" does not, however, include a distribution made by a personal service corporation out of earnings or profits accumulated since December 31, 1917, and prior to January i, 1922 (Art. 1541.) Distribution must be "in the ordinary course of business." — It should be noted particularly ' that the regulation just quoted insists that the distribution shall have been made "in the ordinary course of business." The phrase evidently is meant to distinguish such dividends from liquidation or divi- dends extraordinary.^^ "'" See page 718. [Former Procedure] The definition in the 1918 law is : Law. Section 201. "(a) That the term "dividend" when used in this title (except in paragraph (10) of subdivision (a) of section 234) means (i) any distribution made by a corporation, other than a personal service corporation, to its shareholders or members, whether in cash or in other property or in stock of the corporation, out of its earnings or profits accu- mulated since February 28, 1913, or (2) any such distribution made by a personal service corporation out of its earnings or profits accumulated since February 28, 1913, and prior to January i, 1918." "See page 748. FROM DIVIDENDS 707 What constitutes a distribution? — The 1921 law now pro- vides, in effect, for the constructive receipt^^ of dividends. Law. Section 201 (e) For the purposes of this Act, a taxable distribution made by a corporation to its shareholders or mem- bers shall be included in the gross income of the distributees as of the date when the cash or other property is unqualifiedly made subject to their demands Regulation A taxable distribution made by a corpoi'a- tion to its stockholders or members shall be included in the gross income of the distributees when the cash or other property is un- qualifiedly made subject to their demands. (Art. 1541.) Very few stockholders have available or trustworthy in- formation as to when dividends are declared. Their records show only the receipts of dividends, even when accounts are kept on an accrual basis. It would be rather difficult for a taxpayer keeping accounts on a cash basis to make the neces- sary adjustments at the beginning and end of each year; there- fore stockholders who report dividends as of date of receipt, which is the first time they are under the control of the stock- holders, will be complying with the law. In the case of close corporations the individual accounts of stockholders may be treated as bank accounts and it is rea- sonable to charge such stockholders with notice as to the dates when dividends are credited. Decision It appears that in the year 1916 the earn- ings of the company were distributed to the stockholders by crediting them with their pro rata shares thereof upon the books of the corporation. This dividend was not, however, actually segregated from the general assets of the company. Godfrey F. Park thus re- ceived credit for $21,120.94 and Susan R. Park for $17,836.33. It is well settled that the declaration of a dividend creates a debt from the corporation to the stockholders. If the amount of the dividend be segregated and set apart from the other corporate assets in money or securities or other property, then the same be- comes a trust fund, for the benefit of the stockholders, respectively. But that does not seem to have been done in this case. Therefore, the crediting of the pro rata shares of the plaintiffs, Godfrey F. Park and Susan R. Park, of this amount to their respective accounts " See page 387. 7o8 INCOME upon the books of the company merely evidenced the indebtedness of the company to them, and did not constitute the receipt of income by them. Income means actual cash or its equivalent received, as opposed to contemplated revenue due or unpaid. Maryland Casualty Co. V. U. S., 52 Ct. Cls. 201 209 (Affirmed 251 U. S. 342, 345.) Although, the dividends were not income simply because credits to the extent thereof had been created, yet when the plaintifiTs subse- quently drew, as they did, against those credits and obtained the money thereon, then they did become income ^" In the foregoing case the court was satisfied that certain stockholders could not be charged with the constructive re- ceipt of their dividends, even though credited to their indi- vidual accounts in the books. Under the 192 1 law such divi- dends would be taxable unless the company could not pay the amounts credited.^* May a dividend be rescinded by directors or returned by stockholders? — It sometimes happens that a dividend is de- clared on the strength of book or paper profits and subse- quently it becomes necessary or desirable to reverse the action and arrange to secure a return of the funds paid out or credited to the accounts of stockholders. If a single stockholder objects to the rescinding proposition after the formal declaration of a dividend is communicated to him or after the dividend has been credited, no legal remedy ^"Park V. Gilligan, Collector, U. S. Dist. Ct., So. Dist. of Ohio, West. Div., June 11, 1921 (not reported) ; sec Corp. Tr. Co. 1921 Income Tax- Service, 3067 et seq. '* [Former Procedure] Under the 1918 law the Treasury imposed an impossible condition upon stockholders who keep their accounts on a cash basis. Rulings. "The date of payment rather than date of receipt is the governing factor in determining when a dividend should be treated as tax- able income to the recipient. Consequently, a dividend paid in Kansas and received there by stockholders December 30, 191 7, but not received by stock- holders in California until January, 1918, will be taxable at 1917 rates to the California stockholders." (C. B. i, page 562; O. D. 97.) "A distribution by a corporation in 1919 under court order of an ac- cumulated cash surplus, as a result of suit brought by certain stockholders, which was decided in their favor by the lower court in 1917 and affirmed by the appellate court in 1919, must be returned as income of the stock- holders for the year 1919 and not in amended returns for 1917." (C .B. 2, page 87; A. R. R. 124.) 1 FROM DIVIDENDS 709 is available to compel action on his part. If, however, in fact the dividend has been paid out of capital, the so-called divi- dend is not taxable at all to the stockholders and the directors may be required to reimburse the corporation to the extent to which the dividend was illegal.^' Ruling. A dividend declared and paid by a corporation wa^ in part illegal, inasmuch as it exceeded the true earnings, and the cor- poration later rescinded it. To the extent that the corporation had a legal right to force rescission and repayment of such dividend, and such rescission and repayment vi^ere actually made, the rescinded dividend should not be considered income to the stockholders for the purpose of taxation. (C. B. i, page 25; T. B. M. yy.') But if every stockholder consents to a rescission the case is entirely different. If directors pay a dividend which proves to be unwise, or excessive or illegal, and every stockholder agrees to return the amounts paid or credited, it may be ex- pected that no court will hold that the payments represent income when received and capital payments when refunded, even though the dividends were paid or credited during one taxable year and the refunds occurred during the next year. If the entire transaction occurred during the same taxable year it would not even appear in the returns or accounts of the taxpayer. In effect it would be a transaction marked "void." Therefore, when one part of the transaction occurs very late in one taxable year and the other part in the next taxable year a taxpayer should not be penalized thereby. This, however, is not the view of the Treasury. Ruling. A corporation in due course of business during the calendar year 1918 declared and paid a dividend the major portion of which was paid out of earnings of the calendar years 1914, 191 5, and 1916. Both at the time of declaration and at the time of payment of such dividend the Revenue Act of 1916 as amended by the Revenue Act of 1917 (see sec. 31 (b)) was in force, which pro- vided for the taxation of dividends "at the rates prescribed by law for the years in which such profits or surplus were accumulated by the corporation." In the calendar year 1919, after the passage of the Revenue Act of 1918 which changed the method of taxing '^'^ Auditing , Theory and Practice (1921 edition), by R. H. Montgomery, pages 670-677. 710 INCOME cash dividends so that they became taxable at current rates, the corporation took action purporting to rescind the declaration of the dividend, and the stockholders repaid the amounts receired by them from the corporation. It is inferred from the statement of facts that the declaration and payment of the dividend were legal and that the corporation could not have required the stockholders to pay back the amounts received in distribution but that such repayments were made voluntarily The rights of the stockholders with respect to the dividend became fixed at some time not later than the date of payment thereof. Such rights were not subject to any liability to repay amounts re- ceived. The dividend, therefore, became during the calendar year 19 18 a part of the gross income of the stockholders. After it had acquired the character of gross income the stockholders could not by voluntary action on their part take away such character. The repayment of the dividend was a new and independent transaction. . . . . (C. B. I, page 65; T. B. R. 42.) The author wholly disagrees with the foregoing ruling. When the dividend was declared and paid the stockholders were justified in assuming that Congress would keep faith with the corporations which were induced to pay special dividends in 19 18 under a guarantee of special treatment.^* Congress did not keep faith and later imposed a different rate of tax by retroactive legislation. The corporations having acted under a law which was subsequently repealed were legally entitled to rescind what was done under a mistaken idea of the good faith of the government. The government having secured action through deceit is estopped from bene- fitting by such action. In a subsequent case, the Treasury held the repayment of a dividend did not relieve the stockholders of surtax thereon, even though the original payment of the dividend was made before proper provision had been made for federal taxes, re- sulting in an impairment of capital. Ruling. At the time of the declaration of the dividend the cor- poration had earnings and profits accumulated since February 28, 1913, out of which the dividends could be paid. In December, 1919, additional income and excess profits taxes were found to be due from this corporation for the year 1917, the collection of which would " See page 732. FROM DIVIDENDS 711 seriously have impaired the capital of the corporation. It was therefore agreed at a meeting of the stockholders, held in December, 1919, that the dividends previously paid should be returned to the corporation It might be inferred that no dividends may be declared from surplus and undivided profits unless a reserve fund is established for the payment of any Federal taxes which might accrue for the year prior to that in which the dividend is declared. However, such a principle could not be applicable to all prior years in which ad- ditional assessments might be made. The Commissioner is em- powered, under the Revenue Act of 1918, to make an additional as- sessment of income and excess profits taxes for any given year at any time within five years after the return was due or was made, and in the case of a false or fraudulent return with intent to evade the tax the amount of tax due may be determined and collected at any time after the return is filed (section 250 (d) ). It is apparent, therefore, that if we are to take into consideration a contingent liability that arises by reason of additional assessment, no point of time will arrive at which directors may safely say that earned sur- plus and undivided profits are available for distribution to stock- holders in the form of dividends. (C. B. 4, page y^; Sol. Op. no.) The foregoing ruling is not sound. The repayment of the dividend was an honest and legal method of rectifying a mis- take. The attempt of the Treasury to force the payment of income taxes on an improper diversion of funds, ignoring the return of the funds, is inexcusable. In a recent case" the Treasury- held that under almost similar circumstances the taxpayer could make an amended return for the year when the dividend out of capital was re- ceived, on the ground that it was not income. Distributions by foreign corporations considered "divi- dends." — In the definition quoted on page 705 the term "divi- dend" is held to include a distribution by a foreign as well as by a domestic corporation, but the 192 1 law^^ imposes a definite limitation on such dividends before they can be free of the normal tax in the hands of individual stockholders, or from income tax imposed on a corporation recipient, i.e., more than See I-3-27; I. T. 1 164. Sections 216 (a), 234 (a-6). 712 INCOME 50 per cent of the gross income of the foreign corporation paying the dividend, for the three-year period prior to declara- tion of the dividend, must have been from sources within the United States. The insertion of this Hmitation in the 192 1 law was to pre- vent the recipient of dividends from a foreign corporation securing credit for normal tax on income even though normal tax has never been paid by the foreign corporation. In other words, if the business of a foreign corporation in the United States is so small or so unprofitable as to jdeld little or no tax, the recipient of dividends will not now secure credit for a tax which has not been collected from the corporation.^" Method of return of dividends from foreign corporations. — Receipt by an individual of a $250 dividend on the ordinary shares of a British company indicates that the dividend cred- ited was $357.14 and that the com.pany paid to the British government an income tax of 30 per cent, or $107.14. The gross amount ($357.14) should be entered in the return as a Mividend subject to surtax only, and credit is taken for the full amount of the tax ($107.14). This applies when the British company received more than 50 per cent of its gross income for the three-year period preceding the declaration of the dividend, from sources within the United States. When the British company received less tb.an 50 per cent of its gross income from the United States as above noted, the full divi- dend ($357.14) must be entered as sul^ject to both normal tax " [Former Procedure] Ruling. "Individuals are entitled to a credit for the purposes of the normal tax, of dividends, regardless of the amount of such dividends, re- ceived from a foreign corporation taxable upon income from, sources within the United States, irrespective of the amount of such income. This applies equally to the Revenue Acts of 1916, 1917 and 1918. The same credit is allowed to corporations under the Revenue Act _of.i9i7, for the purpose of the 4 per cent war income tax imposed by section 4 of that Act. but not for the purpose cf the 2 per cent tax imposed by section 10 (a), Revenue Act of 1916 as amended bv the Revenue Act of 1917." (C. B. 2, page 159; O. D. 383.) FROM DIVIDENDS 713 and surtax, bnt credit is taken for the 30 per cent tax ($107.14).^" Distributions received from personal service corporations after January i, 1918, may or may not be "dividends." — Dis- tributions by personal service corporations lose their char- acter as "dividends" when made out of earnings or profits accumulated after December 31, 19 17, and prior to January i, 1922. Law. Section 201. (a) That the term "dividend" .... means any distribution made by a corporation to its shareholders or mem- bers, .... except a distribution made by a personal service corpora- tion out of earnings or profits accumulated since December 31, 1917, and prior to January i, 1922 Any distribution received from a personal service corpora- tion must be analyzed. If declared out of earnings accumu- lated after December 31, 19 17, and prior to January i, 1922, it must not be treated as a dividend. If the personal service corporation has not paid the tax on it, it is subject both to the normal tax and to the surtax in the hands of the recipient. If declared from earnings accumulated prior to January i, 1918, or after December 31, 192 1, it is subject to the surtax or exempt from all tax, the same as an ordinary cash dividend would be. The reason for this is that prior to January i, 1918, for income tax purposes, personal service corporations were taxed like regular corporations and paid the normal income tax on their earnings up to the end of 191 7. Beginning with Janu- ary I, 1918, personal service corporations were not subject to income tax, but their earnings were taxed to the individual stockholders.-^ Under the 1921 law [section 218 (d)], per- sonal service corporations, after December 31, 192 1, will again be taxed like regular corporations. Thus, to detennine ""Sec Chapter XXXVI for limitation on credit for foreign taxes. ■' 1918 law, section 218 (e). 714 INCOME whether or not a "dividend" from a personal service corpora- tion is taxable, it is necessary to consider three periods: 1. March i, 1913, to December 31, 191 7, inclusive. 2. January i, 19 18, to December 31, 1921, inclusive. 3. After December 31, 192 1. If the "dividend" is from earnings accumulated during (i) and (3), it is only subject to surtax, like a regular divi- dend. If from (2), it is not a "dividend" at all and is not subject to tax in the hands of the recipient since the tax on such earnings has already been imposed on the individual stockholders.^" Earnings prior to March i, 1913, are tax- exempt when distributed by personal service corporations, just as are the earnings of ordinary corporations. Dividends from personal service corporations derived from earnings accumulated after December 31, 1917, and prior to January i, 1922, are to be treated as income from a partner- ship. Therefore income received by the personal service cor- poration, such as tax-exempt interest or dividends from fed- eral land banks or national farm loan associations, should have been reported to the stockholders separately, in order that the exemption to which the stockholders are entitled would be secured. In making return on form 1040 the stockholders should segregate the receipts from personal service corpora- tions after December 31, 191 7, and not include any dividends which constitute a distribution of profits accumulated after December 31, 191 7, and prior to January i, 1922. The part of the undistributed income of the personal service corpora- tion which accrued to the stockholders after December 31, 191 7, should be reported in the year of accrual as Item 9, schedule E of form 1040. Dividends received by stockholders of personal service corporations after January i, 1918, which constitute a distribution of earnings prior to that date, should be reported the same as dividends from ordinary corporations. ^For discussion of personal service corporations having fiscal years, see page 820. FROM DIVIDENDS 7^5 For 1922 and subsequent years, dividends received out of earnings accumulated after December 31, 1921, will also be entered the same as dividends from ordinary corporations. After December 31, 1921, dividends paid by personal service corporations are subject to the provisions of section 201 (b)." Dividends paid during 1922 will be applied first to earnings accumulated ratably during 1922. If a personal service cor- poration declares a dividend in March, 1922, payable April i, 1922, it will be held that it must first be applied against earn- ings accrued from January i to March 31, 1922, even though tax-exempt earnings accumulated prior thereto have not been distributed. It would appear to be advisable for all personal service corporations which have available funds, to pay divi- dends immediately in order that the greater part thereof may be apportioned as tax-exempt to the period prior to January i , 1922. The payment ma}" he made b}'- declaration that all such accumulations be credited as dividends to the ])ersonal accounts of the stockholders. Assume a personal service corporation had a surplus at December 31, 192 1, of $200,000, all accumulated since Janu- ary I, 1918. The normal tax and surtax thereon will have been paid by the individual stockholders. Assume further that the earnings from January i to February 28, 1922, are $20,- 000. On February. 28, 1922, a dividend of $15,000 is paid. The sixty-day rule is not applicable. The entire dividend of $15,000 would be deemed to be out of 1922 earnings and tax- able to the stockholders at the 1922 surtax rates, but exempt from normal tax. No part of the $200,000 surplus may be distributed free from tax until all earnings since December 31, 1 92 1, are first distributed.^* Distributions Which Are Not "Dividends" Three types of so-called "dividends" may be excluded from gross income : See page 728. Section 201 (a). For further discussion see pages 721-725. 7i6 INCOME 1. From earnings accumulated prior to March i, 191 3. 2. From appreciation at March i, 1913. 3. Liquidating dividends, to the extent that they are a return of capital. Included hereunder would be dividends stated to be paid from depletion and de- preciation reserves. Law. Section 201 (b) . . . . any earnings or profits accumulated or increase in value of property accrued prior to March I, 1913, may be distributed exempt from the tax, after the earnings and profits accumulated since February 28, 1913, have been distri- buted The words "or increase in value of property" in the 192 1 law are new, and were inserted so as to remove all doubt^^ that dividends paid out of appreciation at March i, 1913, are not taxable, provided the earnings accumulated since that date are first distributed. Regulation. Any distribution by a corporation out of earnings or profits accumulated prior to March i, 1913, or out of increase of value of property accrued prior to March i, 1913 (whether or not realized by sale or other disposition), is not a dividend within the meaning of the Act. Lhe provisions of the preceding sentence shall be applied uniformly to cases arising under the Revenue Act of 1916, the Revenue Act of 1917, the Revenue Act of 1918, as well as the Revenue Act of 1921. A corporation can not distribute earn- ings or profits acciunulated or increase in value of property accrued prior to March i, 19 13, unless and until all earnings or profits ac- cumulated since February 28, 1913, have been distributed. Li de- termining whether a dividend is out of earnings or profits accumulated prior or subsequent to March i, 1913, due consideration must be given to the facts and mere bookkeeping entries increasing or de- creasing surplus will not be conclusive (Art. 1543.) Li the opinion of the author the foregoing regulation cor- rectly interprets the provision regarding dividends paid from realization of appreciation at March i, 191 3, which while new in the 1921 law, in no way change the clear language and intent of the 1916, 1917 and 1918 laws. As the new provision di- "^ For ruling of the Treasury that under ■'h^ 1918 law dividends paid out of realized appreciation at March i, 1913, are taxable, and discussion thereon, sec pages 718 to 721. FROM DIVIDENDS 717 rectlv concerns dividends paid in recent years, the history of the dividend sections of the various laws will be discussed in full. Under the 191 3 law the Supreme Court has held that cash dividends declared between March i, 19 13, and December 31. 1915, even though admittedly out of surplus accrued prior to March i, 1913, are taxable. -'* The decisions would seem to be controlling so far as ordi- nary cash dividends paid prior to December 31, 1915, are con- cerned, but in other decisions"' the Supreme Court has held that special circumstances would justify a departure from the former decision, so that cash dividends paid after March i, 19 1 3, have in some cases been held free from taxation and in other cases subject to the tax. 1916 Law. Section 31. (a) That the term "dividends" as used in this title shall be held to mean any distribution made or ordered to be made by a corporation, joint-vStock company, association, or insur- ance company, out of its earnings or profits accrued since March first, nineteen hundred and thirteen, and payable to its shareholders, whether in cash or in stock of the corporation, joint-stock company, association, or insurance company The 19 1 6 law definitely declared that earnings accumu- lated prior to March i, 1913, had been capitaHzed and that dividends therefrom were free from all income taxes. No provision was made that the earnings subsequent to March i, 1913, should be exhausted before declaring dividends out of the prior period. Under the 19 16 law the Treasury made no effort to restrict the payment of dividends out of surplus accrued prior to March i, 1913, but very properly required evidence that the corporations were keeping strict account of the disposition of the surplus at that date. The Treasury Department consistently interpreted the 1916 "^ Lynch v. Hornby, 247 U. S. 339 (June, 1918) ; Pcabody v. Eisner, 247 U. S. 247 (June, 1918). '-''Southern Pacific Co. v. Lozvc, 247 U. S. 330 (June 3, 1918) ; Gulf Oil Corpn. V. Lcwellyn, 248 U. S. 71 (December 9, 1918) ; see page 739. 7i8 INCOME law to mean that a board of directors might specify the period to which dividends appHed, and, if a surplus existed at March I, 1913, and a board of directors informed stockholders that a certain dividend applied thereto, such dividend was not re- turnable and of course not taxable to the stockholder. In the first drafts of the revenue bill of 19 17 it was pro- vided that all dividends declared during 19 17 were applicable first to the latest earnings of corporations. As many special cash and stock dividends (declared after January i, 191 7) had been designated as payable out of surplus at March i, 191 3, and as most such dividends would not have been paid at all if subject to the 191 7 income tax rates, great injustice would have been done if no change had been made in the draft. It was finally decided that the application of dividends to the latest earnings should be obligatory only from August 6, 191 7. This was the date on which the Senate Finance Com- mittee reported the revenue bill as amended to the Senate. As reported, the bill indicated the intention to compel the distri- bution of all earnings subsequent to March i, 191 3, before the surplus at that date could be distributed. This was sufficient notice of a radical change in the 19 16 law, and directors who declared dividends during 191 7 but after August 6, were chargeable with a knowledge that the 19 16 law was to be amended."^ Dividends out of surplus prior to March i, 191 3. — The following opinion of the Solicitor of Internal Revenue which has been overruled by article 1543 of Regulations 62 is of more than ordinary interest because it held that certain divi- dends, theretofore believed to be exempt from tax, are tax- able. Ruling. The following question is raised: Is the profit made by a corporation in 1918 or subsequent years, from the realization of the appreciation of the March ist value of property (that is, the profit realized between cost and March ist value of property sold in 1918 " See Reg. 33, 1918, Art. 107 ; and C. B. 3, page 36 ; O. D. 655. FROM DIVIDENDS 719 or subsequent years), taxable as income, when distributed as a dividend to a stockholder in 1918 or subsequent years? To illustrate the point, the M Corporation purchased capital assets in 1910 for $10,000. On March i, 1913, these assets had a value of $20,000. In the year 1918 or a subsequent year the M corporation sells these assets for $20,000 and distributes the $10,000 realized gain to its stockholders as dividends. The question asked is v^^hether the $10,000 thus distributed is taxable as income to the stockholders. It was held in Lynch v. Hornby, 247 U. S. 339 (T. D. 2731), that such increase in the value of corporate assets accrued prior to March I, 1913, was taxable income under the Income Tax Act of 1913 when distributed as a dividend in the ordinary course of business. The court stated: Hence we construe the provisions of the Act that "the net in- come of a taxable person shall include gains, profits, and income de- rived from .... interest, rent, dividends, .... or gains or profits and income derived from any source whatever" as including (for the purposes of the additional taxes) all dividends declared and paid in the ordinary course of business by a corporation to its stock- holders after the taking effect of the Act (March i, 1913), whether from current earnings or from the accumulated surplus made up of past earnings or increase in value of corporate assets, notwithstand- ing it accrued to the corporation in whole or in part prior to March I, 1913. (Italics mine.) The definition of income contained in section 213, Revenue Act of 1918 is, in its essentials, the same as the definition in the Act of 1913, and it follows, tljerefore, that unless Congress has by other statu- tory provisions exempted such income it is taxable. Pertinent provisions in the Revenue Act of 1918 bearing on this point are section 201 (a) and (b) which provide as follows: (a) That the term "dividend" when used in this title (except in paragraph (10) of subdivision (a) of section 234) means (i) any distribution made by a corporation, .... to its shareholders or members, .... out of its earnings or profits accumulated since February 28, 1913 (b) .... any distribution made in the year 1918 or any year thereafter shall be deemed to have been made from earnings or profits accumulated since February 28, 1913, or, in the case of a personal service corporation, from the most recently accumulated earnings or profits; but any earnings or profits accumulated prior to March i, 1913, may be distributed in stock dividends or otherwise, exempt from the tax, after the earnings and profits accumulated since February 28, 1913, have been distributed. It seems clear that the distribution here in question is a "divi- dend" within the meaning of section 201 (a), which defines a divi- dend as "any distribution made by a corporation, .... out of its earnings or profits accumulated since February 28, 1913." Mere 720 INCOME increase of capital assets unrealized is not, in our judgment, "earnings or profits." Obviously it is not an earning. Is it a "profit," as that term has come to be understood in income tax parlance? In Lynch V. Tiirrish, 247 U. S. 221, the Supreme Court quoted with approval the following from Gray v. Darlington, 15 Wall. 63: Mere advances in value in no sense constitutes the gains, profits, or income specified by the statute. In Eisner v. Macomber, 252 U. S. 189, the court in commenting on the meaning of income states : Here we have the essential matter : Not a gain accruing to capital, not a grozvth or increment of value in the investment, but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, .... Here profit is made synon3^mous with income, and income is held not to include mere appreciation of capital. Hence the word "profit" can not include mere appreciation of capital. The statute, section 213, defines income as including "profits." Surely a part can not be said to be greater than the whole as that whole has been de- fined by the Supreme Court. See also article 23, Regulations 45, holding appreciation of capital is not income. Such appreciation becomes income, or profit, however, when real- ized through the sale of such assets (Merchants Loan & Trust Co. v. Smietanka, decided by the Supreme Court, Mar. 28, 1921 ; T. D. 3173, C. B. 4, p. 34). It is clear, therefore, that this increase did not become "earnings and profits" to the" corporation until after Febru- ary 28, 1913. Therefore any distribution out of it must have been a distribution out of the earnings and profits accumulated after Feb- ruary 28, 1913. That such increase when realized is not taxable to the corporation because accrued prior to March i, 1913, is immaterial. The definition of a dividend does not confine itself to taxable or non- taxable earnings or profits. It is concluded, therefore, that the dis- tribution is a dividend within the meaning of section 201 (a). It remains to be determined whether this distribution falls within the express exemption of section 201 (b), which provides in part: Any distribution made in the year 1918 or any year thereafter shall be deemed to have been made from earnings or profits accumu- lated since February 28, 1913 hnt any earnings or profits ac- cumulated prior to March i, iQij, niay be distributed in stock divi- dends or otherwise, exempt from the tax, after earnings and profits accumulated since February 28, 19 13, haA^e been distributed. This section, read in connection with the definition of a dividend makes manifest the intention of Congress to exempt "earnings and profits" which would otherwise be taxable under the doctrine of the Hornby case. It will be noted, however, that the statute is pecul- iarly silent as to the increase of capital assets accrued prior to March I, 19 13. At the time the Revenue Act of 1918 was passed by Congress FROM DIVIDENDS 721 the case of Lynch v. Hornby had been decided and it must be assumed that Congress knew that under that decision increase of corporate assets as well as earnings and profits accumulated prior to March I, 1913, but distributed later in the ordinary course, were taxable as income. Whatever may be conjectured as to the intention of Con- gress to reverse by statute the entire ruling laid down in the Hornby case, the fact remains that it did not use language which in our judgment is sufficient to accomplish that result, and it can not be assumed by an executive department that Congress intended to ex- tend the exemption beyond the clear import of the words used. The express exemption applies to "earnings and profits" accumulated prior to March i, 1913, and as has already been demonstrated, these terms do not include unearned increment. A distribution like that under consideration in this case is not, therefore, within the ex- emption. For the reasons above stated it is concluded that profits made by a corporation in 1918 or subsequent years from the realization of ap- preciation of corporate assets accrued before March i, 1913, is tax- able income to the stockholder when distributed as a dividend in 1918 or subsequent years. ( B. 43-21-1878, Oct. 26, 1921; L. O. 1 0/3-) The foregoing" ruling, in the author's opinion, is erroneous. It is based upon the propositions ( i ) that the words "earnings and profits" do not embrace an increase in value of corporate assets while unconverted; (2) that immediately upon realiza- tion by sale or conversion after March i, 19 13, such increase becomes "earnings and profits accumulated after February 28, 1913" ; and (3) that although it has accrued prior to March i, 191 3, it does not come within the saving provisions of section 201 (b). It is manifest that the Solicitor has indulged in some very fine-spun reasoning, and has given to the statute a very narrow interpretation, contrary to the well-settled rule that tax statutes must be construed strongly against the gov- ernment and in favor of the citizen.'" If for argument it be conceded that the words "earnings and profits" do not embrace -a mere "increase in value" until the latter is realized through sale or conversion, still there is no justification, especially under a statute which in case of doubt must be construed in favor of the taxpayer, for holding Gould V. Gould, 245 U. S. 151. 722 INCOME that the profit which has resulted from a sale or conversion was "accumulated since February 28, 1913." The "profit" as such, it is true, has been realized since that date, but it has not "accumulated" since then. The word "ac- cumulated" means "to bring together by degrees or successive additions."^" There can be no accumulation, in the ordinary and proper sense of that word, when an increase in value is turned into a profit by the single act of sale or conversion. If the words "earnings and profits," as used in section 201, are to be given the meaning ascribed to them in the above ruling and the word "accumulated" its ordinary one, then the increase in value of corporate assets, when distributed among stock- holders, may not be considered "a dividend" within the mean- ing of that section and hence is probably not taxable. This would apply to increases which have accrued subsequent to March i, 191 3, as w^ell as prior thereto. Such a construction would not, however, in the author's opinion, be proper because the various income tax acts have sought to tax both individuals and corporations on the in- creases in value arising after March i, 191 3, when reahzed through sale or conversion; and there is nothing to show that there was any intention on the part of Congress to exempt stockholders from the tax, except as set forth in section 201 (b). Nor is there anything to indicate that Congress pro- posed to exempt any dividends in the hands of individuals from the normal tax when the corporation was not subject to a tax on the moneys represented thereby. Yet that would be the result of the above ruling, because any increase in value, in so far as it is represented in the value as of March i, 19 13, is not, even after sale, an earning or profit which can be taxed against the corporation. But it is thought that the act as a whole when considered in connection with the prior acts and the Act of 192 1, repels the idea that any such narrow interpretation of the words 'Standard Dictionary. FROM DIVIDENDS 723 "earnings and profits" may be adopted as the Solicitor has indulged in. The Act of IQT3 contained no exemption what- ever. The 1916 and 19 17 acts exempted dividends out of "earnings or profits accrued" prior to March i, 1913. They were passed after decisions adverse to taxing dividends paid in the ordinary course of business after March i, 1913, out of a surplus accumulated before that date, had been rendered by the District Court and the Circuit Court of Appeals in the Hornby case, but before the Supreme Court had rendered its decision to the contrary. The 19 18 act was in all respects material to this question the same as the 191 7 act. The foregoing ruling was made after the first House draft of the 1 92 1 act appeared. In the latter, the words of the ex- emption clause of section 201 (b) were, as in the 1918 act, "but any earnings or profits accumulated prior to March i, 191 3, may be distributed exempt from the tax." After the ruling was promulgated, the House draft was amended in the Senate by inserting after the word "accumulated" in the clause in question, "or increase in value of property accrued." Thus there is evidenced a clear and well-defined purpose or policy commencing in 1916 on the part of Congress to exempt from tax, dividends paid out of corporate assets accumulated before March i, 191 3. The fact that this change in the last law was made after a department ruling diametrically contrary thereto, is most convincing evidence that Congress intended in the 19 18 act, that increases in value' should be included in the words "earnings or profits accumulated," as used in section 201 (a) and (b). The reason for such a policy is to make the tax on dividends the same in principle as that assessed against other kinds of income, and to carry out the purpose, as announced in Congress, of the framers of the 191 7 act to encourage the payment of dividends out of surplus (without distinction as to its source) accumulated after March i, 1913. All of the acts since 191 3 have exempted individuals and corporations from tax on appreciation in values of property up to March i, 19 13. The reasonable conclusion, therefore, is that Congress in- 724 INCOME tended, by section 201, subdivisions (a) and (b), of the 1918 act, to exempt from tax such of the profits distributed by a corporation as represent increases in value which have accu- mulated before March i, 1913, and which later have been realized by sale or conversion, as well as those which represent earnings and other profits. The Solicitor states that section 213 defines "income" as including "profits," and goes on to say, "surely a part cannot be said to be greater than the whole as that whole has been defined by the Supreme Court." He fails to state that section 213 is a definition of gross — not net — income and that all of the items in section 213 are to be included in the taxable year. If section 213 is controlling and realization of appreciation prior to March i, 1913, is a profit, it must be a taxable profit. But of course it is not. So with the Solicitor's other extracts from decisions and sections of the law. He makes the part greater than the whole. The law as a whole defines taxable income, taxable gains, taxable dividends. The designation of appreciation and surplus at March i, 191 3, has been capital uniformly since tJie enactment of the ipi6 law (with which the Hornby case had nothing to do), and no part of that capital is to be taxed. The attempt to tax it in the hands of its bene- ficial owners is a clear disregard of the letter as well as the intention of the law. Dealing specifically with the 19 18 law, which forms the special burden of the Solicitor's opinion, it must surely be assumed that the different sections of the law which deal with the same sul:)ject or related parts of it were intended to be consistent and to give the same meaning to the same thing. Section 201 (a), in defining the term "dividends," deals with • the "earnings or profits accumulated since February 28, 1913," by a corporation. Section 202 and sections 232-234 define the earnings or profits of a corporation. Section 202 states how "gain derived .... from the sale or other disposition of property" is to be computed; the section simply says "gain," not "taxable gain," though, of course, only gain computed in FROM DIVIDENDS 725 accordance with this section is taxable. In the case of prop- erty acquired prior to March i, 19 13, the "gain derived" is only the realization in excess of the value at that date. Section 232 states how the "net income" of a corporation is to be computed, namely, by deducting from "gross income" as de- fined in section 233 the deductions permitted by section 234, section 234 provides that the deduction for depletion shall be on the basis of the value of the property at March i, 191 3. Is it not obvious that in speaking of the earnings or profits of a corporation accumulated since February 28, 191 3, they must be viewed in the light of the sections which define how gains and income of a corporation are to be computed, and that the exclusion of appreciation of property values accrued prior to March i, 19 13, in sections 202 and 234, requires a similar exclusion in section 201 (a) ? The treatment of appre- ciation prior to J\Iarch i, 191 3, in sections 202 and 234 auto- matically includes such appreciation in the "earnings or profits accumulated prior to March i, 191 3," which are referred to in section 201 (b). Application of tax-free distributions in computing gains and losses. — The second sentence of section 201 (b) provides that in computing losses in final realization, prior tax-free dis- tributions must be credited as partial returns of capital. Sec- tion 201 (c), on the contrary, provides that in computing gains in final realization, prior tax-free distributions may be ignored. For illustrations see Chapter XXIX. Distribution from proceeds of a claim at March 1, 1913. — The fact that what a corporation had at March i, 191 3, was capital and that payments out of capital are not taxable in- come, is clearly stated in a recent case,"^ decided under the 1916 law. '^Park V. Gilligan, Collector, U. S. Dist. Ct., So. Dist. of Ohio, West Div., June 11. 1921 (not reported) ; sec Corp, Tr. Co. 1921 Income Tax Service, 3067 et scq. 726 INCOME Decision. The item represented, therefore, the distribution of the proceeds of a chose in action arising ex delicto long prior to March I, 1913. It was compensation for an injury which John D. Park & Sons Co. had suffered by reason of a violation of the anti- trust law. It was not in itself a profit, but was indemnification for a wrong which had caused a loss of profits. On March i, 1913, it was represented by an accrued chose in action. On November i, 1916, it was reduced to cash. By the Act of 1913 dividends were taxable if paid after March i, 1913, whether from profits theretofore accrued or thereafter. Lynch V. Hornby, 247 U. S. 339 But by the Act of 1916 taxable dividends were limited to those made out of earnings or profits ac- crued since March i, 1913. And, I take it, whatever claims the cor- poration had upon that date, whether arising from profit or otherwise, are to be considered as capital then accrued, for the purposes of this act, and that profit since accrued means after-acquired gain, which did not then exist, and that the mere fact that a then existing claim, even though representing a profit, was afterwards collected, would not make it a profit accrued after the prescribed date. The same limitation was carried in the amendment of October 3, 1917, and substantially the same in Section 201 of the Act of 1918, the date being there changed to February 28, 1913. Any distribution of property or money accumulated by a corporation prior to March i, 1913, has not been taxable as income at any time since the enactment of the Act of September 8, 1916. And it was under that act that the taxes in question were imposed. Therefore, the distribution of the sum realized from the compromise of the chose in action under discussion was not a dividend taxable as income unless that sum can be regarded as representing profit accrued after March i, 1913. The brief filed by the Government rests its contention upon the proposition that when a dividend is declared and paid by a corpora- tion such dividend is presumed to have been paid from profits, and not from capital, and that if the value of the capital of this corporation, after the distribution of said sum of $85,000, was equal to its value of March i, 1913, the distribution of the $85,000 was a distribution of the profits, and the shares received by the plaintiffs were taxable in- come. But the evidence is that all, or practically all, of the profits that accrued to this corporation between March i, 1913, and January 1, 1917, were paid out in other dividends, and it was impossible that this $85,000 could have been paid out of earnings on hand. The cor- porate surplus was practically exhausted by the payment of such other dividends from year to year. Therefore, the presumption upon which the argument of the Government, as set forth in the brief, rests, to-wit, that this distribution was made from profits accumulated within the taxable period, is overcome by the evidence. The fact is that this asset, which had accrued and existed in the form of a chose FROM DIVIDENDS 727 in action at and long prior to March i, 1913, was on November i, 1916, realized upon and distributed, and tlie corporate property as it stood at the former date was thereby diniinisbed accordingly. There is no evidence that this chose in action was of any greater value on the latter date than it was on the former. Therefore, as this distribu- tion was not out of profits accrued since the statutory date, it was not taxable to the distributees as income. In the foregoing" decision the court upholds the conten- tions of the author that under the 1916 and subsec[uent laws dividends paid out of capital at March i, 19 13, whether on the books or not, were not taxable, even though paid prior to January i, 1921. Rentals paid to stockholders. — In a recent case'^ the trustee in bankruptcy sought to deduct from the bankrtipt's gross in- come as an expense of operation certain rentals for films which the Treasury claimed were a distribution of net profits. The bankrtipt had contracted with ten manufacturers of moving picture films, each originally owning one-tenth of the bank- rupt's common stock, whereby they were to lease to it their films at a certain sum per foot plus a payment at the end of the year, which payment was to be made from the bankrupt's net profits during the year in excess of a specified dividend on its stock. Since this additional payment was based entirely upon the amount of film footage each lessor had furnished the bankrupt during the year and had no reference to the stock- holdings, it was held that these additional payments were prop- erly deductible as additional rent and did not constitute an attempt to distribute surplus to stockholders. Allocation of Dividends to Periods When Accumulated No phase of the subject of income tax has demanded so much attention as the determination of the period to which dividend payments should be allocated. Dividends, for pur- '' In re Ciencrul Film Corporation, C. C. A., Second Circuit, 274 Fed. 903. ;28 INCOME poses of allocation, under the 192 1 law may be separated into four classes, i. c, as paid from : 1. Earnings accumulated since February 28, 191 3. 2. Earnings accumulated prior to March i, 1913. 3. Appreciation in value at March i, 191 3. 4. Capital. Law. Section 201 (b) For the purposes of this Act every distribution is made out of earnings or profits, and from the most recently accumulated earnings or profits, to the extent of such earnings or profits accumulated since February 28, 1913; .... The following section of the 192 1 law is a re-enactment of 201 (e) of the 1918 law, and is for the purpose of deter- mining invested capital only, not for computing income taxes. It loses significance with the repeal of the excess profits tax. Law. Section 201. . . . . (f) Any distribution made during the first sixty days of any taxable year shall be deemed to have been made from earnings or profits accumulated during preceding taxable years; but any distribution made during the remainder of the taxable year shall be deemed to have been made from earnings or profits accumulated betvireen the close of the preceding taxable year and the date of distribution, to the extent of such earnings or profits, and if the books of the corporation do not show the amount of such earnings or profits, the earnings or profits for the accounting period within which the distribution was made shall be deemed to have been ac- cumulated ratably during such period. This subdivision shall not be in effect after December 31, 1921. The general regulation covering allocations reads in tliis manner : Regulation, (a) For the purpose of income taxation every distribution made by a corporation is made out of earnings or profits and from tlie most recently accumulated earnings or profits, to the extent of such earnings or profits accumulated since February 28, 1913; {b) Every distribution made by a corporation during the first 60 days of a taxable year shall be deemed to have been made from earnings or profits accumulated during tlie preceding taxable years. Every distribution made during the remainder of the taxable year after the first 60 days shall be deemed to have been made from earn- ings or profits accumulated during the taxable year up to the date of the distribution to the extent of such earnings or profits. The pre- FROM DIVIDENDS 729 sumptions contained in this paragraph affect the determination of in- vested capital for the purpose of the excess profits tax and are not in effect after December 31, 1921. They have no effect upon the rates at which dividends paid in 1921 and subsequent years are taxed. In ascertaining v^aiether or not a distribution was made out of earn- ings or profits of the taxable year there should first be set aside a proper reserve for the payment of accrued income and excess profits taxes.^' .... In the case of a personal service corporation every distribution is made out of earnings or profits and from the most recently accumu- lated earnings or profits, to the extent of such earnings or profits accumulated since February 28, 1913. Such a distribution, if made during the first 60 days of a taxable year, shall be deemed to have been made from the most recently accumulated earnings or profits of preceding taxable years,^* and if made during the remainder of the taxable year after the first 60 days, from earnings or profits accumu- lated during the taxable year up to the date of distribution to the ex- tent of such earnings or profits. The presumption contained in the preceding sentence is not in effect after December 31, 1921. As stated in article 1541 the term "dividend" does not include a distribution made by a personal service corporation out of earnings or profits ac- cumulated since December 31, 1917, and prior to January i, 1922. (Art. 1542.) The Treasury has gone to considerable length in explain- ing its position in regard to the manner of applying the rule laid down above. Apparently one of the first rulings on this subject was questioned and a subsequent ruling, quoted in part below, was issued. Ruling. The word "accumulated," as used in the phrase "accu- mulated since February 28, 1913," in ruling 31-20-1098, O. D. 610, means, in the judgment of the Committee, profits which have been earned and not dissipated by subsequent losses. While it is recog- nized that assets can not be earmarked as representing earnings of any particular year, it is a fair assumption that the earliest surplus of a corporation is likely to be represented in its balance sheet by fixed assets, while the later earnings are more apt to be represented by liquid assets. Consequently any losses sustained in a given year will be met out of the most recent earnings embraced in its surplus. It follows that profits of any year can not be diminished by prior losses, but it is fair to assume that such earnings, to the extent necessary, will go to satisfy subsequent losses. There is no obliga- ' See Appendix A, Chapter XI. See page 733- 7ZO INCOME tion to recognize for tax purposes the surplus of March i, 1913, as capital which must be made good before there can be any distribu- tion of profits. (C. B. 3, page 36; A. R. M. 82.) In the detailed ruling the following illustration is given: Earnings Losses Surplus Mar. I to Dec. Jan. 1/14 to Dec. Mar. 1/13 .$100,000 31/13 $10,000 31^16 $25,000 Dec. 31/13. 110,000 Jan. I to Dec. Dec. 31/16. 85,000 31/17 15,000 Jan. I to Dec. Dec. 31/17. 100,000 Jan. I to Dec. 31/18 10,000 Dec. 31/18. 90,C|po 31/19 5,000 Dec. 31/19. 95,000 Jan. 1/20 to date of dividend.. 15,000 Dividend, 1920. $25,000 The most recent loss shown is that of 1918. This, of course, was met out of earlier earnings and the corporation must have on hand at the present time the $5,000 earned in 1919 as well as the $15,000 earned in the current year. Of the $15,000 earned in 1917, $10,000 was lost in 1918, leaving it with $5,000 earnings of 1917 still on hand. The $15,000 of 1920 earnings, together with the $5,000 of 1919 earnings and the $5,000, remaining of 1917 earnings covers the dividend of $25,000, showing that all of the dividend was paid out of earnings accumulated since March i, 1913, not- withstanding the fact that the company's surplus on December 31, 1919, was $5,000 less than it was on March i, 1913. From this it might be argued that necessarily, since its surplus on December 31, 1919, was less than that of March i, 1913, any distribution in excess of the earnings of 1920 must have come out of the March i surplus. This, however, is a fallacy since there is no obligation to recognize for tax purposes the surplus of March i, 1913, as capital which must be made good before there can be any distribution of profits A corporation with a surplus of $100,000 on March i, 1913, might have losses in alternate years up to 1923 aggre- gating $100,000 and profits in other years (all paid out in dividends) aggregating the same amount. The effect of the ruling would be that on January i, 1923, it would have no surplus. The surplus at March i, 1913, which was supposed to be free from tax, would in effect all have been taxed, although the dividends paid exactly exhausted that surplus. If no dividends were paid, the corporation on January i, I FROM DIVIDENDS 73 1 1923, would have a surplus of $100,000, all of which would be deemed to have been earned after March i, 19 13. The foregoing ruling is seriously questioned in the follow- ing :'' In the supposititious case a corporation was in possession of a surplus of say $100,000, March i, 1913. During the period ended December 31, 1919, it sustained a net loss of $5,000, thereby reducing its surplus to $95,000. It declared a dividend of $25,000 some time in 1920, during which year and up to date of which declaration its earnings are supposed to have been $15,000. Hence, under the most limited interpretation the corporation must have paid its divi- dend out of the $15,000 earned in 1920, and $10,000 out of its sur- plus earnings of March i, 1913. The department has ruled that because the corporation earned, say, $5,000 in 1919 and $15,000 in 1920, only $5,000 of the $25,000 dividend could be considered to have been paid out of the surplus of March i, 1913. Truly a remarkable decision reached by a unique method of reasoning. In the foregoing ruling the Treasury declines to recognize surplus at March i, 1913, as capital, but in the following ruling dividends paid during the first 60 days of 19 18, which under the law should have been applied first to earnings accumulated during preceding taxable years (note the plural), were taxed at the 1918 rates, on the ground that the years prior to 1913 were not taxable years. In the latter case surplus at March i, 1913, is treated as capital. In the former case the surplus at March i, 191 3, is treated as if it were taxable earnings. The rulings are not consistent and one of them must be erroneous. The author is of the opinion that the following ruling is sound and the one on page 729 is unsoimd. Ruling. Where a corporation has profits accumulated prior to March i, 1913, but none accumulated between that date and January I, 1918, and pays dividends during the first 60 days of 1918, such dividends will be deemed to have been paid from earnings or profits accumulated after December 31, 1917. (C. B. i, page 26; T. B. R. 43.) "Journal of Accountancy, Income Tax Department, November, 1920. 7-:;2 INCOME The definition of the word "accumulated" in A. R. M. 82 merely states that it means "profits which have been earned and not dissipated." The definition is not in accord with the ordinary meaning of the two words. Effect of stock dividend on surplus at March i, 19 13. — Ruling. A corporation having a surplus accumulated in part prior and the remainder subsequent to March i, 1913, transfers to its capital account a portion of its surplus and issues new stock repre- senting the amount transferred, then declares a dividend payable partly in cash and partly in shares of the new issue, allocating the cash dividend to the period prior to March i, 1913, and the stock issue to the period subsequent thereto. Held, in view of section 201 of the Revenue Act of 1918, which provides that a distribution whether paid in cash or in other prop- erty is not a dividend for income tax purposes unless representing earnings accumulated since February 28, 1913, and the decision of the Supreme Court in Eisner v. Macomber, that a stock dividend issued as a result of the transfer of earnings accumulated subsequent to February 28, 1913, to capital account or other bookkeeping pro- cedure equivalent thereto, is not a distribution which is taxable under the Revenue Act of 1918, or previous income tax statutes, that the portion of the dividend which is paid in cash will be deemed to have been paid out of surplus accumulated since February 28, 1913, to the extent of the earnings and profits accumulated since that date and subject to tax, while that portion of the dividend which is paid in stock will not be taxable as income. (Also arts. 1542 and 1545.) (C.B. 3, page 2350.0.587.) The foregoing ruling is believed to accord with good ac- counting practice. All cash dividends received after January 1, 1918, taxable at rates in force in period when received."® — Under both the 1918 and 1921 laws, all dividends (except stock dividends) are taxable to the recipients as income at the rates in force for the period during which the dividends are received, e.g., all cash dividends received in 1921 are taxable at 1921 surtax rates, and those received during 1922 at 1922 rates. ^^ ■° For former procedure as to all dividends taxable at rates of former years, see Income Tax Procedure, 1920, pages 485-487. "Section 211 (a-2). For discussion regarding taxability of dividends on the basis of the year in which earned, see Income Tax Procedure, 1920, page 485, and Income Tax Procedure, 1921, page 575. FROM DIVIDENDS 733 Status of dividends received during first sixty days of tax- able year. — To clear up the difficulty of determining the period to which dividends should be charged for the purposes of the excess profits tax law, it has been arbitrarily decided that all dividends paid within sixty days after the close of a taxable year shall be assumed to have been declared out of earnings which accumulated during preceding taxable years. If a tax- able year ended December 31, 1920, any dividend paid (no mat- ter when declared) between January i, and March i, 1921 (both inclusive) would be deemed to have been out of the earn- ings which accumulated prior to January i, 1921.^* The amount of such dividend thereupon decreases the invested capital of the corporation from and after the date of payment. If paid after March i the dividend will be deemed to have been paid out of 192 1 earnings (to the extent of the earnings from January i to date of dividend payment), and the invested capital as of January i, 192 1, will not be decreased thereby. Like many other provisions which affect the excess profits tax, the rule in most cases works out fairly. The next dividend date after March i is usually April i. By April i there is usually opportunity to accumulate suf- ficient funds to pay the dividend of that date out of current earnings. But in very many cases dividends paid long after April I are deemed by the directors to be out of earnings of the previous calendar year. As construed by the regulations in the case of ordinary corporations, the provision has no bearing on anything other than tlie excess profits tax, and consequently its consideration will be of no importance in making returns for calendar years ending after December 31, 1921. Sixty-day clause has no reference to rates. ^'-^ — - Ruling. Cash dividends received during the first 60 days of 1918 are taxable at 191S rates. (C. B. 2, page 25; A. R. R. 127.) ""See ruling and conunent, .appendix A, Chapter XI. "For discussion of this question, see Income Tax Procedure, 1920, pages 461-2. 734 INCOMK Cash dividends received during the first sixty days of 1921 and subsequent years are taxable at the rates of the years in which received (article 1542). Local Taxes Paid on Bank Stocks No Longer Equivalent of Dividends In addition to the cash dividends received from banks, the owners of some bank stocks have local taxes paid for their account by the banks. The amount of such payments is deduc- tible by the bank*° and does not form constructive income to the stockholder,*^ Salaries in Excess of Reasonable or Necessary Allowances to be Treated as Dividends As to the treatment of amounts ostensibly paid as com- pensation, the Treasury has issued the following regulation. Regulation (i) In the case of excessive payments by corporations, if such payments correspond or bear a close relationship to stock holdings, the amount of the excess should be treated as divi- dends and would thus be exempt from the normal tax in the hands of the recipients (Art. 106.) Before the foregoing regulation can be applied, salaries must be found to be excessive. For a full discussion of salary allowances, see Chapter XXVI. Dividends Paid Otherwise Than in Cash Regulation. Dividends paid in securities or other property (other than its own stock), in which the earnings of a corporation have been invested, are income to the recipients to the amount of the market value of such property when receivable by the stock- holders (Art. 1547. Reg. 45, Art. 1544.) Most dividends are paid in cash or in stock, but occasion- ally distributions are made in some other form. When a divi- *" Section 234 Ca-3). "Section 214 (a-3-d). [Former Procedure] Under the 1918 and prior laws, taxes assessed on stockholdings and paid by banks on behalf of their stockholders, were considered as additional dividend to such stockholders, the latter in turn entering the taxes as a deduction in their personal returns. FROM DIVIDENDS 735 dend other than cash or stock is received, it should be returned for taxation at its cash value. If its equivalent cash value cannot be ascertained at time of receipt it should be returned when and if cash value can be determined. In the foregoing regulation no mention is made of any restriction upon the credit which may be taken for the normal tax. The law defines a dividend to be "any distribution made by a corporation .... out of its earnings or profits."*^ In one section of the 1918 law there is an indication that the credit for the normal tax is based upon and limited to the earnings or profits upon which income tax has been imposed.''' It is logical and proper that a taxpayer should only receive credit for the normal tax upon an amount equal to the earnings which have paid the tax. In the 1 92 1 law, dividends from foreign corporations de- riving 50 per cent or more of their gross income from outside the United States may not be credited for normal tax. The courts have drawn a very fine distinction between divi- dends which are in final liquidation and those which are "recur- ring" or which leave the capital intact. In 1921 the Supreme Court of the United States decided several cases which must be deemed to be conclusive of these factors.^* When a dividend is paid in the stock of other companies, or in property, which has a fair market value, or a read- ily realizable value, and when the capital stock of the paying corporation remains unimpaired, the dividends are taxable as ordinary cash dividends. The foregoing principles were affirmed in the cases of United States v. Rockefeller,^^ New York Trust Company, et al. V. Edwards, ^'^ and United States v. Phellis.*'' In these "Section 201 (a). "Section 216 (a), 1918 law. ** Lynch v. Turrish, 247 U. S. 221 ; 38 S. Ct. 537; 62 L. Ed. 1087; Lynch V. Hornby, 247 U. S. 339; 38 S. Ct. 543; 62 L. Ed. 1149; Brushaber v. Union Pac. Ry. Co., 240 U. S. i ; 36 S. Ct. 236; 60 L. Ed. 493. "274 Fed. 952; affirmed November 21, IQ21 ; advance opinions, 66 r.. Ed. 74- "274 Fed. 952; affirmed; advance opinions, 66 L. Ed. 74. '■ U. S. V. Fhellis. advance ()i)inions, 06 L. Ed. 69 (N<)vem1)or 21. 1921). 736 INCOME cases dividends were paid in the stock of a pipe line company and in the stocks and securities of a powder company. In each case the securities had a known and reahzable market value, and in each case the capital of the paying companies was unim- paired by the distributions. In other words, the court held that the dividends were paid from surplus. In each case values at March i, 191 3, were taken into consideration. The court said in the Rockefeller case : Decision The facts are in all essentials indistinguish- able from those presented in United States v. PhelUs, decided this day. In these cases as in that, regarding the general effect of the entire transactions resulting from the combined action of the mass of stock- holders, there was apparently little but a reorganization and financial readjustment of the affairs of the companies concerned, here a sub- division of companies, without immediate effect upon the personnel of the stockholders, or much difference in the aggregate corporate activities or properties. As in the Phellis case, the adoption of the new arrangement did not of itself produce any increase of wealth to the stockholders, since whatever was gained by each in the value of his new pipe line stock was at the same moment withdrawn through a corresponding diminution of the value of his oil stock. Nevertheless the new stock represented assets of the oil companies standing in the place of the pipe line properties that before had constituted por- tions of their surplus assets, and it was capable of division among stockholders as the pipe line properties were not. The distribution, whatever its effect upon the aggregate interests of the mass of stock- holders, constituted in the case of each individual a gain in the form of actual exchangeable assets transferred to him from the oil com- pany for his separate use in partial realization of his former indi- visible and contingent interest in the corporate surplus. It was in substance and effect, not merely in form, a dividend of profits by the corporation, and individual income to the stockholder In the Phellis case the court said : Decision After the reorganization and the distribution of the stock of the Delaware corporation, the New Jersey corporation continued as a going concern, and still exists, but except for the re- demption of its outstanding bonds, the exchange of debenture stock for its preferred stock, and the holding of debenture stock to an amount equivalent to its own outstanding common and the 'collection and disposition of dividends thereon, it has done no business. It is not, however, in process of liquidation Upon the face of things, however, the transfer of the old com- I FROM DIVIDENDS 737 pany's assets to the new company in exchange for the securities issued by the latter, and the distribution of those securities by the old com- pany among its stockholders, changed the former situation materially. The common stock of the new company, after its transfer to the old company and prior to its distribution, constituted assets of the old company which it now held to represent its surplus of accumulated profits — still, however, a common fund in which the individual stock- holders of the old company had no separate interest. But when this common stock was distributed among the common stockholders of the old company as a dividend, then at once — unless the two companies must be regarded as substantially identical — the individual stock- holders of the old company, including claimant, received assets of exchangeable and actual value severed from their capital interest in the old company, proceeding from it as the result of a division of former corporate profits, and drawn by them severally for their in- dividual and separate use and benefit. Such a gain resulting from their ownership of stock in the old company and proceeding from it constituted individual income in the proper sense There is more force in the suggestion that, looking through and through the entire transaction out of which the distribution came, it was but a financial reorganization of the business as it stood be- fore, without diminution of the aggregate assets or change in the general corporate objects and purposes, without change of personnel either in officers or stockholders, or change in the proportionate in- terest of any individual stockholder. The argument, in effect, is that there was no loss of essential identity on the part of the company, only a change of the legal habiliments in which the aggregate corpor- ate interests were clothed, no substantial realization by individual stockholders out of the previous accumulation of corporate profits, merely a distribution of additional certificates indicating an increase in the value of their capital holdings. This brings into view the gen- eral effect of the combined action of the entire body of stockholders as a mass. In such matters, what was done, rather than the design and pur- pose of the participants, should be the test. However, in this case there is no difference. The proposed plan was set out in a written communication from the president of the New Jersey corporation to the stockholders, a written assent signed by about 90 per cent of the stockholders, a written agreement made between the old company and the new, and a bill of sale made by the former to the latter, all of which are in the findings. The plan as thus proposed and adopted, and as carried out, involved the formation of a nezv corporation*^ to take over the business and the business assets of the old; it was to be and was formed under the laws of a different State, which nec- ' The italics here and those later on are the court's. 738 INCOME essarily imports a dittereiit measure of responsibility tu the public, and presumably different rights between stockholders and company and between stockholders inter sese, than before. The articles of as- sociation of neither company is made to appear, but in favor of the asserted identity between the companies we will assume (contrary to the probabilities) that there was no significant difference here. But the new company was to have authorized capital stock aggregating $240,000,000 — nearly four times the aggregate stock issues and funded debt of the old company — of which less than one-half ($118,515,900) was to be issued presently to the old company or its stockholders, leaving the future disposition of a majority of the authorized new issues still to be determined. There was no present change of officers or stockholders, but manifestly a continuation of identity in this respect depended upon continued unanimous consent or concurrent action of a multitude of individual stockholders actuated by motives and influences necessarily to some extent divergent. In the light of all this we can not regard the new company as virtually identical with the old, but must treat it as a substantial corporate body with its own separate identity, and its stockholders as having property rights and interests materially different from those incident to ownership of stock in the old company. The findings show that it was intended to be established as such, and that it was so created in fact and in law. There is nothing to warrant us in treating this separateness as imaginary, unless the identity of the body of stockholders and the transfer in solido of the manufacturing business and assets from the old company to the new necessarily have that effect. But the identity of stockholders was but a temporary condition, subject to change at any moment at the option of any individual. As to the assets, the very fact of their transfer from one company to the other evidenced the actual separate- ness of the two companies .... There was neither express nor implied condition, arising out of the plan of reorganization or otherwise, to prevent any stock- holder from selling it; and he could sell his entire portion or any of it without parting with his capital interest in the parent company, or affecting his proportionate relation to the interests of other stockholders. Whether he sold the new stock for money or retained it in preference, in either case when he received it he received as his separate property a part of the accumulated profits of the old com- pany in which previously he had only a potential and contingent in- terest. It thus appears that in substance and fact, as well as in appearance, the dividend received by claimant was a gain, a profit derived from his capital interest in the old company, not in liquidation of the capital but in distribution of accumulated profits of the company; something of exchangeable value produced by and proceeding from FROM DIVIDENDS 739 his investment therein, severed from it and drawn by him for his sep- arate use. Hence it constituted individual income within the meaning of the income tax law, as clearly as was the case in Peabody v. Eisner, 247 U. S. 347 The court failed to state in the foregoing cases what its decision would have been if any one of the old companies had distributed all or part of their capital. Inferentially the use of italics would justify an inference that, if the capital of the old companies had been distributed, the substance of the trans- actions would have been that the stockholders received noth- ing in the way of taxable income, provided that the new securities were ratably issued to the old stockholders who there- after merely owned what they had owned before the distribu- tion and that there was a change in form only. In the Phellis case the court said : Decision We recognize the importance of regarding matters of substance and disregarding forms in applying the provisions of the Sixteenth Amendment and income tax laws enacted thereunder. In a number of cases besides those just cited we have under varying conditions followed the rule. Lynch v. Ttirrhh, 247 U. S. 221 ; South- ern Pacific Co. v. Loive, 247 U. S. 330 ; Gulf Oil Corporation v. Lezvellyn, 248 U. S. 71. It would appear, therefore, that the court regarded the unimpairment of the capital of the old companies as a factor of substance. • Dividends paid in stock of another corporation.— Regulation A dividend paid in stock of another corpo- ration is not a stock dividend, even though the stock distributed was acquired through the transfer by the corporation declaring the divi- dend, of property to the corporation the stock of which is distributed as a dividend. Where a corporation declares a dividend pay- able in stock of another corporation, setting aside the stock to be so distributed and notifying the stockholders of its action, the income arising to the recipients of such stock is its market value at the time the dividend becomes payable '*'' (Art. 1547. Reg. 45, Art. 1 544-) *• See Art. 53. . , 740 INCOME It will be noted that the rule of a "market value" is reiter- ated ill this regulation. A dividend paid in the stock of another corporation is treated as a cash dividend if the readily realizable market value can be determined. In such case the credit for the nor- mal tax may be taken. Dividends paid in Liberty bonds and other government securities. — Many corporations have paid dividends in the form of United States bonds. ^° Some stockholders formed the opinion that, because the income from the 3^ per cent Liberty bonds was entirely tax-free, no tax would accrue to income received in the form of the bonds themselves. This view, of course, was erroneous because the tax is assessed against the receipt of the dividend and, so long as the dividend is received in cash or its equivalent, the tax should be levied. The case is precisely the same as if the corporation declared the dividend in cash and the stockholder purchased tax-free securities with the proceeds. ^^ When Liberty bonds are selling at a discount, the tax can be assessed only on the cash value of the dividend." Regulation Although interest on State bonds and cer- tain other obligations is not taxable when received by a corporation, upon amalgamation with the other funds of the corporation such in- come loses its identity and when distributed to stockholders in divi- dends is taxable to the same extent as other dividencis (Art. 1541-) On its face it would appear that it is inequitable to assess stockholders for surtaxes on dividends which can be identified as having been paid out of funds derived from tax-free se- curities. As owners of the corporation the stockholders in effect own the tax-free securities and in theory should pay no tax whatever on the income therefrom. But the fact that the '" For opinion of the Attorney General of the United States on the taxability of dividends paid in tax-exempt bonds, see Income Tax Pro- cedure, 1918, pages 154-156. " Conversely, the corporation is permitted to take the loss. (C. B. 4. page 27; A. R.'R. 435.) "" Letter from Deputy Commissioner L. F. Speer, November 12, 1918, and Art. 1547. FROM DIVIDENDS 74 1 corporation and its stockholders are separate entities prevents the practical application of the theory. If the directors of a corporation desire its stockholders to receive the benefit of the exemption it will be necessary first to distribute the se- ctffities to the stockholders. After the distribution to indi- vidual stockholders the income will be entirely free from, taxation. Dividends paid in bonds which sell at a considerable dis- count should be entered by the recipients at the market value of the securities received. If the securities are subsequently sold at a lower price, credit may be claimed for the loss sus- tained. If sold at a higher price, the profit realized should be reported. Dividends other than in cash are not closed and completed transactions when the property received has no '"readily realiz- able market value." But the rule is of slight significance in the case of government bonds which are so nearly the equiva- lent of cash that fluctuations which may be only temporary can be disregarded. Dividends paid in debenture bonds. — In ruling that divi- dends paid in debenture bonds were taxable, the court said : Decision. The plaintiffs received an actual payment (in the form of securities available for disposition in the market and en- tirely severed or distinguished from their control of the property as stockholders) of profits which the company wished to distribute as earnings to its stockholders "'■■ Scrip dividends. — Regulation Scrip dividends are subject to tax in the year in which the warrants are issued. (Art. 1547. Reg. 45, Art. 1544.) The rule of readily realizable market value is to be applied in this case also. As scrip dividends are issued only by corporations unable '^^ Docrschuck v. [J. S.. and 'riioinus v. U. S., 274 Fed. 739, U. S. Dist. Ct., East. Dist. of N. Y., March 17, 1921. 742 INCOME to pay cash, the vahiation of such scrip for tax purposes should be carefully considered. Of course, if the scrip- runs for a comparatively short period, as one or two years, if the rate of interest it bears is high enough and if the credit of the issuing corporation is good enough, then the recipient of the dividend might prop- erly treat the scrip as a receipt of cash and return it accord- ingly. This, however, assumes that his books are kept on an accrual basis ; otherwise when the scrip is redeemed in cash he may include it again. For a person reporting on the basis of cash receipts, the safer method in the case of receipt of scrip of doubtful char- acter or which has no active market would seem to be to wait until something more substantial is received than a "scrap of paper." In the following ruling the principle of readily realizable market value and the equivalent of cash seems to be ignored : Ruling. The M Insurance Company issues certificates of profit based upon premiums received on marked-off risks of the previous year. These certificates mature in six years and are subject to the future losses and expenses of the company until redeemed and may be reduced by the board of trustees in the case of losses and ex- penses in any subsequent year exceeding the estimated profits of that year. Interest is payable annually upon the face value of the cer- tificates. Held, that the certificates are in the nature of scrip dividends in accordance with article 1544 of Regulations 45, and are taxable at the rate for the year in which declared or issued to the extent that they represent undistributed earnings or accumulated profits. Inasmuch as they are affected by the gains or losses of the company during their maturing period, the amount of such gain or loss should be accounted for in the taxable year in which the certificates mature or are redeemed. The amount of interest annually payable on these certificates is taxable income for the vear in which it is received. (C. B. 3, page 37; O. D. 589.) If the certificates mentioned above are readily convertible into cash the market or discounted value thereof would seem to be the proper basis of the return. FROM DIVIDENDS Part of stock dividend paid in scrip. — 743 Ruling. A corporation declared a dividend payable in stock of the company at par and in making the distribution of fractions of shares issued scrip certificates. These scrip certificates at the option of the stockholders were sold by the corporation as agent for the stock- holders. Held, that the scrip certificates do not represent a cash dividend but a stock dividend and are therefore not subject to tax. (C. B. 4, page 24; O. D. 859.) The profit on the scrip certificates sold would have to be computed as in the case of any other stock dividends.^* Scrip dividends redeemable in cash or stock. — When scrip dividends give an option to the recipient to redeem the scrip in cash or stock, the question arises as to whether or not they are stock dividends, and therefore not taxable, par- ticularly when the stock has a market value considerably above the amount payable in cash. When they are issued no liability is created, the only entries in the books being a debit to surplus and a credit to "scrip dividend payable." Therefore no tax can be imposed at that point, because no asset of any kind has been segregated or distributed. It is, in effect, merely a sus- pense account. If any stockholder takes cash, there is to that extent only a diminution of assets and a distribution. When all stockholders take stock there is no distribution, but there is a transfer from surplus to capital, and all the elements of a stock dividend are present. Cash Dividends, the Taxability of which Has Been Questioned Dividends declared from depreciation and depletion re- serves. — During 19 17 certain corporations, particularly copper mining corporations, adopted a policy of declaring special dividends which were described as return of capital and not a distribution of profits. As such distributions were charged " See page 770. 744 INCOME to depletion reserves on the corporation's books, it was claimed that the surplus and undivided profits were not affected thereby and for this reason no tax could be assessed on the so-called dividends. Regulation. A reserve set up out of gross income by a corpora- tion and maintained for the purpose of making good any loss of capital assets on account of depletion or depreciation is not a part of surplus out of which ordinary dividends may be paid. A distribution made from a depletion or depreciation reserve based upon the cost of the property will not be considered as having been paid out of earnings or profits, but the amount thereof shall be applied against and reduce the cost, or other basis, of the stock upon which declared for the purpose of determining the gain or loss from the subsequent sale of the stock. A distribution made from that portion of a deple- tion reserve based upon a valuation as of !March i, 1913, which is in excess of the depletion reserve based upon cost, will not be con- sidered as having been paid out of earnings or profits, but the dis- tributee shall not be allowed as a deduction from gross income any loss sustained from the sale or other disposition of his stock or shares unless, and then only to the extent that, the basis provided in section 202 exceeds the sum of (i) the amount realized from the sale or other disposition of such stock or shares, and (2) the ag- gregate amount of such distributions received by him thereon. No distribution, however, can be made from such a reserve until all the earnings or profits of the corporation have first been distributed. (Art. 1546.) The foregoing regulation differs from the corresponding one under the 19 18 law (Regulations 45, article 1549)'^ in ^^ [Former Procedure] The first ruling of the Treasury held that dividends out of depletion reserves were not taxable, as indicated by the following : Ruling. "Receipt is acknowledged of your letter of July 3, 1917, and in reply you are advised that, as may be seen upon reference to Treas- ury Decision 2481, the federal income tax law of September 8, 1916, author- izes corporations, joint-stock companies, etc., when making annual income tax returns, to deduct from gross income a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business or trade, and in the case of oil and gas wells and mines, a reasonable allowance for depletion of natural products. "You are further advised that when such deductions are made and their amounts are carried to a reserve account, and later a dividend is declared and paid from that account, the amount of the dividend is held to rep- resent a return of capital invested, and it is not subject to income tax in the hands of the shareholders." (Letter to Henry W. Beal, Boston, signed by Deputy Commissioner L F. Speer and dated July 14, 1917.) FROM DIVIDENDS 745 which a distribution from a depletion reserve is called a "liqui- dating dividend." It is clear, however, that after all profits accumulated since March i, 1913, arc distributed, a dividend from depletion reserve is : 1. A return of capital. 2. A reduction of the cost or March i, 19 13, value of the shares of stock. A corporation should not be permitted to declare dividends out of capital so long as a surplus exists on the books. If no surplus exists, a distribution of capital should be coincident with a reduction in the capital stock of the corporation. Re- serves are created for the purpose of keeping the capital intact, and any diminution of such reserves automatically re- duces the capital. This should not be done unless stock- holders can be depended upon to grasp the significance of the transaction. It is not likely that an ordinary stockholder who received a dividend described as having been charged to a depletion reserve would comprehend that it represented a distribution of capital. He would retain his stock certificate and would not be notified that the par value had been re- duced. It is most likely that he would report the dividend for taxation with other dividends. Certain corporations have notified their stockholders that parts of the dividends were from depletion reserves. Stock- holders of such corporations may naturally assume that the earned surplus of the corporations has been exhausted and that the dividends are in fact out of depletion reserves. When such dividends are received they should be entered by the re- cipients as receipts of capital and should not be reported as taxable dividends. The ruling quoted in footnote on previous page was revoked by T. D. 2540 (October 10, 1917). Regulation. "A distribution from such a reserve will be considered a liquidating dividend and will constitute taxable income to a stockholder only to the extent that the amount so received is in excess of the cost or fair market value as of March i, 1913, of his shares of stock " (Reg. 45, Art. 154Q.) 746 INCOME Even llioiigii a])prcciali()ii at March i, 1913, lias not been realized through sale, or through depletion charges,^" tax-free distributions may be made therefrom, provided, of course, earnings since March i, 19 13, have all been distributed. Dividends paid out of appreciation of goodwill. — The author does not care to assume that cash dividends would ever be paid out of surplus arising from appreciation in the value of goodwill or other capital assets. But since stock dividends are sometimes paid out of marked-up assets, no doubt some corporations will attempt to pay cash dividends from the same source." If the stockholder were to receive a dividend accompanied by a notice from the corporation that it was in fact from surplus so created the stockholder should enter the dividend as free from tax. Appreciation accrued after March i, 191 3, is taxable when realized, but in the case cited it should be specifically stated that realization had not taken place. The dividend, in fact, would be out of capital and would not be taxable. The stockholder would be entitled to assume that the earned surplus of the corporation had been exhausted. Dividends from capital surplus. — The regulations are clear that no tax will be imposed upon a dividend paid from capital surplus.^* Capital surplus may arise through the payment by stockholders of an amount in excess of the par value of capital stock, through appreciation set up on the books as an asset, through the creation of shares of "no par" value and in other ways. It is sometimes claimed that distributions similar to the foregoing may be made at any time irrespective of whether or not the surplus earned since March i, 191 3, has been dis- tributed. See pages 718-725. See Chapter XXIII, "Stock Dividends." Art. 1543, page 716. FROM DIVIDENDS 747 Obviously the distribution of capital dividends diminishes the assets of a corporation to exactly the same extent as when a distribution of earnings is made. This question then arises : Is a provision of law enforceable which forbids any distribution until distribution is made of surplus earned since March i, 1913? Section 201 (b) reads: Law. Section 201 (b) .... every distribution is made out of earnings or profits, and from the most recently accumu- lated earnings or profits, to the extent of such earnings or profits accumulated since February 28, 1913; but any earnings or profits ac- cumulated or increase in value of property accrued prior to March i, 1913, may be distributed exempt from the tax, after the earnings and profits accumulated since February 28, 1913, have been distri- buted The author is of the opinion that this provision of the law is enforceable except when the distributions consist of pay- ments required by the reduction or cancellation of capital stock. When a corporation reduces its capital stock state cor- poration laws require that the stock certificates shall be can- celed or stamped, and it would be illegal for a corporation to advise its stockholders that payments in reduction or retire- ment of capital stock should be deemed to be dividends out of recent earnings, merely because of a federal law which attempts to require a distribution of current earnings before previous earnings are distributed. As a matter of fact payments in reduction of capital stock may be made to only one of several classes of stockholders. In many cases the obligations to retire preferred stock^* are contractual and the payments must be made if the corpora- tions are in funds. This view has been accepted by the Treasury. Ruling. The term "distribution" as used in Section 201 (6) of the Act means the dehvery or transfer of property by a corpora- tion to its stockholders. Whether any distribution by a corporation " For discussion of redemption of stock held to be equivalent of a cash dividend [section 20J (d)], ?ee page 764. 748 INCOME is to be deemed to have been made from earnings or profits depends upon the facts in each case. However, the term '"distribution" as used in Section 201 (b) of the statute does not contemplate the pay- ments made by a corporation to its stockholders in retiring its own stock if the liquidation of the stock was in pursuance of an obligation arising out of the stock contract, unless it appears that the corpora- tion had the option of distributing its assets with a credit to capital stock account or to surplus account. However, inasmuch as a retire- ment of capital stock would indicate that additional capital was not required, any retirement of common stock, leaving the surplus stand, would be regarded by this office as making the corporation one coming within the provisions of Section 220 of the Revenue Act of I9t8.«o^ (C. B. 2, page 25; O. D. 360.) The foregoing rule may not be applicable when the dis- tribution to stockholders consists of the return by a corpora- tion of a special or temporary assessment on its stockholders which is specifically returned when the emergency is over. Liquidating Dividends The 192 1 law makes no specific reference to distributions in liquidation. Section 201 (c) of the 1918 law which pro- vided that "amounts distributed in the liquidation of a cor- poration shall be treated as payments in exchange for stock," appeared in the House draft of the 192 1 law but was stricken out in the Senate. The new subsection (c) which was in- serted in conference reads : Law. Section 201. . . . . (c) Any distribution (whether in cash or other property) made by a corporation to its shareholders or members otherwise than out of (i) earnings or profits accumulated since February 28, 1913, or (2) earnings or profits accumulated or in- crease in value of property accrued prior to March i, 1913, shall be applied against and reduce the basis provided in section 202 for the purpose of ascertaining the gain derived or the loss sustained from the sale or other disposition of the stock or shares by the distri- butee Whatever the reason for eliminating specific reference to the liquidation of a corporation, it is clear from the fore- going section of the 1921 law that any distribution out of ** See Chapter XXXV, "Tax on Undistributed Profits of Corporations-" FROM DIVIDENDS 749 earnings accumulated since March i, 1913, is a dividend. If not clear in subsection (c), there is nothing ambiguous in subsection (a) which provides that the term dividend "means any distribution made in cash or in other property, out of its* earnings or profits accumulated since February 28, 1913." It is probable that the narrow construction placed by the Treas- ury upon section 201 (c) of the 1918 law is responsible for the change. That section was construed to mean that the credit for normal tax could not be taken in distributions in liquida- tion.''^ In the author's opinion the 1918 law did not so state and there certainly was no intention to deprive stockholders of the credit. Distributions which are dividends. — As heretofore stated, dividends include any distribution out of earnings accumu- lated since March i, 19 13. There is not a word in any section of the law^ w^hich contradicts this statement in section 201 (a). A distribution may be final or partial. The section contem- plates final distributions in its reference to distributions in property other than cash. Regulation. Where a corporation distributes all of its property in complete liquidation or dissolution, the gain realized by the stock- holder from the transaction, computed under section 202, is taxable as a dividend to the extent that it is paid out of earnings or profits of the corporation accumulated since February- 28, 1913. If the amount received by the stockholder in liquidation is less than the cost or other basis of the stock, a deductible loss is sustained. (Art. 1545.) Therefore, the right to credit the normal tax is perfectly clear. In computing excess profits tax in 191 7 the Treasury held that liquidation dividends were dividends, and could be "credi- ted" as ordinary dividends. Taxable status of liquidation dividends. — The term "dividend" as used in section 201 (a) may be limited to dis- "' See page 75 1- y^(y INCOME trilnitious made from earnings accumnlated since February ->>, ^913- Corporations have [)ai(l the normal tax on these earnings. Stockholders are liable for the surtax. • Distributions which are not dividends. — In view of the hmitation on the term "dividend" in section 201 (a), it is obvious that all distributions, otherwise. than out of earnings accumulated since March i, 191 3, are returns of capital, either taxable or not taxable according to their nature. Regulation. Any distribution made by a corporation to its stock- holders otherwise than out of (i) earnings or profits accumulated since February 28, 1913, or (2) earnings or profits accumulated or increase in value of property accrued prior to March i, 1913, is not a dividend and is not taxable to the recipient. Any such distribution, however, shall be applied against and reduce the cost, or other basis, of the stock upon which declared, for the purpose of determining the gain or loss from the subsequent sale of the stock. Example. — A purchased certain stock in 1915 for $10,000 and re- ceived in 1921 a distribution thereon of $2,000 paid by the corporation otherwise than out of its earnings or profits or the increase in value of property accrued prior to March i, 1913. This distribution does not constitute taxable income to A. If A subsequently sells the stock the difference between the amount realized therefor and $8,000 is taxable gain or deductible loss, as the case may be. (Art. 1544.) The foregoing regulation properly intimates that distribu- tions out of earnings accumulated since March i, 191 3, are dividends. It also intimates that distributions out of earnings or increase in value of property accrued prior to March i, 1913, may be dividends. As the latter distributions are not taxable in any event, it should be immaterial how they are designated. *^- The stipulation that distributions which are not dividends shall be applied to reduce the cost, or March i, 1913, value, of the stock upon which declared is proper. It is equivalent to stat- ing that such cost or value shall be reduced by the receipt of any distribution of capital which the corporation may make. Taxable status of distributions which are not divi- dends. — Naturally any distributions of capitak are free from It does make a difference, however. See page 748. FROM DIVIDENDS 751 normal or surtaxes, unless and until there is a taxable net gain, in which case the gain is taxable as any other net gain, viz., if the stock is held for more than two years the maximum tax is I2J/2 per cent;"^ if held for less than two years the gain is sub- ject to the full surtax rates. Under the 19 18 law it was the duty of the directors to dis- tribute the assets in such a way that all earnings subsequent to March i, 1913, should first be distributed formally as divi- dends. Distributions of surplus and appreciation at March I, 19 1 3. should first have been made and finally the capital returned. The last noted distribution was taxable or not tax- able under section 201 (c) and article 1544. Liquidating dividends under the 1918 law. — The 19 18 law contained this specific provision : Law. Section 201. . . . . (c) Amounts distributed in the liqui- dation of a corporation shall be treated as payments in exchange for stock or shares and any gain or profit realized thereby shall be taxed to the distributee as other gains or losses It was a new provision and was intended to set up an equitable basis for the taxation of distributions in liquidation. It was not intended as a substitute for the sections which governed the distributions of earnings accumulated since March I, 19 1 3. It was not intended as a penalty clause nor as im- posing double taxation. The Treasury, however, construed it as an inclusive pronouncement that in connection with the liquidation of a corporation there could be no such thing as a dividend. The position was not justified by the language of the law; on the contrary it was inconsistent with the clear meaning of several other sections. In its administration there were difficulties which were caused by the unwarranted con- struction placed upon section 201 (c) rather than by the facts. Regulation. So-called liquidation or dissolution dividends are not dividends within the meaning of the statute, and amounts so dis- tributed, whether or not including any surplus earned since February "' See page 627. ;7-2 INCOME 28, 1913, are to be regarded as payments for the stock of the dis- solved corporation. Any excess so received over the cost of his stock to the stockholder, or over its fair market value as of March i, 1913, if acquired prior thereto, is a taxable profit. A distribution in liquidation of the assets and business of a corporation, which is a return to the stockholder of the value of his stock upon a surrender of his interest in the corporation, is distinguishable from a dividend paid by a going corporation out of current earnings or accumulated surplus when declared by the directors in their discretion, which is in the nature of a recurrent return upon the stock. (Reg. 45, Art. 1548.) The following" case is typical of an average dissolution. Usual!}' there are several distributions. Ruling. In May, -1917, a corporation declared a dividend out of surplus profits earned during the three years immediately pre- ceding, a distribution being made accordingly in 1917. In July of the same year, at a meeting of the board of directors, a sale of the real estate owned by the company was authorized and in February, 1918, the stockholders agreed that the capital stock should be re- turned to them according to the number of shares they held on that date and that all other assets of the corporation be distributed and paid as dividends. Held, that the dividends received in 1917 should be treated as a distribution of earnings or profits accumulated subsequent to March I, 1913, and subject to tax in the hands of the stockholders as pro- vided in section 31 of the Revenue Act of 1917, but that the entire amounts distributed as a single and final dividend in 1918, including both capital and surplus, should be treated as the proceeds of a liqui- dation. (B. Digest 47-20-1309;' A. R. M. 93.) As a matter of fact, the distribution in May, 19 17, was just as much part of a final distribution as that made in Feb- ruarv. 1918. The law reads "amounts distributed in the liquid- ation." Surely the distribution in May, 1917, was "in" (not out) of the distribution. In the following ruling the Treasury apparently reversed its position that a liquidating dividend was to be applied against the cost of the stock and any excess would be subject to both normal and surtax. Only the "return of capital" is applied against the cost. Ruling. Each and every distribution made by the corporation to its stockholders during the taxable vear will be deemed to have FROM DIVIDENDS 753 been made from earnings or profits of tlie corporation to the extent that the corporation had such earnings and profits on hand at the time the distribution was made. Any distribution in excess of the earnings and profits of the corporation on hand at the date of distribution represents a return of capital to the stockholders, and if such return of capital added to any amounts of capital previously returned to the stockholders does not equal the cost to them of their stock it will not be subject to either the normal tax or surtax in their hands. If at the time of any distribution the stockholders had received a return of capital in an amount equal to the cost of their stock, the entire amount distributed to them in excess of the earnings and profits of the corporation on hand at the date of distribution represents taxable in- come to them subject to both normal tax and surtax at the rates for the taxable year. In case of the subsequent liquidation of the corporation or the sale by the stockholders of their stock upon which they have had any return of capital, the amount so returned to them must be added to the amount received in liquidation or to the selling price, as the case may be, for the purpose of determining the gain or loss arising to them from the transaction. (C. B. 4, page 44; O. D. 9550 In a subsequent ruling (Bulletin 36-21-1797; Sol. Op. 115) the Treasur}' returned to its former position of subjecting liquidating dividends to both normal and surtax. Liquidating dividends under 1917 and prior laws. — As the 1918 law is the only one which contains any reference to dis- tributions in liquidation, as distinguished from any other kind of distribution, we are compelled tmder the 191 3, 1916, 1917 laws, as well as under the 1921 law, to depend on the laws themselves for guidance. In the 191 7 law there was a clearly defined method prescribed for all ordinary and extraordinary dividends. °* When a corporation was dissolved and its assets were distributed, they were taxable as dividends or as gains, depending on circumstances. In the absence of special statutes, words must be given their usual significance. Therefore the use of the word "dividends" in 191 7 and prior laws included dividends in dissolution or liquidation as well as ordinary dividends. °* For dividends allocated to and taxed at the rates in force in prior years, see Income Tax Procedure, 1918, pages 136, 145. 754 INCOME The Supreme Court of the United States passed upon this very point in two decisions handed down the same day. The cases are Lynch v. Turrish^^ and Lynch v. Hornby, ^^ decided June 3, 1918. In the Turrish case the court held that a divi- dend in dissolution was not taxable; and in the Hornby case the court decided that a dividend was taxable. In both cases the dividends were from earnings or gains accumulated prior to March i, 1913. In the Turrish case, even though there was a final and complete distribution, the court always referred to the distribution as a dividend. The Commissioner assessed the tax on the theory that it was "a dividend received from a domestic corporation" and taxable as an ordinary dividend. The court held that no taxable income arose from the receipt of the dividend. Reference w^as made to the fact that a stockholder has no title to the property of a corporation "prior to a dividend being declared." It is obvious that prior to the enactment of the 1918 law- no one questioned the fact that a dividend in liquidation was a "dividend." There were serious questions regarding the taxable status of values at March i, 19 13, and the position of stockholders w^io purchase at a high price and who might pay excessive taxes upon a dividend in partial liquidation. But these questions never arose regarding the distribution of earn- ings accumulated since March i, 19 13. In the case of new stockholders who pay excessive taxes on partial liquidations, because they are deemed to be ordinary dividends, the United States Supreme Court in the case of United States v. Phellis'^^ said : Decision. The possibility of occasional instances of apparent hardship in the incidence of the tax may be conceded. Where, as in this case, the dividend constitutes a distribution of profits accumulated during an extended period and bears a large proportion to the par value of the stock, if an investor happened to buy stock shortly before the dividend, paying a price enhanced by an estimate of the capital "247 U. S. 219. "247 U. S. 338. "^ Advance opinions, 66 L. Ed. 69. FROM DIVIDENDS 755 plus the surplus of llic company, and after distribution of llic surplus, with corresponding reduction in the intrinsic and market value of the shares, he were called upon to pay a tax upon the dividend received, it might look in his case like a tax upon his capital. But it is only apparently so. In buying at a price that reflected the accumulated profits, he of course acquired as a part of the valuable rights pur- chased the prospect of a dividend from the accumulations — bought "dividend on," as the phrase goes — and necessarily took subject to the burden of the income tax proper to be assessed against him by reason of the dividend if and when made. He simply stepped into the shoes in this as in other respects of the stockholder whose shares he ac- quired, and presumably the prospect of a dividend influenced the price paid, and was discounted by the prospect of an income tax to be paid thereon. In short, the question whether a dividend made out of company profits constitutes income of the stockholder is not affected by antecedent transfers of the stock from hand to hand. Under section 202 (c) and (e)"^ of the 1921 law, there is no doubt that upon a reduction in capital stock, or an ex- change of shares for shares and cash in a "reorganization," the cash is to be applied in reduction of the cost of the original shares. Deferred dividends and redemption of preferred stock. — Ruling. In 1919 a corporation paid three deferred dividends on its outstanding issue of first preferred stock and at the same time redeemed the entire issue of such stock at a premium of 12V2 per cent. It is stated that the dividends so paid were those due February I and August i, 1910, and February i, 1911; that the actual surplus necessary to pay them was accumulated prior to December 31, 1911; that there had not been any actual declaration of these dividends prior to 1919 for the, reason that the terms of issue of the stock prescribed when the dividends became due, the company merely having the privilege of deferring payment and that it was the understanding of the officers of the company that its surplus was held to pay past due dividends. The stock certificates contained a provision in accordance with which the deferred dividends were paid and the stock redeemed. The three deferred dividends will be considered to have been paid out of earnings and profits accumulated since February 28, 1913, as provided for in section 201 (a) and (b). Revenue Act of 1918, unless it can be shown that all earnings and profits accumulated since that date were first distributed. If it can not be shown that See pages 535 and 592. 756 INCOME the earnings and profits accumulated since February 28, 1913, were first distributed, the distribution constitutes income to the recipient stockholders subject to additional tax at the graduated rates, but not to the normal tax. The payment in redemption of the stock was a distribution in part liquidation of the corporation within the meaning of section 201 (c), and not a dividend as defined in section 201 (a) of the act. The amount received by each stockholder in excess of the cost of his shares of stock to him or their fair market value as of March i, 1913, if acquired prior to that date, represented taxable income to him, subject to both normal and additional tax. (C. R. 2, page 29; O. D. 488.) The last paragraph of the foregoing ruling is probably ttn- sound under the 1918 law and would not be applicable under the 1 92 1 law. Assume a corporation has: Common stock $150,000 Preferred stock 100,000 Surplus (accumulated since March i, 1913) 80,000 In 192 1 the entire preferred stock was redeemed at a premium of 123/4 per cent. The charge to surplus would be $12,500, as distribution from "earnings or profits accumulated since February 28, 1913"; thus coming within the definition of a "dividend"'''' which is exempt from normal tax. Dividends of uncertain character. — Corporate officers should ascertain the exact status of funds from which divi- dends are paid before sending out dividend cheques. Vague statements as to the source of funds are confusing to the recipients and lay the corporation open to just criticism for not finding out in advance whether or not the dividend is taxable. One dividend notice read : • Of the $1,600,000 which we declared January 10, 1919, as accu- mulated dividends on the second preferred stock, $427,347.18, or 26.7 per cent of the total, was out of 1918 earnings, and the balance, $1,172,652.82, or 73.3 per cent, out of the earnings of 1917. Section 201 (b). See page 716. FROM DIVIDENDS . 757 Such a wording puts a stockholder on notice that there may be a measure of non-taxability in the dividend. In the case cited the dividend would be fully taxable because it made no difference when the earnings were accumulated. There was no excuse for sending out such a misleading notice. Another notice sent out early in 1919 was as follows: Notice to stockholders: The federal income tax law provides that the term "dividends" as used in the law, means any distribution made by a corporation "out of its earnings or profits." All the distributions made by this company during the year 1918 are considered by the company to have been made not out of "earn- ings or profits," but out of capital, as the charges for depletion and depreciation for the year 1918, were in excess of the operating profits for the year. The company assumes no responsibility for the cor- rectness of this opinion. As the company which sent out the foregoing notice was a large one, it would have better served the interests of its stockholders if it had secured and included a good legal opinion, thus giving the stockholders something affirmative to work on, instead of scaring them by disclaiming all re- sponsibility. The notice should state whether the dividend is paid from: 1. Earnings accumulated since February 28, 19 13. 2. Earnings accumulated before March i, 19 13. 3. Appreciation at March i, 1913. 4. Capital (in reduction of capital stock). If from (i), the dividend is subject to surtax only; if from (2) or (3), or both, the dividend is "tax-free," but wull re- duce the cost or March i, 191 3, value in case of sale pf the shares at a loss. If from (4), the "dividend" is not subject to tax, but reduces the cost or March i, 1913, value of the shares in case of sale, whether a gain or a loss is made. Dividends on life insurance policies. — So-called dividends declared by life insurance companies on certain classes of un- 758 INCOME matured policies are in fact reductions of premiums and are not taxable. As a rule policyholders deduct the amounts of such so-called dividends from the premiums payable, but even if dividends are drawn in cash by the insured, such items, unless received on paid-up policies, do not constitute taxable income and should be excluded from returns. Regulation Distributions on paid-up policies which are made out of earnings of the insurance company subject to tax are in the nature of corporate dividends and are income of an individual only for the purpose of the surtax. (Art. 47.) Dividends on tontine policies. — Ruling. A taxpayer took out an insurance policy on the tontine plan in 1902 and in 1917 received the total accumulated dividends. The face value of the policy will be paid to him in 1922, if living. Held, that the amount received in 191 7 was not required to be reported as income for that year. The excess of the amount received at maturity of the policy plus all dividends received thereon, over the total premiums paid prior to March i, 1913, or the cash surrender value of the policy as of that date, whichever is greater, plus the premiums paid subsequent to March i, 1913, will represent taxable income to be reported for the year in which received for both normal and additional tax purposes. (C. B. 2, page 85; O. D. 490.) So-called dividends which are in fact refunds are not tax- able. — The word "dividend" is often carelessly used. There- fore, the recipient of a dividend (or what purports to be a dividend) from an unusual source should ascertain the source from which it is derived before returning it for taxation. The income tax is not imposed on refunds which are merely repayments of excessive prices paid for goods purchased, etc. Regulation rebates made to purchasers, whether or not members of the association, in proportion to their purchases may be excluded from gross income in computing the net income subject to tax. Any profits made from non-members and distributed to mem- bers in the guise of rebates are, of course, subject to tax. (Reg. 45, Art. 522.) Premiums received from a corporation on its capital stock are equivalent of dividends. — Many issues of preferred stocks FROM DIVIDENDS 759 contain provisions compelling the retirement or purchase there- of by the issuing corporations at substantial premiums above par value. When corporations acquire shares of their capital stock in this manner the payments must be charged to surplus and cannot be treated as allowable deductions. The payments are clearly distributions of surplus or profits''" and the normal income tax having been paid thereon by the corporations, the stockholders are not required again to pay the normal tax. In reporting premiums for income tax purposes stock- holders should enter the amounts precisely as if a dividend had been received. If the earned surplus were not sufficient to pay the premiums, and the funds were derived from capital surplus or from gifts to the corporation by holders of common stock, the recipients could not claim credit for the normal tax. In the absence of advices to the contrary it may be assumed that the premiums represent a distribution of earnings. Corpora- tions which have no surplus are rarely able to carry out the redemption provisions of a preferred stock issue. Under the 192 1 law such distributions are clearly divi- dends.^^ Dividends in kind. — Article 1570 states that when a part- nership distributes its assets in kind and not in cash, the part- ner realizes no gain or loss until he disposes of the property. No mention is made of "dividends in kind" by corporations.'' A dividend in kind, generally speaking, means a distribu- tion of taxable assets which cannot readily be turned into money, or which the stockholders or directors do not desire to turn into money. A stock dividend is not a dividend in kind. When a cor- poration distributes to its stockholders the stock of another " The term "dividend" means any distribution made bj- a corpora- tion out of its earnings or profits. [1921 law, section 201 (a).] '' C. B. 2, page 29; O. D. 488. See page 755. "[Former Procedure] Art. 1566, Reg. 45 (April 17, 1919 edition), provided for distributions in kind by corporations but the provision was eliminated by T. D. 2924 (September 26, 1919). -r,0 INCOME company it is a dividend in kind. If the stock so distributed has a fair market value the dividend is taxable. If it does not have a fair market value it is not taxable until realized. There ha\c been some so-called distributions in kind which should be held to be taxable. A corporation sells its capital assets for cash, invests the proceeds in marketable securities and divides the securities among its stockholders. This is simply a dividend payable in securities and is taxable,'' even though, technically, it is a dividend in kind. A corporation buys a plot of land and holds it for some years. No sales are made and no fair market price is ascer- tainable. The corporation dissolves and conveys the land pro rata to its stockholders. This is a distribution in kind and no tax can be imposed until the stockholders dispose of their holdings, in whole or in part. The foregoing illustrations are of clear cases — one im- mediately taxable and the other not. Between the two there are cases not so easy to decide. Whether or not the dividend is presently taxable depends largely on two factors : ( i ) When were the assets divided in kind acquired? (2) Is there any fair market value for the assets distributed? Dividends Received by Corporations The 192 1 law has two new features in respect of dividends received by corporation. Law. Section 234. (a) That in computing the net income .... there shall be allowed as deductions (6) The amount received as dividends (a) from a domestic cor- poration other than a corporation entitled to the benefits of section 262, or (b) from any foreign corporation when it is shown to the sat- isfaction of the Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such part of such period as the foreign corpora- " See page 734- FROM DIVIDENDS 761 tion has been in existence) was derived from sources within the United States as determined under section 217; . . . . It imposes no tax on dividends received by one corporation from another corporation unless r<^ceived from (a) A domestic corporation receiving most of its in- come from within a possession of the United States. (b) A foreign corporation deriving 50 per cent or more of its income from without the United States under certain conditions/'* Dividends other than (a) and (b) arc to be inchided in gross income, but the full amount may be deducted in ascer- taining net income. It is now recognized that it is not equitable to impose tax on dividends received by a corporation, because the normal tax has already been paid on the earnings so distributed. Fur- thermore, when a corporation, which has received dividends, in turn pays out its own net income in dividends, the recipients (if individuals) are subject to the surtax. Therefore, any income tax assessed against dividends received by corpora- tions is double taxation. The 1913, 1916 and 19 17 laws all imposed expressly or by implication full or partial income taxes upon dividends received by corporations, but the 19 18 law' granted full credit for dividends received in determining the taxes payable by the receiving corporation.^'^ The 1 92 1 law has placed a limitation on the full credit [section 234 (a-6)]. Dividends (received by corporations) which are not tax- able. — Under the 191 6, 191 7, 1918 and 1921 laws, dividends payable out of surplus accrued prior to March i, 191 3, are not taxable. This provision applies to corporations as well as to individuals.^*^ "Section 234 (a-6). See page 760. " [Former Procedure] For regulations and procedure under former laws see Income lax Procedure, 1919, pages 344-347. " Section 201 (a). 762 INCOME Under the 191 3 law, the Supreme Court has held that dividends received prior to December 31, 191 5, are taxable even though paid out of surplus accrued prior to March i. 1913," but in a ruling case an exception was made to the rule/* The departure from the rule was justified by the court on the ground that the holding company was in actual possession and control of the funds represented by dividends prior to March i, 191 3, and that the declaration of the divi- dends after March i, 1913, merely resulted in bookkeeping entries, there being no transfer of cash or property nor in fact any change in actual status. As stated by the court, "the payment was only constructive." In a later case'^ the Supreme Court again decided that a dividend paid out of surplus accrued prior to March i, 1913, was not taxable, on the ground "that the transaction should be regarded as bookkeeping rather than as dividends declared and paid in the ordinary course by a corporation." A holding company acquired all of the stock of a sub- sidiary. The subsidiary then paid its entire surplus to the holding company as a dividend. The Treasury held : Ruling. A cash dividend paid in 1916 by a subsidiary to parent corporation, its sole stockholder, is taxable under the Revenue Act of 1916 to the extent that such dividend was paid from surplus earned after March i, 1913 (1916 law only). (C. B. i, page 19; T. B. R. 45.) "Lynch v. Hornby, 247 U. S. 338 (June, 191H,). '"Southern Pacific Company v. Lowe, 247 U. S. 330 (June, 1918). ''Gulf Oil Corporation v. LeivcUxn, 248 U. S. 71 (December 9, 1918). See also Park v. Gilligan, U. S. Dist. Ct., So. Dist. of Ohio, West. Div., Juno II, 1921 (1916 Act). CHAPTER XXIII INCOME FROM STOCK DIVIDENDS The Supreme Court of the United States has decided that stock dividends are not taxable as income/ There are those who still believe that a benefit accrues to the recipient of a stock dividend. Such people show an utter disregard of the market quotations for stocks before and after stock dividends are declared. In most cases the old shares freely sell higher than the new shares, including the dividend. However, the feeling exists that some sort of a legal tax should be imposed and corporations are on notice that what could not be done directly may be done indirectly. In at least two states stock dividends have been held to be taxable income." Since imposition of the federal income tax in 19 13, the author has consistently taken the position that the Supreme Court would decide that the declaration of a stock dividend could not be treated as a distribution of income. Those who are interested in the various laws, regulations, rulings and court decisions which preceded the handing down of the de- cision in the Alacoiuber case in 1920 will find them discussed in detail in Income Tax Procedure, \c)iy to 1920, both in- clusive. Procedure of current interest includes the definition of a stock dividend, the computation of gain or loss upon the sale of the old or new stock and the method employed in obtaining credit for or refund of the tax collected before the final decision. ' Eisner v. Macomber, 252 U. S. 189, 40 S. Ct. 189, 64 L. Ed. 521, March 8, 1920. For full text of decision of court and minority opinion, see Cor- jjoration Trust Company 1920 Income Tax Service, pages 468-487. 'State ex rel. Dulaney v. Nygaard, 183 N. W. 884 (Wise.) ; Tax Com- missioner V. Putnam, 2.2r/ jVlass. 522; 116 N. E. 904; L. R. A. 1917 F. 806. 763 J 764 INCOME What Is a Stock Dividend? A stock dividend is a dividend declared by a corporation payable in stock of the same corporation. Uncertainty regard- ing stock dividends still exists.^ Some confuse a stock divi- dend with a dividend payable in the stock of another cor- poration. Some hold that a dividend on common stock pay- able in preferred stock is not a true stock dividend. The former view is clearly erroneous. The latter view has some merit; but the author is of the opinion that a dividend payable in any class of stock of the same corporation is not taxable. The principal change in the 1921 law regarding stock divi- dends is the addition of the following: Law. Section 201 (d) A stock dividend shall not be subject to tax but if after the distribution of any such dividend the corporation proceeds to cancel or redeem its stock at such time and in such manner as to make the distribution and cancellation or re- demption essentially equivalent to the distribution of a taxable dividend, the amount received in redem.ption or cancellation of the stock shall be treated as a taxable dividend to the extent of the earnings or profits accumulated by such corporation after February 28, 1913 The foregoing new section is reasonable. It would be unfortunate if a tax-exempt distribution, the equivalent of cash, could be made indirectly, whereas a direct distribution would be taxable. In providing that the proceeds of redemp- tion of stock dividends shall be treated as dividends instead of as the proceeds of sales of stock, the law now recognizes the principle that the proceeds of the sale or redemption of stock dividends are free from the normal tax,* to the extent that the dividend represents a charge against surplus accrued since February 28, 19 13. The methods of issuing stock dividends have been de- scribed by the Treasury as follows : * See hearings before the Committee on Ways and Means, House of Representatives, March 18 and 19, 1920, page 38 et seq. The question as to whether a stock dividend can legally be declared in the state of Missouri has been decided in the affirmative. (C. B. 4, page 24; O. D. 887.) " See page 770. FROM STOCK DIVIDENDS 765 Definition o£ stock dividend. — RuL'iNG I. Where a corporation, being authorized so to do by the laws of the State in which it is incorporated, transfers a portion of its surpkis to capital account, issues new stock repre- senting the amount of the surplus so transferred, and distributes the stock so issued to its stockholders, such stock is not income to the stockholders and the stockholders incur no liability for income tax by reason of its receipt. Cash dividend with option or agreement to buy stock. — 2. Where a corporation, being thereunto lawfully authorized, increases its capital stock, and simultaneously declares a cash divi- dend equal in amount to the increase in its capital stock, and gives to its stockholders a real option either to keep the money for their own or to reinvest it in the new shares, such dividend is a cash divi- dend and is income to the stockholders whether they reinvest it in the new shares or not. 3. Where a corporation, which is not permitted under the laws of the State in which it is incorporated to issue a stock dividend, increases its capital stock and at the same time declares a cash divi- dend under an agreement with the stockholders to reinvest the money so received in the new issue of capital stock, such dividend is subject to tax as income to the stockholder. (C. B. 3, page 38; T. D. 3052.) The foregoing ruling is not sustained by the following" : Decision.^ The sole question in this case is whether the dividend received by the defendant from the Gulf Oil Corporation in 1913, constituted taxable income within the meaning of the Act of Congress. If it be a stock dividend, then the plaintiff cannot recover, for the Supreme Court in Towne vs. Eisner, 245 U. S. 424, has held that a dividend received by the stockholder in shares of stock of the cor- poration, was not income within the meaning of the Act of 1913. It is clear that if the resolution declaring the dividend in question, had provided for the payment of the dividend in stock, the dividend would not have been taxable. It is also clear that the defendant received pay- ment of the dividend in shares of stock, and that he did this pursuant to an agreement made prior to the declaration of the dividend, which agreement was communicated to the corporation before that declaration was made. It is clear that out of 112,080 shares, the hold- ers of all but 1740 shares actually accepted payment of the dividend in stock, and that the money to pay cash to the holders of said 1,740 ° Lezvellyn, Collector v. Mellon, U. S. District Court, Western District of Pa. (July 13, 1921) (1913 Act). 766 INCOME shares was provided by T. Mellon & Sons pursuant to an agreement made before the declaration of the dividend, that they would take and pay for any such shares as the holders might refuse to accept as pay- ment therefor. After the transaction, the defendant had two shares to represent the interest in the same property, which prior thereto was represented by one. After the transaction, there were twice as many shares of the corporation in the hands of stockholders as there were before. The corporate assets had not been diminished by the transac- tion. Therefore, for two shares which defendant possessed at the close, there was for him the same value as for one share represented at the beginning In every view of the transaction, we find that its substance is clear. In cases like the present, substance is con- trolling, and not form. The courts look through all forms of corporate transactions, and have regard to the substance. Southern Pacific Co. vs. Lowe, 247 U. S. 330; Gulf Oil Corporation vs. Lewelly-n, 248 U. S. 71 ... . the Government urged upon the Court the necessity of observing the form, not in so many words but by their brief filed. They insist that the dividend was a cash dividend, because the resolu- tion of the Board so stated. By implication, therefore, they would place the defendant in the position of having the right to use the check of thq corporation, which as a matter of fact, never came into his hands, and w'hich as a matter of fact, must have been drawn against "no funds," notwithstanding his agreement wnth his associates and with T. Mellon & Sons, and notwithstanding the important fact that without such agreements the resolution of the Board would never have been passed. That the Board would never have passed such resolution if there had been no such agreement, seems clear, not only from the testimony of the witnesses to that effect, but from other facts which appear in evidence, as, for instance, the absence of sufficient money and the limited credit possessed by the corporation, whose obligations to banks were given high standing by the endorsement of some of the very men who entered into the said agreement. In every aspect of this case, the defendant was not in the position where he was merely entitled to carry out his agreement, but he was bound to do so. The dividend in question seems to be a final step in a series of transac- tions having for their object the refinancing of the corporation, and was based upon earnings and accumulations by subsidiary companies through a period of years. The foregoing decision, if maintained by the higher courts, would seem to make the following ruling illegal : Stock dividends declared by national banks, — Ruling. In view of the fact that national banks are authorized by law to issue only cash dividends (see "Instructions of the Comp- FROM STOCK DIVIDENDS 767 troller of the Currency Relative to the Organization and Powers of National Banks" for 1919, p. 56) such dividends, coupled with the right to apply same to the purchase of an increase in capital stock, are not within the decision of the Supreme Court in the Eisner v. Macomber case and are taxable income to the stockholder for surtax purposes. (C. B. 3, page 24; O. D. 588.) When a national bank issues to its stockholders cheques which are supposed to be used in payment for new stock but are negotiable, so that a stockholder not wishing to purchase the new stock can freely divert the dividend to any other pur- pose, the dividend cannot be called a stock dividend. But if on each cheque were the words "stock dividend," and if most of the stockholders, pursuant to a general agreement, turned back the cheques in payment for new stock, it is probable that the courts will look through the form and find the substance to be a stock dividend. If the bank were to issue non-negotiable cheques, with conditions stated to the effect that the only pos- sible use to be made of them would be to return them in ex- change for shares of new stock without power of assignment or hypothecation, it may be assumed that the courts will hold this to be a stock dividend, on the ground that the national bank act did not intend that a bank should be deprived of privileges possessed by other corporations. On the other hand, a national bank receives from the government broad privileges, and an unusual supervision is maintained over its affairs, and it may not be feasible for a national bank to pay a dividend which would be held to be the equivalent of a stock dividend. Stock dividend from surplus accumulated prior to March I, 1913.— Ruling 4. Where a corporation, having a surplus accu- mulated in part prior to March i, 1913, and being thereunto lawfully authorized, transfers to its capital account a portion of its surplus, issues new stock representing the amount so transferred to the capital account and then declares a dividend payable in part in cash and in part in shares of the new issue of stock, that portion of the dividend 768 INCOME paid in cash will, to the amount of the surplus accumulated since March i, 1913, be deemed to have been paid out of such surplus, and be subject to tax, but the portion of the dividend paid in stock will not be subject to tax as income (C. B. 3, page 38; T. D. 3052.) The Supreme Court has held that a stock dividend is not a distribution. Therefore, the cash dividend would be applied to the earnings accumulated after March i, 19 13. In other words, capitalizing surplus by means of a stock dividend will not serve to render cash dividends tax-free unless and until the surplus accumulated since March i, 191 3, has been dis- tributed in cash. Stock dividend in preferred stock. — A dividend in pre- ferred stock is held not to be taxable," because the amount thereof is transferred from surplus to capital, and as each existing stockholder receives a pro rata share of the new pre- ferred stock there is no change whatever in the evidences of interest in the corporation's net worth. Each stockholder has the same proportionate share after the dividend as before. If the charter or by-laws of a corporation permitted it to dis- tribute new stock to certain of its stockholders to the exclusion of others it could hardly be deemed to be a stock dividend. If there is an existing issue of preferred stock and addi- tional shares of preferred are issued to common stockholders as a dividend, the position of the common stockholders will be changed if the earnings are insufficient to pay the preferred stock dividend or in case of dissolution. Ruling. A stock dividend paid in true preferred stock is ex- empt from tax the same as though the dividend were paid in common stock; however, if the stock issued and distributed as a dividend ranks with or prior to the interest of general creditors with respect to the payment of either interest or principal), it can not be considered true preferred stock, and must be treated as income to the recipient. (C. B. 4, page 24; O. D. 801.) Art. 1548. See page 774. FROM STOCK DIVIDENDS 769 Stock dividends received from subsidiary companies. — When a subsidiary corporation declares a stock dividend, the holding corporation owning the majority of the stock of such subsidiary, if it has not theretofore taken up the surplus of the subsidiary, may set up on its books as an asset its interest (the percentage of its ownership of stock) in the surplus capitalized on the books of the subsidiary corporation for the purpose of the stock dividend. This should be done, however, only in case the subsidiary has earned, since the acquisition of owner- ship by the holding corporation, profits of an arnount which at least equals the amount of surplus so capitalized. In other words, if the holding company owned 93 per cent of the sub- sidiary, it would be justified in entering on its books the stock dividend at a value equal to 93 per cent of the amount of sur- plus transferred to the capital accouiit on the books of 'the subsidiary. The amount so transferred or capitalized is ordinarily, if not invariably, the par value of the stock issued as a dividend. It has been urged that the dividend may be set up ''at the same value as the cost per share of its original holdings in said subsidiary," but this is not correct. ■ Assuming that $100 per share, i.e., the par value, is regarded as the cost to the holding corporation, the statement quoted would produce the same re- sult as the above rule. This, however, would really be a mere coincidence. If the holding corporation has purchased con- trol for more or less than par, and if this value is so recorded on its books, such procedure would not produce the desired results. The holding corporation could of course declare a stock dividend on the amount that it credits to surplus on account of the value placed on the stock dividend received from the sub- sidiary. Dividend paid in stock of another corporation is not a stock dividend. — When a new corporation has been organized to take over certain properties of an old corporation and the 770 INCOME stock that the new corporation paid to the old for such proper- ties is distributed as a dividend to the stockholders of the old corporation, the dividend is held to be taxable and not a stock dividend/ Ruling 5- A dividend, paid in stock of another cor- poration held as a part of the assets of the corporation paying the dividend, is income to the stockholder at the time the same is made available for distribution to the full amount of the then market value of such stock (Peabody v. Eisner, 247 U. S. 347) ; and if such stock be subsequently sold by the stockholder, the difference between its market value at date of receipt and the price for which it is sold is additional income or loss to him, as the case may be (C. B. 3, page 38; T. D. 3052.) This ruling is sound. If the stock received does not have a fair market value, the equivalent of cash, no tax can be im- posed until sale is made. The proceeds of sale, when realized, are free from the normal tax. Section 216 of the law would appear to free dividends from the normal tax in any event, but the in- tention of the section is to apply the credit for the normal tax only up to the earnings or profits upon which income tax has been imposed.^ Computation of Profit or Loss on Sales of Stock Dividends or of Stock upon Which Such Dividends Were Declared Under the 1918 and prior laws, the Treasury treated the proceeds of sales of stocks and liquidation dividends as sales of property (stock) and failed to allow credit to stockholders for the normal tax which had been paid by corporations. If the Treasury's theory is correct, the carrying of a stock divi- dend for tw^o years now enables the holder to take advantage of the 123^ per cent tax on capital gains. The loss of the ' U. S. f. Phcllis, Supreme Court No. 260, October Term 1921, advance opinions, 66 L. Ed. 69. Also see cases cited on page 739. * Section 216 (a). See pages 347-350. I FROM STOCK DIVIDENDS 771 credit for normal tax is in every case of a substantial income far more than offset by freedom from surtax rates. The author, however, does not believe that the past prac- tice of the Treasury regarding dividends has been in accord with the laws.^ General rules for ascertaining cost. — Regulation. Stock issued by a corporation as a dividend does not constitute taxable income to a stockholder in such corporation, but gain may be derived or loss sustained by the stockholder from the sale of such stock. The amount of taxable gain derived or deductible loss sustained from the sale of such stock, or from the sale of the stock with respect to which it is issued, shall be determined as pro- vided in article 1561, after the cost, or both the cost and fair market value as of March i, 1913, if acquired prior thereto, of both the old and the new shares is determined in accordance with the following rules : When shares are of same character. — (i) Where the stock issued as a dividend is all of substantially the same character or preference as the stock upon which the stock dividend is paid, the cost of each share (or when acquired prior to March i, 1913, the fair market value as of such date) will be the quotient of the cost (or such fair market value) of the old shares of stock, divided by the total number of the old and new shares (Art. 1548. Reg. 45, Art. 1547.) Comments on regulations. — Proceeds of the sale of stock dividends declared out of the earnings accumulated since March i, 191 3, should be entered as dividends received up to the par value of the stock, in order to receive the benefit of the credit for the normal tax. The excess, if any, above par value, less the cost as ascertained by using the formula in the regu- lation, constitutes a profit and is taxable as such. If the profit is not sufficient to permit this method, one should enter the proceeds, up to the par value of the shares, as a dividend and claim credit as a realized loss for the dif- ference between cost and the total price realized, less the amount entered as a dividend. This works out as follows : ' See page 748. 772 INCOME Cost on July i, 1913 (new corporation) of 100 shares . . .- $10,000.00 Stock dividend, in 1921, 100 shares Total shares 200 Total cost (average cost per share $50) $10,000.00 In 1921 sell 100 shares for $10,000.00 Cost of 100 shares 5,000.00 Taxable profit $ 5,000.00 -As the corporation char^^ed the 1921 dividend to its sur- phis account and paid the normal income tax thereon as the earnings were reahzed during" 19 13 to 1921 and credited to surplus, the stockholder's holdings as to $50 per share on 200 shares or $100 per share on 100 shares are free from normal tax. Therefore the taxpayer would in this case enter the entire profit of $5,000 as a dividend received. Again : Cost on July i, 1913, of 100 shares $10,000.00 Stock dividend in 1921, 100 shares Total shares 200 Total cost (average cost per share $50) $10,000.00 In 1921 sold 200 shares for $12,000.00 Cost of 200 shares 10.000.00 Taxable profit $ 2,000.00 The corporation has paid the normal tax on $10,000. In order to secure the benefit thereof the taxpayer must enter in his 1 92 1 return a dividend^" of $10,000 and take credit for a loss of $8,000, thus accounting for realized net income of ^^ It is, of course, not a dividend in a technical sense, but the re- turns are not flexible enough to permit its entry in any other way. The transaction should be explained on the return. i FROM STOCK niVIDENDS 773 $2,000, which will be subject to the surtax. If the taxpayer were merely to return the $2,000 as a profit the entire credit for the normal tax paid on $10,000 would be lost. It is clear that the recipient of a stock dividend when being taxed on the proceeds thereof is entitled to the benefit of the normal tax which the corporation has already paid on the earnings since March i, 191 3. The new regulations con- form to this principle. This principle has been followed by the Treasury in deny- ing to taxpayers the right to treat dividends on preferred stocks as entitled to credit for the normal tax when the paying corporations have not been taxed on the net income from which the dividends are derived. ^'^ Ruling. In explanation of rule 2 contained in article 1547 [Regulations 45] 1- . . . ., the following example is given: The X Company, which has outstanding a certain number of shares of common stock of a market value of $90 per share, declares a 10 per cent stock dividend payable in preferred stock having a market value of $120 per share. A, who owns 100 shares of common stock having a market value of $9,000, receives 10 shares of pre- ferred stock which have a market value of $1,200, making the market value of his holdings on the date of the receipt of the dividend $10,200, of which 15/17 represents the value of the common stock and 2/17 the value of the preferred stock. If the common stock cost the shareholder $8,500 (or if it was acquired prior to March i, 1913, and had on that date a value of $8,500) such cost or value shall be apportioned to the common and the preferred stock in the ra- tio of 15 to 2. In other words 15/17 of $8,500, or $7,500, represents for the purpose of determining gain or loss the "cost" or the fair market value, as the case may be, of the 100 shares of common stock in respect to which the preferred stock was issued. The basis for determining the gain or loss arising from the sale of any share of such common stock will, therefore, be $75. Of the $8,500 representing the original cost of the 100 shares of common stock, or their market value as of March i, 1913, if they were acquired prior to that date, 2/17, or $1,000, will represent the "cost" of the 10 shares of preferred stock received as a dividend, the basis for deterrnining the gain or loss upon the sale of each share of such stock being $100. (C. B. 3, page 39; O. D. y^2.) "C. B. I, page 93; O. D. 3^«- '-'Art. 1548. 774 INCOME In tabulated form, this appears as follows : Market value Total market per share value loo common $ Qo "' $9,000 (a) 10 preferred 120 1,200 (b) $10,200 (c) Ratio of (a) to (c) = 15/17 X $8,500 = $7,500 = new cost of 100 common Ratio of (b) to (c) = 2/17 X $8,500 = $1,000 = new cost of 10 preferred When shares are of different character. — Regulation (2) Where the stock issued as a dividend is in whole or in part of a character or preference materially different from the stock upon which the stock dividend is paid, the cost (and when acquired prior to March i, 1913, the fair market value as of such date) of the old shares of stock shall be divided between such old stock and the new stock, in proportion, as nearly as may be, to the respective values of each class of stock, old and new, at the time the new shares of stock are issued, and the cost (or when acquired prior to March i, 1913, the fair market value as of such date) of each share of stock will be the quotient of the cost (or such fair market value as of March i, 1913) of the class to which such share belongs divided by the number ot snares m that class (Art. 1548. Reg. 45, Art. 1547.) Purchases at different times and different prices. — Regulation (3) Where the stock with respect to which a stock dividend is issued was purchased at different times and at dift'erent prices and the identity of the lots can not be determined, any sale of the original stock will be charged to the earliest purchases of such stock and aiiy sale of dividend stock issued with respect to such stock will be presumed to have been made from the stock issued with respect to the earliest purchased stock, to the amount of the dividend chargeable to such stock. (4) Where the stock with respect to which a stock dividend is declared was purchased at different times and at dift'erent prices, and the dividend stock issued with respect to such stock can not be identified as having been issued with respect to any particular lot of such stock, then any sale of such dividend stock will be presumed to have been made from the stock issued with respect to the earliest pur- chased stock, to the amount of the stock dividend chargeable to such stock. (Art. 1548.) "The market value of $90 is considered to be after the dividend is dis- tributed. FROM STOCK DIVIDENDS 775 The last paragraph (4), of the foregoing regulation was not in the old regulations/* When the dividend stock cannot be identified as issued to any particular purchase, it must now be allocated to the earliest purchased stock. Formerly, a tax- payer was permitted to "allocate, according to his wishes. "^^ The author has suggested in previous editions of this work that purchases should be averaged as such method accords with good accounting practice. It is easily computed and readily understood and in the long run produces the same amount of tax. If the average method is not used, the principle of alloca- tion to the earliest purchases has been stated in a recent case^^ as follows : Decision The law may, and in fact does, recognize an identity in every share, which can indeed be- traced upon the books of the company, at least until certificates are consolidated and later subdivided. The purchase of a number of shares can be earmarked by the certificate, and it is an enormous convenience to keep the pur- chase separate. Yet it is possible and consistent when new shares are declared to attribute them ratably in subdivision of those already issued. They are not so entered on the books, it is true, but the books are not kept in accordance with the underlying doctrine of Eisner v. Macomber, 252 U. S. 189, 40 S. Ct. 189, 64 L. Ed. 521, in any event. At least the earlier certificates need not lose their separate identity because new shares are filiated to them in proper proportion. An illustration will make clear what I mean. Suppose a man has certificate A, for 100 shares, bought at $100, certificate B, for 100, bought at $150, and certificate C, for 100, bought at $200. Suppose, further, that a stock dividend of 50 per cent is declared, and he gets one certificate D, for 150 shares, without paying anything. If he sells certificate A, he would be deemed to sell not the whole of his first purchase, but only two-thirds of it, and he could credit himself with only $6,666. If he sold certificate B, he would credit him- self with $10,000, and if certificate C with $13,333. If '''^ sold cer- tificate D, he could credit himself with $15,000, made up of $3,333 from his first purchase, $5,000 from his second, and $6,666 from his third. If, on the other hand, he sold only a part of certificate D, some arbitrary rule of apportionment must be adopted, allocating the "T. D. 3238 (October 22, 1921) added paragraph 4 to Art. 1547, Reg. 45. "C. B. 3, page 40; O. D. 735. ^' Toiviw V. McEUtfjott. U. S. District Court, Southern District of New York, 274 Fed. 960 (August 5, 1921). 776 INCOME shares sold among his purchasers. The most natural analogy is with payment upon an open account, where the law has always allocated the earlier payments to the earlier debte, in the absence of a contrary in- tention. Accordingly, if all the new shares were not sold at once, I think the first sales would be attributed to the first purchases still re- maining unsold when the stock dividend was declared. I do not see that this method will result in confusion in its application, and it carries into effect the underlying theory of Eisner v. Maconibcr. supra. The two illustrations given below show the procedure to be followed. Market Cost Value Purchased lo shares common @ $ioo $i,ooo $ 900(a) " 40 " " @ 80 3,200 3,6oo(b) " 30 " " @ 40 1,200 2,700(0) Total 80 $5,400 $7,200 10% Stock Dividend: " I share preferred $ 80(d) 4 " " 320(e) 3 " " 240(f) Total 8 $640 Ratio of (a) to (a) + (d) =: 900/980=91.8 Ratio of (b) to (b) -f (e) = 360/392=91.8 Ratio of (c) to (c) -f- (f) = 270/294=91.8 Per cent Total 91.8 X $1,000= cost apportioned to first 10 shares of common = 91.80 per share $ 918.00 91.8 X $3,200 = cost apportioned to second 40 shares of common ^= 73-44 per share 2,937.60 91.8 X $1,200 ^ cost apportioned t j third 30 shares of common = 36.72 per share 1,101.60 Total original cost $4,957.20 The above reveals that when sales are made from any one of the three lots shown a different cost is used for each lot. In contrast with this method is the use of an average, to which the Treasury objects, viz., 91.8 per cent of $5,400 (total cost as above) = $4,957.20 total new cost Total cost apportioned to old shares divided by number of old shares = $4,957.20 -^ 80 = 61.97 average cost of old share. The following computation illustrates the allocation of the cost between stock originally purchased and dividend stock of FROM STOCK DIVIDENDS yyy a different class when several different lots were purchased at different prices : When more than one stock dividend is received, and vari- ous purchases have been made, the effect of the receipt of each stock dividend is to reduce the proportion of the cost to be assigned to each share of the increased number of shares. Each lot of purchased stock will usually carry a different orig- inal cost, and sales are made gradually eliminating the earliest purchases. There is thus a continually changing l)asis on which to compute profit from sale. Statement of Acquisition of Stock and Cost No. of Shares Cost 1909 Purchased i.ooo $ 84,800.00 1910 Stock dividend 3354% ZZiVi Purchased zVz 495-75 Total (average $63.81 per share) .. . 1,336^ $85,295.75 1911 Deduct: Shares given to son, taken at $63.81 per share iG^i 1,063.50 Mar. I, 1913 Held at this date 1,320 $ 84,232.25 1914 Received as legacy, taken at market value at date of decedent's death 200 40,000.00 1917 ( I ) Stock dividend 5o7c 760 1918 Purchased 120 24,000.00 1919 (2) Stock dividend 25% 600 1920 (3) Stock dividend 40% 1.200 Totals 4.200 $148,232.25 Allocation of Stock Dividends to Earliest Purchases or Acqui- sitions TO Determine Profit on Subsequent Sale No. of Shares Cost Stock held at March i, 191 3, at market value at that date 1,320 $264,000.00 (1) 50% stock dividend received in 1917 (50% of 1,320) 660 (2) 25% stock dividend received in 1919 (25% of 1,980) 495 (3) 40% stock dividend received in 1920 (40% of 2,475) 990 3,465 at $76. 19 = $264,000.00 778 INCOME Stock received as a legacy in 1914 200 $ 50,000.00 (i) 50% stock dividend received in 191 7 (50% of 200) 100 (2) 25% stock dividend received in 1919 (257f of 300)... ;...._. 75 (3) 40% stock dividend received in 1920 (40% of 375) 150 525 at $95.24 = $ 50,000.00 Stock purchased in 1918 120 $ 24,000.00 (2) 25% stock dividend received in 1919 (25% of 120). 30 (3) 40% stock dividend received in 1920 (40% of 225) 60 210 at $1 14.29 = $ 24,000.00 Total shares owned at June 30, 1921 — as above 4,200 at $80.48 =^ $338,000.00 1921 Stock sold at 1,000 at $70.00= 70.000.00 Cost per share of shares owned at March i, 1913, after allocating stock dividends = $84,232.25 -^ 3.465 shares $ 24.31 Cost of 1,000 shares sold in 1921 $24,310.00 Value as at March i, 1913,'' of 1,000 shares sold in 1921 $76,190.00 Proceeds of 1,000 shares sold in 1921 $70,000.00 Since the sales price is less than value at March i, 1913. but more than cost, the taxpayer reports neither gain nor loss. In the ca.se of a sale of 1,000 shares received as stock divi- dend (par $100,000), the amount to be reported as dividend and also deducted on return so as to secure the benefit of the normal tax which has been paid by the corporation on the earnings transferred to capital account through issuance of stock dividends, is computed as follows : March i, 1913, shares owned 1,320 Dividend stock allocated to holdings at March i, 1913 2,145 Total shares in lot to which sale in 1921 is allocated 3465 Shares sold in 1921 (having par value of $100,000) 1,000 Portion of $100,000 representing proceeds of sale of stock divi- dends exempt from normal tax : 2,145 X $100,000 = $61,904.76 3,465 '== " See ruling (C. B. i, page 31; A. R. 6). J FROM STOCK DIVIDENDS ■/79 In order to secure the benefit of the credit for normal tax, the entire $61,904.76, when part of sale is original holdings and part is stock dividend, and, when wholly the proceeds of sale of stock dividend, should be entered as a dividend on one side and as a loss on the other side of the return. Dividends paid in scrip are stock dividends. — Ruling. A corporation declared a dividend payable in stock of the company at par. In making the distribution of fractions of shares scrip certificates were issued. In order to facilitate the disposal for the stockholders of their scrip, where they did not desire to purchase additional scrip to entitle them to a full share of new stock, the cor- poration sold in the open market as an agent of the stockholders the scrip certificates received for fractional shares of dividend stock. The sale was entirely optional with the stockholders. Held, that the scrip certificates received as a dividend do not repre- sent a cash dividend but a stock dividend and are not subject to tax. (C. B..4, page 24; O. D. 859.) Fractional shares must be used in ascertaining new cost. — When fractional sliares of stock are received as a dividend, they serve to reduce the average cost. Sometimes adjustments are made in cash on account of such fractional shares, the cash payment representing the market price of the stock, which may be more than par. In such cases the amount of the payment should be returned as the proceeds of a dividend up to par and adjustment should be made for the excess, depend- ing on cost of old stock or value at March i, 1913. Ruling. The resolution of the board of directors of a corporation, declaring a stock dividend, provided that no fractional shares of stock should be issued, but that all fractions of shares should be united into whole shares and sold by the treasurer and the proceeds thereof paid to the stockholders entitled thereto, such resolution hav- ing been approved by the stockholders. Held, that the stockholders by approving the action of the board of directors approved and, in fact, authorized the action of the treasurer^ in uniting and sell- ing the fractional shares and paying over the proceeds therefrom to those stockholders entitled to the fractional shares, and that those stockholders entitled to receive fractional shares, but who actually received cash representing their portion of the proceeds of the sale 78o INCOME of the fractional shares should compute the gain or loss thereon under the provisions of Treasury Decision 3059.^^ (C. B. 4, page 28; O. D. 781.) Stock dividends declared out of surplus created by a re- appraisal of or appreciation in assets. — There may be some justification for reappraising physical assets, but there can be no good excuse for issuing stock for goodwill unless it has been made the subject of sale. It is to be hoped that only few such instances occur. Any corporation which writes up the value of goodwill, credits the amount to surplus account, and out of such alleged .surplus declares a dividend, may expect to be charged with practicing a fraud on its stockholders and on anyone who afterwards acquires the stock. Goodwill when it appears on the balance sheet of a corporation or partnership is supposed to be carried at cost price or less, and any action which tends to obscure this inference may result in deception, even if there is no intention to deceive. Refund of Taxes Paid on Stock Dividends Ruling. A claim for credit on Form 47A for payment of tax on stock dividends is to be accepted as a suspension of immediate collection of tax due only — (i) Against income or income and excess-profits taxes due and unpaid. (2) If amount claimed as a credit does not exceed the amount of tax collected on the stock dividend less any additional tax due and unpaid upon the sale of stock received as a dividend or stock upon which the dividend was declared. (The basis of determining the gain or loss upon sale of stock is stated in Regulations 45, article 1547, paragraphs i and 2. That article provides that the cost of each share of stock is the quotient of the cost of the old stock divided by the number of old and new shares added together.) (3) When accompanied by an affidavit of the taxpayer (sup- ported by statements from the corporation which distributed the dividends as to the amount distributed to the taxpayer and years " C. B. 3, page 38. ". . . . that portion of the dividend paid in cash will, to the amount of the surplus accumulated since March i, 1913, be deemed to have been paid out of such surplus, and be subject to tax " FROM STOCK DIVIDENDS 781 in whicli the profits distributed were eanietl) covering the following information : (a) Whether the dividend consists of stock of the corporation distributing the dividend to the taxpayer, or of stock of another cor- poration acquired by the distributor. (b) The name of each corporation declaring, the declaration of, and the date of receipt by the taxpayer of, the stock dividends, the tax on which was paid and is covered by the claim. (c) The year in which the stock dividend was included in the taxpayer's return of income. (d) The number of shares the taxpayer received and the value placed upon the dividend in the return. (If no sale of stock was made, the taxpayer need not furnish the following information.) (e) If any sale has been made of stock of the corporation de- claring the dividends, whether the stock be that acquired by a divi- dend, or upon which the dividend was declared, state — (i) The number of shares sold. (2) The selling price. (3) The date or dates of sale. (4) The portion, if any, of the selling price included as taxable profit in the return of net income for the year the sale was made and the item in the return under which the amount was reported. (/) State how many shares of stock the taxpayer owned at the time he received the first stock dividend; how much that stock cost the taxpayer and the date the stock was acquired. (If acquired prior to March i, 1913, state its value on that date and manner of determining the value.) (g) State separately the dates from March i, 1913, upon which you received stock dividends, the number of shares received on each date, and the names of the corporations distributing the dividends. The receipt or canceled check covering the pa3'ment of tax involved in the claim should be attached to the claim. (C. B. 2, page 246; M. 2436.) Stock dividends on shares carried on margin with broker. — Ruling. A taxpayer in 19 18 carried on margin with a stock brokerage firm shares of stock in a certain corporation. As the stock was not owned outright by the taxpayer it was not registered in his name but in the name of the broker, together with other shares carried under similar conditions. Subsequently the corpora- tion paid a stock dividend to its recorded stockholders, of which the brokerage firm was one, and it in turn distributed the same pro- portionately to the marginal owners. For the purpose of making claim for credit or refund of the -82 INCOME taxes paid on these stock dividends, the taxpayer should accom- pany his claim with a statement from the paying corporation showing the number of shares of stock standing in the name of the brokerage firm, and the amount of stock dividends paid to such firm during the year 1918; also a statement, signed by the brokerage firm, indi- cating the number of shares of the corporation's stock which the firm carried for his account, and the amount of stock dividends turned over to him by the brokerage firm. (C. B. 3, page 308; O. D. 625.) Can recipient of stock dividend on which tax was paid re- fuse to accept refund of tax? — Taxpayers, who received stock dividends on which income tax has been assessed and collected and have since sold their stock, may have suffered a loss which they would not have incurred if Congress had not made such a mess of the whole subject of the taxation of stock dividends. It might be possible for anyone who has sold his stock to maintain this position : that having followed the law and the regulations, and having paid the tax assessed against him, he was justified in assuming that the matter was entirely closed. In other words, the government would be estopped from col- lecting a greater tax in such cases. If thereafter he sold the stock received as a dividend and reported the proceeds of sale in accordance with the law and the regulations, having paid the tax assessed upon him, he was again justified in assuming the matter was closed. If he is compelled to accept a refund of the tax paid on account of the dividend and amend his return on account of the sale, he may be assessed for a very large additional tax for which he would not have been liable except for the action of Congress.^" Does Stock Dividend Belong to Life Tenant or to Remainderman ? On the question whether a stock dividend goes to the life tenant as income or to the remainderman as capital, there are at least three rules. ■" The United States Supreme Court"^ and '* For further comment and illustration, see Income Tax Frocednre, 1920, pages 498-9. FROM STOCK DIVIDENDS 783 a minority of state courts give it to the remainderman. Among the states is Massachusetts,-^ although it holds the dividend taxable as intome. England gives the stock dividend to the life tenant if it is an ordinary dividend and to the remainder- man if it is an extraordinary one.-^ New York,"* Pennsyl- vania"'^' and several other states^** split it. What comes from corporate profits acquired subsequent to the creation of the trust goes to the life tenant. What comes from earlier ac- cumulations is kept for the remainderman. Retroactive Tax on Stock Dividends Mr. Wayne Johnson, Solicitor of Internal Revenue, testi- fying before the Committee on Ways and Means of the House of Representatives said : It has been decided by the Supreme Court in the Brushaber'-^ case that we could have an act retroactive in its features, and that has been done An excise tax. or any other tax, on tlie issue of stock based on capitalization of surplus, which would be equivalent in amount to the revenues which we have lost on account of the adverse stock dividend decision, would be perfectly valid Since the foregoing statement was made the 192 1 law has been enacted. It contains no provision for the imposition of an excise tax 011 stock dividends. It is therefore most unlikely that any further attempt wnll be made to impose a retroactive tax on stock dividends, to recoup the revenue lost by the gov- ernment by reason of the Supreme Court decision. *" "The Judicial Debate on the Taxability of Stock Dividends as In- come," by Thomas Reed Powell, Bulletin of the National Tax Association, May, 1920, page 247. '^Gibbons v. Mahon. 136 U. S. 549, 34 L. Ed. 525, 10 S. Ct. 1057. " Minot V. Paine, 99 Mass. loi. ^ See note on pages 801-802 to Brander v. Brandcr, 4 Ves. Jr. 800 (Am. Ed.) ; 31 Eng. Rep. 414. -* Matter of Osborne, 209 N. Y. 450, 50 L. R. A. (N. S.) 510, Am. Ann. Cas. 1915 A. 298, 52 N. Y. Supp. 48; affirmed, 166 App. Div. 547. ''Earp's Appeal, 28 Pa. St. 368. ^° See cases cited in Tax Commissioner v. Putnam, 227 Mass. 522, 532. ^ Brushabcr v. Union Pac. Ry. Co., 240 U. S. i, 36 S. Ct. 236, 60 L. Ed. 493. CHAPTER XXIV INCOME FROM PARTNERSHIPS, LIMITED PARTNERSHIPS AND PERSONAL SERVICE CORPORATIONS The T921 law made no change in the status of the part- nership under the income tax law/ Like the previous laws, the present one in effect ignores the partnership's existence as an independent entity and taxes the partners on the income from the business in substantially the same manner as though the income were received from an individual business enter- prise. What is a partnership under income tax law? — There are three classes of taxpayers upon which in all cases, or in specific cases, taxes are imposed upon what is known as a partnership basis. This simply means that the tax is not levied upon a group or an entity, but upon the individuals who com- pose the group. These groups are : 1. Common law partnerships 2. Limited partnerships of a certain type 3. Personal service corporations. - Under the federal income tax laws the treatment of the foregoing classes is not entirely uniform. Individual mem- bers of common law partnerships are uniformly taxed as in- dividuals. Members of limited partnerships may or may not be taxed as individuals. Stockholders of personal service cor- porations are supposed to be taxed as individuals, but the fed- eral income tax law lacks the power to change a corporation into a partnership and the attempt to do so has resulted in certain complications which are discussed hereafter. 'As in the case of the 1918 law, it relieves partnerships of the excess profits tax. -Only to December 31. 1921 ; after that date personal service corpora- tions are taxed as ordinary corporations. 784 I FROM PARTNERSHIPS 785 General ownership. — Ordinarily when two or more per- sons are associated together for the purpose of conducting a business for profit, they are deemed to constitute a partner- ship. The following article points out when certain rela- tionships do not constitute a partnership. Regulation. Joint investment in and ownersliip of real and personal property not used in the operation of any trade or business and not covered by any partnership agreement does not constitute a partnership. Co-owners of oil lands engaged in the joint enterprise of developing the property through a common agent are not neces- sarily partners. In the absence of special facts affirmatively showing an association or partnership, where a vessel is owned by several in- dividuals and operated by a managing owner or agent for the account of all, the relation does not constitute either a joint-stock association or a partnership. The participation of two United States corpora- tions in a joint enterprise or adventure does not constitute them partners. (Art. 1507.)^ A joint venture entered into by agreement between a United States corporation and an individual was held not to be a partnership.* When the net losses, if any, were to be borne by one of the parties, it was held that this one fact was insufficient to show that the agreement was not a partnership.^ Ruling. A taxpayer and several others were the subscribers to a syndicate agreement of which B was the manager, the purpose of which was the purchase of stock in a certain corporation. The articles state -that "nothing herein contained or otherwise shall con- stitute the parties hereto partners," and there is no evidence that a partnership was in fact established. The agreement further pro- vides that no subscriber shall be liable except to the extent of his in- dividual obligation. The legal and equitable title to the stock was in the subscribers, a fact inconsistent with the view that the syndicate was either a corporation or association. Nothing in the agreement indicates a trust relationship. .... The relation is called subscriber and manager and is anal- ogous to client and broker. The broker buys and sells the stock, realiz- ^ [Former Procedure] RuLiNf;. Article 150/", Regulations 45 (revised) applies to situations arising under both the Revenue Act of 1917 and the Revenue Act of 1918. (C. B. 2, page II ; O. D. 411.) ' C. B. I, ])agc 9; O. D. 96. °C. B. 2, page II ; S. 1361. 786 INCOME ing a profit or loss reflected in the client's account. The entrance of others into this relation as joint principals does not affect it. The re- lationship remains that of principal and agent. Held, that these agreements constituted the principals joint owners in a ioint venture. As such each is taxable in his individual capacity on income from that source. Each subscriber has an interest in the joint account of such a nature that a pro rata profit or loss inures to him on each completed transaction evidenced by a purchase and sale of stock at a higher or lower price as the case may be. Dividends upon the stock held by the syndicate should be reported in the taxpayer's return for the year in which the dividends were declared and collectible in the proportion which his interest bears to the total amount of stock held by the syndicate. The average cost to the syndicate can not be set up as a basis for establishing a loss to the taxpayer upon the termination of the agree- ment when he paid to the syndicate the excess of the purchase price over the market price on that day. The sale of his stock at the lower market price to a new syndicate at the termination of the first agreement would constitute a closed transaction reflecting a loss to the extent that such stock is not trans- ferred to him as his pro rata share of the new syndicate. (I-2-15; I. T. 1156.) The foregoing ruling" states that the net income of subscrib- ers is based upon closed transactions. These no doubt are sub- ject to deductions for expenses. It would seem necessary for the managers to render periodical reports to subscribers in order that the latter may return the aggregate net income for the taxable periods. Return of estimated profits on joint accounts. — Ruling. In case two distinct partnerships enter into a single venture under agreement to terminate in two years no part of profit to be distributable or drawings allowed during that period and any profit to be held intact until the latter part of 1919, the amount of profit realized and determinable each taxable year should be reported proportionately in the respective returns of the partnerships regard- less of the agreement. Individual members of each partnership are subject to tax upon their pro rata share of profit even though actual distribution is postponed until termination of the agreement. (C. B. I, page 174; O. D. 187.) The foregoing is sound only so far as there is an amount of "realized and determinable" profit before the end of the FROM PARTNERSHIPS 787 period. If it is a single venture there can hardly be a realized profit unless and until the venture as a whole is closed. The case is not analogous to the closing of books upon an inventory or accrual basis. Domestic partnerships. — The following regulation defines a domestic partnership : Regulation. A domestic .... partnership is one organized or created in the United States, including only the States, the Territo- ries of Alaska and Hawaii, and the District of Columbia, and a foreign .... partnership is one organized or created outside the United States as so defined The nationality or residence of members of a partnership does not affect its status. A partnership cre- ated by articles entered into in San Francisco between residents of the United States and residents of China is a domestic partnership. .... (Art. 1509.) The Treasury has also issued several rulings defining partnerships.® Ruling. A, and B, his wife, founded a hospital under an oral agreement that it was to be their joint business. The original invest- ment of approximately x dollars was contributed by B. The building for the enterprise is owned jointly by A and B and the balance of the property used in the business is owned by them equally. The profits arising from the enterprise over and above living expenses have been placed back in the business and the losses, if any, are charged to the enterprise. The powers and responsibilities are equally divided, each party having authority to draw checks, receive payments, and per- form similar acts. Neither party may dispose of his or her interest without the consent of the other. Since there is an equal sharing of the profits and losses, a com- munity of interest, a mutual agency between the parties to the agree- ment, and an intention to form a partnership, and since a wife may enter into a partnership with her husband in the particular State, the business conducted by A and B is held to be a partnership for the purpose of Federal taxation. (I-1-2; I. T. 1151.) Annual Returns by Partnerships Partnerships pay no income taxes as entities, but the part- ners are individually taxable on their distributive shares. See B. 40-21-1850; A. R. R. 629; and B. 33-21-1772; Sol. Op. 117. 788 INCOME Nevertheless, every partnership must, under the 1921 law" file an annual return giving the data necessary for the deter- mination of the distributive shares. Law. Section 224. That every partnership shall make a return for each taxable year, stating specifically the items of its gross in- come and the deductions allowed by this title, and shall include in the return the names and addresses of the individuals who would be entitled to share in the net income if distributed and the amount of the distributive share of each individual. The return shall be sworn to by any one of the partners. The return should be made on form 1065. (See Appendix.) The Commissioner has extended the time for filing partner- ship returns for 1921 until May 15, 1922.^ This extension does not apply to members of partnerships. It will be neces- sary for them to apply for an extension, unless a general exten- sion is authorized. Regulation. The return of a partnership shall state speci- fically (a) the items of its gross income enumerated in section 213 of the statute; (b) the deductions enumerated in section 214, other than the deduction provided in paragraph (11) of subdivision (a) of that section; (c) the amounts specified in subdivisions (a) and (b) of section 216 received by the partnership; (d) the amount of any income, war profits and excess profits taxes of the partnership paid during the taxable year to a foreign country or to any posses- sion of the United States, and the amount of any such taxes accrued but not paid during the taxable year; (e) the names and addresses of the individuals who would be entitled to share in the net income of tlie partnership if distributed; (/) the amount of the distributive share of such net income of each such individual; and (g) such other facts as are required by form 1065. (Art. 412.) Consolidated returns.'' — The 1918 law did not either per- mit or require partnerships to make consolidated returns with ' [Former Procedure] Before 1918 partnerships were required to file returns only upon special request of the Commissioner or collector. (Reg. 33, 1918, Art. 30.) Such requests were made in 1914, but none sub- sequently except that under the 1917 law returns were required from all partnerships as a basis for the assessment of excess profits tax. (Sec- tion 211.) The 1918 law required returns. * T. D. 3272, dated January 19, 1922. ° This subject is also discussed further in Appendi.x A, Chapter XIV, "Consolidated Returns of Affiliated Corporations." FROM PARTNERSHIPS 789 corporations the stock of which was owned by them. The 192 1 law, while not specifically permitting taxpayers to include partnerships in consolidated returns, authorizes the Commis- sioner to consolidate the accounts of two or more related busi- nesses of corporations or partnerships or individuals owned or controlled by the same interests. Law. Section 240 (d) .... in any case of two or more related trades or businesses (whether unincorporated or incorpo- rated and whether organized in the United States or not) owned or controlled directly or indirectly by the same interests, the Commissioner may consolidate the accounts of such related trades and businesses, in any proper case, for the purpose of making an accurate distribution or apportionment of gains, profits, income, deductions, or capital be- tween or among such related trades or businesses. Regulation This provision relates not to the payment of taxes, but to the determination of the true income of related trades or businesses and thus indirectly to the amount of taxes which may be due under Title II (income taxes) and Title III (excess profits taxes) of the statute. (Art. 637.) It would appear only equitable that the Commissioner should exercise the power conferred on him by section 240 (d) in every case where a consolidation of partnership accounts with other partnership or corporate accounts is necessary to obviate hardship which would otherwise be imposed on a partnership. Therefore, taxpayers should request the Com- missioner to exercise his power in those cases where it seems necessary to the imposition of only a fair tax on profits of partnerships having affiliations with corporations or other partnerships. ^° ^^ [Former Procedure] No provision whatever for consolidated re- turns, either of corporations or partnerships, appeared in either the 1913 or 1916 laws. In the administration of the 1917 law, the Treasury permitted consolidated returns by corporations for excess profits purposes but not for income tax purposes. The 1921 law confirms this administrative procedure as follows : Law. Section 1331. "(a) That Title II of the Revenue Act of 1917 shall be construed to impose the taxes therein mentioned upon the basis of consolidated returns of net income and invested capital in the case of domestic corporations and domestic partnerships that were affiliate(/ during the calendar year J 917. 790 INCOME Distributive shares of partners — taxability. — Regulations. Partnerships as such are not subject to taxa- tion under the statute, but are required to make returns of income. .... Individuals carrying on business in partnership are, however, taxable upon their distributive shares of the net income of such partnership, whether distributed or not, and are required to include such distributive shares in their returns. The net income of the partnership shall be computed in the same manner and on the same basis as the net income of an individual, except that the deduction of contributions or gifts is not permitted, as these are allowable deduc- tions to the respective partners in their individual returns. (Art. 331.) The distributive share of the net income of the partnership which a partner is required to include in his return is his proportionate share of the net income of the partnership, either (a) for the taxable year upon the basis of which the partner's net income is computed, or (b), if the partner's net income is computed upon the basis of a taxable year different from that upon the basis of which the net in- come of the partnership is computed, for the taxable year of the partnership ending within the taxable year upon the basis of which the partner's net income is computed. Amounts earned and distributed to a partner by a partnership after the end of its taxable year and before the end of his corresponding taxable year should be accounted for both by the partnership and by the partners in their returns for their next succeeding taxable years. Where the result of partnership operation is a net loss, the loss will be divisible by the partners in the same proportion as net income would have been "(b) For the purpose of this section a corporation or partnership was afiiliated with one or more corporations or partnerships (i) when such corporation or partnership owned directly or controlled through closely afifiliated interests or by a nominee or nominees all or substantially all the stock of the other or others, or (2) when substantially all the stock of two or more corporations or the business of two or more partnerships was owned by the same interests : Provided, That such corporations or partnerships were engaged in the same or a closely related business, or one corporation or partnership bought from or sold to another corporation or partnership products or services at prices above or below the current market, thus effecting an artificial distribution of profits, or one corporation or partner- ship in any way so arranged its financial relationships with another cor- poration or partnership as to assign to it a disproportionate share of net income or invested capital. For the purposes of this section, public service corporations which ( i) were operated independently, (2) were not physically connected or merged and (3) did not receive special permission to make a consolidated return, shall not be construed to have been affiliated; but a railroad or other public utility which was owned by an industrial corpora- tion and was operated as a plant facility or as an integral part of a group organization of affiliated corporations which were required to file a consoli- dated return, shall be construed to have been affiliated. "(c) The provisions of this section are declaratory of the praxi^§iojQis of Title II of the Revenue Act of 1917." FROM PARTNERSHIPS 791 divisible, unless the partnership agreement provides for the division of a loss in a manner different from the division of a gain, and may be used by the individual partners in their returns of income. (Art. 332.) Establishment of fiscal years. — Section 226 of the 1 92 1 law makes it possible for a partnership to change from a calendar year to a fiscal year, a fiscal year to a calendar year or one fiscal year to another.^^ The procedure is fully out- lined in the chapters on returns.^" Partnership fiscal years. — Law. Section 205 (c) If a fiscal year of a partnership be- gins in 1920 and ends in 1921, or begins in 1921 and ends in 1922, then (i) the rates for the calendar year during which such fiscal year be- gins shall apply to an amount of each partner's share of such partner- ship net income (determined under the law applicable to such year) equal to the proportion which the part of such fiscal year falling within such calendar year bears to the full fiscal year, and (2) the rates for the calendar year during which such fiscal year ends shall apply to an amount of such partner's share of such partnership net income (de- termined under the law applicable to such calendar year) equal to the proportion which the part of such fiscal year falling within such calen- dar year bears to the full fiscal year. The 192 1 law with net income differently computed and different rates of tax in 1922 than under the 1918 law, in- volves adjustments in case of fiscal year partnerships so as to tax the income in accordance with the law in effect when the income was earned. Fiscal years i 920-1 921. — The following regulation pre- scribes the method for ascertaining the amount of partnership income attributable to the portions of the calendar years 1920 and 192 1 included within the partnership fiscal year. Regulation. If the fiscal year of a partnership began in the calendar year 1920 and ended in the calendar year 1921, the method of computing the taxes of the partners is as follows: (a) The amount " [Former Procedure] In the past it was customary to require a partnership to give notice of the establishment of a fiscal year thirty days prior to March i. (Reg. 33, 1918, Art. 31.) " See page 69 et seq. 792 INCOME of each partner's distributive share of the net income of the partner- ship for such fiscal year attributable to the calendar year 1920 is found by determining the net income of the partnership for its entire fiscal year in accordance with the law applicable to the calendar year 1920 (Title II of the Revenue Act of 1918) and the distributive share thereof of each partner, and then taking such proportion of that dis- tributive share as the part of the taxable period falling within the calendar year 1920 bears to the entire taxable period; (b) the amount of each partner's distributive share of the net income of the partner- ship for such fiscal year attributable to the calendar year 192 1 is found by determining the net income of the partnership for its en- tire fiscal year in accordance with the law applicable to the calendar year 1921 and the distributive share thereof of each partner, and then taking such proportion of that distributive share as the part of the taxable period falling within the calendar year 1921 bears to the full taxable period. (Art. 334.) Although the rates of tax for the years 1920 and 192 1 imposed itpon the income of the individual members of part- nerships are the same, there are certain differences in the com- putation of net income under the 1918 and 192 1 laws, which will affect the tax applicable to the portions of the years 1920 and 192 1, included in the partnership fiscal year. The chief differences are : 1. Allowance for net losses. 2. Additions to reserve for bad debts. 3. Interest paid to carry certain Liberty bonds. 4. Dividends from certain foreign corporations and from appreciation at March i, 1913. 5. Exempt Liberty bond interest. 6. Loss on "wash sales." 7. Credits for foreign taxes. 8. Income from business carried on in a possession of the United States. The foregoing regulation prescribes three steps : ( 1 ) Determine the net income for the full fiscal year : (a) Under the 19 18 law (for 1920). (b) Under the 1921 law. (2) Compute each partner's share as if for a full year. viz., FROM PARTNERSHIPS 793 (a) His share of (i-a). (b) His share of (i-b). (3) Each partner's share is deemed to be the sum of: (a) That portion of (2-a) which the part of the fiscal year falHng in 1920 is of a full year. (b) That portion of (2-b) which the part of the fiscal year falling in 192 1 is of a full year. The amount of net income in (3-a) is taxable at rates in efifect for year 1920 (under the 19 18 law) ; the net income in (3-b) is taxable at the 1921 rates (under the 1921 law). Fiscal years 1921-1922. — Regulation. If the fiscal year of the partnership began in the calendar year 1921 and ends in the calendar year 1922 the rates of tax for the calendar year 1921 apply to the amount of each partner's distributive share of the net income of the partnership for such fiscal year attributable to the calendar year 1921, and the rates for the calen- dar year 1922 to the amount of each partner's distributive share of such income of the partnership attributable to the calendar year 1922. (a) The amount of each partner's distributive share of the net in- come of the partnership for such fiscal year attributable to the cal- endar year I9jfi is found by determining the net income of the part- nership for its entire fiscal year in accordance with the law applicable to the calendar year 1921 and the distributive share thereof of each partner, and then taking such proportion of the distributive share as the part of the taxable period falling within the calendar year 1921 bears to the entire taxable period; (b) the amount of each partner's distributive share of the net income of the partnership for such fiscal year attributable to the calendar year 1922 is found by determining the net income of the partnership for its entire fiscal year in accord- ance with the law applicable to the calendar year 1922 and the dis- tributive share thereof of each partner, and then taking such propor- tion of that distributive share as the part of the taxable period falling within the calendar year 1922 bears to the entire taxable period. .... (Art. 335.) The principles governing the computation of net income attributable to the calendar years 1921 and 1922 are the same as illustrated herein above for fiscal years 1 920-1 921. While a fiscal year ending in 1922, however, is affected by only one law, viz., the 192 1 law, the capital gains provisions thereof are 794 INCOME not effective until January i, 1922.'" The restriction on losses from "wash sales" is not effective until November 23, 1921. The dift'erent treatment of such items under the same law, but as applied differently in the years 1921 and 1922, requires that two computations of net income be made, each for the full fiscal year: 1. As if the fiscal year was the calendar year 1921. 2. As if the fiscal year was the calendar year 1922. From this point the procedure for determining the pro rata part attributable to 192 1 and 1922 is the same as illustrated above for 1 920-1 921 fiscal years. Example Assume the following: A partnership with fiscal year ended Sep- tember 30, 1921, has net income for the full year of $40,000 (when computed under the 1918 law). When computed under the 1921 law, the net income for the full fiscal year is $36,000. Partner A has a one-half interest in the profits. A's income from the partnership would he computed as follows : I Net income for full year under 1918 law as above $40,000 A's share ('4 of $40,000) $20,000 Taxable at igi8 rates (3 months falling in 1920, or 34 year), 14 of $20,000 $ 5.000 II Net income for full j'ear, under 1921 law as above $36,000 A"s share (54 of $36,000) $18,000 Taxable at 1921 rates (9 months falling in 1921, or ^ year), ^ of $18,000 13.500 Total to be reported $18,500 Application of different rates for fiscal years 1921-1922.^* — Regulation In determining the rates of tax applicable to the amounts of the distributive shares of the partners attributable " See page 627. '* [Former Procedure] Application of rates of previous years. — 1918 Law. Section 206. "That whenever parts of a taxpayer's income FROM PARTNERSHIPS 795 to the calendar years 1921 and 1922, respectively, the amounts subject to the rates for the calendar year 1922 shall be placed in the lower brackets of the rates schedule provided in the present statute, and the amounts attributable to the calendar year 1921 in the next higher brackets of the rates schedule applicable to that year. (Art. 335.) Congress did not re-enact in the 1921 law the provisions of section 206 of the 19 18 law which provided for the superim- position of income of the earlier year on that of the later year. The Treasury in the foregoing regulation follows the method previously prescribed by the 19 18 law\ The 1921 law is not specific as to how the computation should be made. An illustration will make clear the application of the method. Example Assume that A has income from a partnership (a one-fourth in- terest therein) with fiscal year ended June 30, 1922, and that there are no items requiring different treatment in 1921 and 1922. Partnership profits, 12 months ended June 30, 1922 $100,000 A's share (^ of $100,000) $ 25,000 Other income in calendar year 1922 1,000 Total income to be reported $ 26,000 Taxable at 1922 rates : Yz of A's share of partnership income $ 12,500 Other income 1,000 Total $ 13,500 Taxable at 1921 rates : • • 1/2 of A's share of partnership income $ 12,500 are subject to rates for different calendar years, the part subject to the rates for the most recent calendar j'ear shall be placed in the lower brackets of the rate schedule provided in this title, the part subject to the rates for the next preceding calendar year shall be placed in the next higher brackets of the rate schedule applicable to that year, and so on until the entire net income has been accounted for. In determining the income, any deduc- tions, exemptions or credits of a kind not plainly and properly chargeable against the income taxable at rates for a preceding year shall first be applied against the income subject to rates for the most recent calendar year; but any balance thereof shall be applied against the income subject to the rates of the next preceding year or years until fully allowed." Regulation. Section 206 of the statute applied to a partner's share of partnership net income, to a stockholder's share of the net income of a personal service corporation (Reg. 45, 1641.) 7C)6 INCOME The tax is coiuputed as toUows: Net income $i3,5u72-2>72)- '■" [Former Procedure] Regulations Zi were subject to criticism. It happens that under the 1916 law, the 1918 law and the new 1921 law the kinds of partnership income which it is an advantage to "identify" are "specially provided for." Therefore taxpayers are not concerned at pre.sent about the restriction. For text of old regulations, court decisions and com- ments, see Income Tax I'rnccdnrc, 1920, page 505. 8o2 INCOME Ruling. An individual member of a partnership received a salary for services performed as an employee of a city and, in ac- cordance with his contract with the firm, turned over to it, as the value of his time, the entire amount so received. Held, that the individual partner might deduct the amount of the salary in his personal return as a business expense, but that no deduction could be claimed by the partnership, since to allow the amount received by it to be treated as exempt income would in effect be to regard it as an employee of the city, which was not the fact. (C. B. 2, page 104; A. R. M. 25.) The foregoing ruling does not so state, but it must be assumed that the partner rendering the service omits the salary from his return even though he deducts the entire amount turned over to the firm. Information needed to take advantage of credits AND DEDUCTIONS. — In vicw of the credits and deductions set forth in the preceding paragraphs, the partner should, before preparing his personal return, secure from the partnership specific information regarding the following points in addi- tion to the mere statement of net profit or net loss.^^ 1. Dividends received: (a) W'hen from domestic corporation not entitled to benefits of section 262.-' (b) When from foreign corporation which derives 50 per cent of its gross income from sources within the United States."* 2. Interest received upon "obligations pf the United States and bonds issued by the War Finance Cor- poration which is included in gross income under section 213" of the law.^° '"Which it is assumed would be drawn up in accordance with the law and the regulations. See page 788. -^ See pages 347 to 350. ^ See page 711. "' [Former Procedure] The 1918 law required that interest entirely exempt, including that received on Farm Loan bonds, be reported but not included in net income. The 1921 law did not re-enact this requirement. See page 801. FROM PARTNERSHIPS 803 3. Gifts.^« 4. Foreign income or excess profits taxes. ^^ 5. Capital gains and losses (see Chapter XVII). Deduction for partnership losses. — Partnership losses are, of course, deductible in the returns of the individual part- ners. The following regulation explains the basis of division among partners : Regulation. Losses sustained during the taxable year .... are fully deductible .... if (a) incurred in the taxpayer's trade or business, .... (Art. 141.) Even though the distributive share on the firm's books is a net profit, if the aggregate of dividends and interest de- scribed on page 799 is greater than the net profit the difference is an allowable deduction as a loss to the partner. If the books of a partnership show a net profit of $40,000 with two equal partners, each is subject to surtax on his dis- tributive share, irrespective of the character of the income. If the firm received $50,000 in dividends each partner should return $25,000' from that source and claim credit for a loss of $5,000. The amounts entered as dividends will be free of normal tax, and the difference between $25,000 and $5,000 ($20,000 each) will automatically be subject to the surtax, which commences at $5,000"^ for 192 1, and at $6,000 for 1922. ^"'See Chapter XXXIV. [Former Procedure] When fiscal years ended in 1918, other than at December 31, 1918, it was necessary to know the amount of partnership income subject to the 191 7 income and excess profits tax rates. "' For method of obtaining credit, see Chapter XXVIII. "* [Former Procedure] . Ruling In the case of a partnership sustaining operating losses the question arises as to whether or not the full distributive share of dividends received by the partnership should be included in the amount reported on line 25, page 2, of the form for 1913, eliminating any entry on line 19. The effect of this, if nothing further is done, would be to return the entire distributive share of the dividends received by the partner- ship as liable to surtax, no notice being taken of the operating losses. The Committee is of the opinion that the correct method of treat- ment is to include on line 25 the total distributive share of dividends and to enter on line 32 a proportionate share of the losses sustained, which would have the effect of including, for surtax purposes only, the net distributive share of the partnership income. (C. B. _', page 168; A. R. M. 13.) 8o4 INCOME Net loss pronision applies to partners liips. — Law. Section 204. .... (b) If for any taxable year beginning after December 31, 1920, it appears upon the production of evidence satisfactory to the Commissioner that any taxpayer has sustained a net loss, the amount thereof shall be deducted from the net income of the taxpayer for the succeeding taxable year; and if such net loss is in ex- cess of the net income for such succeeding taxable year, the amount of such excess shall be allowed as a deduction in computing the net income for the next succeeding taxable year; the deduction in all cases to be made under regulations prescribed by the Commissioner with the approval of the Secretary. (c) The benefit of this section shall be allowed to the members of a partnership Regulation Where the result of partnership opera- tion is a net loss, the loss will be divisible by the partners in the same proportion as net income would have been divisible, unless the partner- ship agreement provides for the division of a loss in a manner dif- ferent from the division of a gain, and may be used by the individual partners in their returns of income. (Art. 332.) This subject is discussed in detail in Chapter XXIX. Profits from sale or exchange of capital assets. — Since the 1921 law taxes capital gains on a different basis from other profits,"'^ it is necessary for partnerships to keep a sep- arate record of all sales or exchanges of capital assets. Law. Section 206 (c) In the case of a partnership .... the proper part of each share of the net income which consists, respectively, of ordinary net income and capital net gain, shall be de- termined under rules and regulations to be prescribed by the Com- missioner with the approval of the Secretary, and shall be separately shown in the return of the partnership and shall be taxed to the member .... as provided in sections 218 . . . . , but at the rates and in the manner provided in subdivision (b) of this section.^" Re(;ulatiox. Under subdivision (c) of section 206 the members of a partnership shall be taxed as provided in section 218^ but with respect to any capital net gain, may elect to be taxed as provided in section 206. Similarly estates or trusts or the beneficiaries thereof shall be taxed as provided in section 219, but with respect to any capital net gain may elect to be taxed as provided in section 206. In all cases, however, of election to be taxed under section 206 the mini- mum tax on the total net income (ordinary net income plus capital 'This subject is discussed in detail in Chapter XVII. See page 627. ' See page 628. FROM PARTNERSHIPS 805 net gain) is 123^ per cent. Where the net income of a partnership, estate, or trust consists in whole or in part of capital net gain, there shall he attached to the return, upon the request of any memher or beneficiary (or without such request) at the election of a fiduciary of an estate, a statement showing (i) all items of capital gain, capital loss, and capital deductions, as provided in article 1652, and (2) the names of members or beneficiaries and the amounts of their re- spective shares in such capital net gain. (Art. 1653.) The members of partnerships may elect the basis upon which they will be taxed. This may result in the same capital gain being taxed on two different bases as to the respective shares of partners therein. The accounting period. — The partner is taxable^^ on his dis- tributive share of the net income ''for any accounting period of the partnership ending within the fiscal or calendar year upon the basis of which the partner's net income is computed." The 1918 law, it will be recalled, permitted an individual, for the first time, to report on the basis of his fiscal year. The phrase just quoted makes it clear that a partnership having a fiscal or closing period different from that of the individual partner, need not attempt to make an additional closing of the books or ascertainment of profits or losses in order that the partner may return his share of the net profits or losses of the. partnership for his full, personal fiscal year. Dift'erent partners may, indeed, have fiscal years ending at various dates and to insist upon a closing of the books in each instance would be out of the question. What the government wants from an individual who is a partner in one or more firms is a full and accurate return of his share of the partnership profits for the twelve months ending at some date during his personal fiscal year. The acceptance of this as sufficient obviates the necessity of guess- ing or roughly calculating the partner's income when the fiscal year of the partnership does not agree with that of the partner. It is convenient and accurate to report the amount shown by "" Section 218 (a). 8o6 INCOME the partnership records, and, as the income tax has come to stay, individuals should change their own fiscal periods to the regular closing date of their partnerships. It should be borne in mind that so-called salaries paid to partners are in effect a distribution of anticipated profits (Chapter XXVI). They may, however, have been deducted on the partnership books in determining the net annual profits distributable at the end of the fiscal year. // so deducted such salaries should be included as taxable income, for the year in which received, in each partner's individual return, in addition to his remaining share of the partnership profits for the fiscal year mentioned above. When a partnership begins business at some date other than January i and it is intended to establish a fiscal year end- ing twelve months thereafter the partnership would make no return as of December 31. If the partners keep their personal books on the same fiscal year basis no return would be required for December 31. But if the partners do not establish fiscal years they must report as of December 31. In their returns for the first calendar year, neither profit nor loss from the part- nership would be returned. Procedure when personal and partnership accounts are on different bases. — A partner may have been accustomed to keep his personal accounts on a cash basis, while his firm's accounts are on an accrual basis. In such a case he may continue to keep his personal accounts as before if it is not practicable for him to change to an accrual basis, but in reporting his share of firm profits or losses he must include the entire amount of profit or loss accrued to or incurred by him on the firm's books for the fiscal or calendar year. It is immaterial how or when he receives his share, and whether or not the firm's books include many accrued items. Dissolution of or changes in partnership. — Regulation. When a partner retires from a partnership, or it is dissolved, he realizes a gain or loss measured by the difference be- FROM PARTNERSHIPS 807 tween the price received for his interest and the cost to him of his interest in the partnership, including in such cost the amount of his share in any undistributed partnership net income earned since he became a partner on which the income tax has been paid. However, if such interest in the partnership was acquired prior to March i, 1913, both the cost as hereinbefore provided and the vaUie of such interest as of such date, plus the amount of the share in any un- distributed partnership net income earned since February 28, 1913, on which the income tax has been paid, shall be ascertained and the tax- able gain derived or the deductible loss sustained shall be computed as provided in article 1561. If the partnership distributes its assets in kind and not in cash, the partner realizes no gain or loss until he disposes of the property received in liquidation. Whenever a new partner is admitted to a partnership, or any existing partnership is reorganized, the facts as to such change or reorganization should be fully set forth in the next return of income, in order that the Com- missioner may determine whether any gain or loss has been realized by any partner. (Art. 1570.) Upon the dissolution of or a change in a partnership and a distribution of assets in kind it is not probable that any taxable gain or profit would immediately arise. In a dis- tribution upon the basis of book values there is no gain or loss, because it will be assumed that ithe partners in their individual returns will have accounted for all gains, profits or income which were shown on the books of partnership. When the accounts of the partnership in dissolution are con- tinued a partner may await the result of the transactions for the entire taxable year before taking up in his accounts any gain or loss. The foregoing regulation refers to the cases where a partner realizes in cash or its equivalent some amount greater or less than is shown in his capital account in the firm's books. The books may show that the book value of a partner's one- half interest in the firm is $50,000. Goodwill is not carried as an asset. If the goodwill is valued at $40,000 and sold to the con- tinuing partner or someone else for that amount the retiring partner will receive in cash $70,000. If the goodwill of the business on March i, 19 13, was worth $40,000 the retiring 8o8 INCOME partner will not realize any taxable gain. If the fair market value of the goodwill on March i, 1913, was $25,000 the retiring partner must report a realized profit of $7,500. If the business was started after March i, 1913, his taxable profit is $20,000. Readjustment of partnership interests. — Ruling, (i) .... If a retiring partner or the estate of a de- ceased partner takes his portion of the partnership property in kind there is no realization of income, such realization being postponed until the property so received is in turn sold. (2) If, on the other hand, the retiring partner or the estate sells to the remaining partners his interest in the partnership for cash it is held that the difference between the cost, or value as of March i, 1913, of such interest constitutes gain or loss for the purpose of computing the income of such partner or estate, and that the remain- ing partners, as a result of this transaction, have only added to their holdings in the partnership property. They have made a purchase and not a sale, and can have realized nothing in the way of profit or loss.'- .... ( C. B. 3, page 61 ; Sol. Op. 42.) Assume that a retiring partner's capital account shows a credit balance of $25,000. He sells to a continuing partner for $20,000. If the latter subsequently converts the assets into the equivalent of cash at the book figures he will realize a profit of $5,000. If, however, he purchases fixed assets or fails to convert other assets, the $5,000 credit to the retiring partner's account operates as a reserve and is not true surplus nor gain. Ruling (3) The effect of the admission of a new partner depends upon the terms of his admission. If, under the terms of the partnership agreement he contributes property or cash to the capital of the partnership he acquires a right, upon dissolution, to a return of his contribution together with his proportionate share of the net profits of the partnership business, and in the meantime to a corresponding share in the net earnings of the partnership. There is no realization on the part of any partner. If, on the other hand, he purchases, for cash, an interest in the existing partnership, it is clear that what he has acquired is simply a right to share in the profits of the partnership during its continuance and in any sum See Bulletin 37-21-1820; O. D. 10.33. 'FROM PARTNERSHIPS 809 remaining, upon tlie dissolution of the partnership, after the satis- faction of creditors and of the equities as between the contributing partners. Since this would represent a ])urchase, by the incoming partner, there could be no realization as to him, and, as to the mem- bers of the former partnership, the amount paid by him will clearly be income to them in direct proportion to their respective interests in the former partnership and should be returned by them as such. (C. B. 3, page 61 ; Sol. Op. 42.) Assets of old partnership taken over at current VALUATION. — In the detailed opinion (see digest above), the specific question was stated as follows : An opinion is requested whether upon the dissolution of a part- nership by the withdrawal or death of a partner and the formation of a new partnership which takes over the assets of the old partner- ship belonging to the remaining partners, at current valuation, the transaction is to be considered closed so that the increase in the value of the assets as written up on the books of the new partner- ship over the cost or value as of March i, 1913, of such assets to the former partners constitutes taxable income to them And the answer given by the Treasury confirms the posi- tion taken by the author that unrealized appreciation is not income."" .... In other words, to hold that by valuing his contrilnition to the partnership at a greater amount than its cost to him, or value as of March i, 1913, he could realize the difference as income would be to hold that the partner could make a profit by selling to himself. Such a conclusion is wholly at variance with the decisions of the courts and the rulings of this department Distributions to partners other than in cash. — A partner should return for taxation the exact amount credited to his capital account in the books of the firm at the end of its fiscal year, after deducting tax-exempt interest, etc. Any payments to a partner charged against his capital account are, of course, not returnable because such payments merely represent dis- tributions of capital or of incoine already reported and taxed. The same principle applies to partnership distributions Income Tax Procedure, 1920, page 510. 8io INCOME Other than in cash. For instance, a firm may own property or securities which it wishes to divide among the partners. The amount at which such items appear on the firm's books as assets determines the book value of the partners' interests therein, and when distribution is made the items should be entered by the partnership and the partners at book valuation. After distribution of the assets such book valuation is the basis of gain or loss, except that assets acquired before March I, 19 1 3, must be valued as of that date. Ruling. Where a distribution of partnership profits is made in securities carried in an investment account by the partnership, first each partner must be taxed on the basis of his distributable share of the partnership profits for the year 1917, which partnership profits will be ascertained without claiming any loss with regard to the unsold securities held in the investment account of the partner- ship; second, the individual partners receiving these securities as a distribution of partnership profits shall determine their future gain or loss when such securities are sold and on the basis of the cost of the securities to the partnership or their market value on March i, 1913, if acquired before that date. (C. B. i, page 46; T. B. R. 34.) Partnerships Composed of Corporations As a general rule, a corporation cannot enter into a part- nership."* In a few states, as in Texas, this rule has been changed by statute. The reason for the rule is that to allow a corporation to enter into partnership would be contrary to the general theory of the incorporation acts.^^ For income tax purposes, however, it has been held that a partnership composed of corporations should be classed as a partnership rather than as a corporation.^'^ In regard to the case under consideration, it should be noted that the laws of Hawaii per- mit corporations to become members of a partnership. The subject is not of general interest enough to warrant a full discussion in these pages, but it may be said that unless the '''* Pearcc v. Madison, etc., R. R. Co., 62 U. S. 441. See also Bulletin 42-21-1866; A. R. M. 139. ="C. B. 3, page 18; Sol. Op. 36. '"Haiku Sugar Co. ef al. v. Johnstone, 249 Fed. 103. FROM LIMITED PARTNERSHIPS 8ll charter of a corporation expressly prohibits its entering into partnership relations with other corporations or with individ- uals, it may do so, .subject to the further possible restriction that the corporation laws of the state may inhibit such rela- tionship. Limited Partnerships The Treasury draws a distinction between different types of limited partnerships, regarding one type as corporations and the other type as partnerships for income tax purposes. ^^ Limited partnerships may or may not be partnerships. — Regulation. So-called limited partnerships of the type author- ized by the statutes of New York and most of the States are part- nerships and not corporations within the meaning of the statute. Such limited partnerships, which can not limit the liability of the general partners, although the special partners enjoy limited liability so long as they observe the statutory conditions, which are dissolved by the death or attempted transfer of the interest of a general partner, and which can not take real estate or sue in the partnership name, are so like common law partnerships as to render impracticable any dif- ferentiation in their treatment for tax purposes. Michigan and Illi- nois limited partnerships are partnerships. A California special part- nership is a partnership. (Art. 1505.) Limited partnership as corporation. — Regulation. On the other hand, limited partnerships of the type of partnerships with limited liability or partnership associations au- thorized by the statutes of Pennsylvania and of a few other States are only nominally partnerships. Such so-called limited partnerships, offering opportunity for limiting the liability of all the members, providing for the transferability of partnership shares, and capable of holding real estate and bringing suit in the common name, are more truly corporations than partnerships and must make returns of income and pay the tax as corporations. The income received by the members out of the earnings of such limited partnerships will be treated in their personal returns in the same manner as distributions on the stock of corporations. In all doubtful cases limited partner- ships will be treated as corporations unless they submit satisfactory proof that they are not in effect so organized. A Michigan partner- '" [Former Procedure] All limited partnerships were formerly con- sidered corporations. (Reg. 33, 1918, Art. 62.) 8i2 INCOME ship association is a corporation. Such a corporation may or may not be a personal service corporation. (Art. 1506.) OhxO partnerships. — Ruling. A partnership association or limited partnership organ- ized under sections 8059-8078 of the Ohio Code is an association and not a partnership, within the meaning of section i of the Revenue Act of 1918, and is taxable as a corporation. ( C. B. 2, page 11; O. D. 444-) Virginia partnerships. — Ruling. Virginia partnership associations or limited partner- ships formed under sections 2878 to 2886, inclusive, of the Virginia code of 1904, are to be treated as corporations or joint-stock com- panies for income tax purposes. The status of Virginia limited partnerships formed under the act of March 14, 1918 (acts of Assembly of Virginia, 1918), must be determined in each case by consideration of the certificate of partnership and all pertinent facts. (C. B. i, page 9 ; O. D. 334.) "Pennsylvania" type of limited partnerships. — Lim- ited partnerships of the Pennsylvania type mentioned above are such as are organized under the act of Jtme 2, 1874."^ The lim- ited or special partnerships, created by the acts of March 21. 1836,^''' April 6, 1870/'^ and June 15, 1871,"*^ are not covered. The matter is discussed in an opinion from the Attorney General's department.^" In general, so far as article 1506 applies to limited partnerships created under the act of June 2, 1874, it seems to be sound. Such a limited partnership is a quasi-corporation,*" having many of the characteristics of a corporation. The limited partnerships of 1836, 1870 and 1871 are quite different and are not within the ruling in Coal Com- pany V. Rogers, nor should they be within article 1506. In the circumstances it would be better to designate lim- ited partnerships, which must be treated throughout as cor- =*P. L. 271. '» P. L. 143. '" P. L. 56. " P. L. 389. . ■*"' 5 Pennsylvania District Reports 288. " Oak Ridge Coal Co. v. Rogers, 108 Pa. St. 147. FROM PERSONAL SERVICE CORPORATIONS 813 porations, as being of the "corporation t3q)e" rather than the "Pennsylvania type." Ruling. The M Company, a partnership organized under the laws of the State of Pennsylvania, desires to be classed for Federal tax purposes as a limited partnership of the type mentioned in article 1506 of Regulations 45. The said partnership differs from the type of partnerships pro- vided for in the Pennsylvania statute in that the word "limited" does not appear in the firm name, yearly meetings of the partners are not provided for except by inference, no mention is made of a common seal and no provision is made for limiting the liability of the members. It dift'ers from an ordinary partnership in that it is not dissolved by the death of one or more of the partners, but re- sembles a partnership and differs from a joint stock association or corporation in that it does not provide for the free transferability of the interest of a member. It is held, therefore, that the M Company is a partnership and should be required to file returns as such. ( C. B. 3, page 15; O. D. 599-) Distributions by limited partnerships. — All divisions of profits by limited partnerships which are of the corporation type should be treated by the partners as dividends. The nor- mal tax will have been paid, so that for 192 1 the recipients will receive credit of 8 per cent on such distributions in cal- culating their normal tax. Undivided profits will not be included in the returns of partners of the limited partnership as in the case with ordinary partnerships, but limited partnerships of the corporation type are subject to the excess profits tax.*^ Personal Service Corporations Grouped with Partnerships In an attempt to put partnerships and corporations on a more equal footing the 1918 law established a class of "per- sonal service corporations" which are to be considered part- nerships for income tax purposes. This provision was re-en- " Discontinued after December 31, lOJi. 8i4 INCOME acted by the 1921 law only for the year 1921. Personal ser- vice corporations are specifically exempt from the corporation income and excess profits tax/" Law. Section 218. .... (d) Personal service corporations shall not be subject to taxation under this title, but the individual stock- holders thereof shall be taxed in the same manner as the members of partnerships. All the provisions of this title relating to partnerships and the members thereof shall so far as practicable apply to personal service corporations and the stockholders thereof: Provided, That for the purpose of this subdivision amounts distributed by a personal service corporation during its taxable year shall be accounted for by the distributees; and any portion of the net income remaining un- distributed at the close of its taxable year shall be accounted for by the stockholders of such corporation at the close of its taxable year in proportion to their respective shares Alternative tax on personal service corporations. — The stock dividend decisicjn'"' of the Supreme Court, in which it is held in effect that stockholders cannot be taxed unless they actually receive income in their individual capacity as dis- tinguished from income realized by the corporation as a sep- arate entity, raised a grave doubt as to whether Congress had the right to tax stockholders of personal service corporations on the undistributed income of such corporations. Beginning with 1922, personal service corporations make returns and are taxed as other corporations. To make certain, however, that personal service corpora- tions or the stockholders thereof should not escape taxation entirely for the years 19 18, 19 19, 1920 and 1921 in the event that the personal service sections of the 19 18 and 1921 laws are declared invalid, provision is made in the 192 1 law for an alternative tax for the years mentioned, as regular corporations. In such event returns would have to be made for the years 19 1 8, 19 1 9. 1920 and 1921 as a regular corporation. "Law, section 231 (14). See page 46. *^ Eisner v. Macombcr, 252 LT. S. 189, 40 S. Ct. 189, 64 L. Ed. 521. This was fully discussed by the Solicitor at the "Hearings before the Committee on Ways and Means, House of Representatives," March 18 and 19, 1920. See Incoiiic Tax Procedure. 1921, pages 643-645 FROM PERSONAL SERVICE CORPORATIONS 815 Law. Section 1332. (a) That if either subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of this Act is by final adjudication declared invalid, there shall, in addition to all other taxes, be levied, collected, and paid on the net income (as de- fined in section 232) received during the calendar years 1918, 1919, 1920, and 192 1, by every personal service corporation (as defined in section 200) included within the provisions of such subdivisions, a tax equal to the taxes imposed by Title II and III of the Revenue Act of 1918 and, in the case of income received during the calendar year 1921, by Titles II and III of this Act. (b) In such event every such personal service corporation shall, on or before the fifteenth day of the sixth month following the date of entry of decree upon such final adjudication, make a return of any income received during each of the calendar years 1918, 1919, 1920, and 1921 in the manner prescribed by the Revenue Act of 1918 (or in the manner prescribed by this Act, in the case of income received during the calendar year 1921). Such return shall be made and the net in- come shall be computed on the basis of the taxpayer's annual account- ing period (fiscal year or calendar year, as the case may be) in the manner provided for other corporations under the Revenue Act of 1918 and this Act. (c) If either subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of this Act is so declared invalid, claims for credit or refund of taxes paid under both such sections shall be allowed, if made within the time provided in subdivision (f) of this section. (d) In case the claim.s for credit or refund, filed within six months from such date of entry of decree, represent less than 30 per centum of the outstanding stock or shares in the corporation, the amount of taxes imposed by this section upon such corporation shall be reduced to that proportion thereof which the number of stock or shares owned by the shareholders or members making such claims bears to the total number of stock or shares outstanding. (e) The tax imposed by this section shall be assessed, collected, and paid upon the same basis, in the same manner, and subject to the same provisions of law, including penalties, as the taxes imposed by sections 230 and 301 of the Revenue Act of 1918 (or by sections 230 and 301 of this Act, in the case of income received during the calendar year 1921), but no interest or penalties shall be due or payable thereon for any period prior to the date upon which the return is by this sec- tion required to be made and the first installment paid. The amount of tax paid by any shareholder or member of a personal service cor- poration pursuant to the provisions of subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of this Act shall be credited against the tax due from such corporation under this section upon the joint written application of such corporation and 8i6 INCOME such shareholder or member or his representatives, heirs, or assigns, if such apphcation is filed with the Commissioner within six months from such date of entry of decree. (f) Notwithstanding any other provision of law, no claim for a credit or refund of taxes paid under subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of this Act, may be filed after the expiration of six months from such date of entry of decree: Provided, hoivci'cr, That a personal service corporation of which no shareholder or member has filed such claim within such period of six months, shall not be subject to the tax imposed by this section. Regulation. Section 1332 of the statute is an alternative measure and is of no effect unless and until either subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of the statute of 1921 is declared invalid by final adjudication'. (Art. There is a very serious doubt as to the constitutionaHty of the foregoing section of the law. While the Supreme Court has held consistently that retroactive tax laws are not uncon- stitutional, the author is of the opinion that the courts will find great difficulty in upholding this extension of retroactive legis- lation. Many taxpayers accepted in good faith the provision of the 1 918 law. Business has been conducted on this basis for over four years. There have been many sales of stock. And in many cases the profits have been distributed before the sales were made. In several outstanding cases taxpayers who controlled personal service corporations have died and control has passed to new owners. The provision is probably illegal l^ecause it is an attempt to lcv\- a tax by alternative legislation. It will 1)6 recalled that the first draft of the 1918 excess profits tax law proposed alternative methods, but it was re- jected ])ecause the ''constitutional" lawyers in Congress said that it would be unconstitutional. Section 1332 is preceded by a heading which reads : ''Alternative tax on personal service corporations." This heading was placed there by Congress. Therefore, there is no doubt about this being alternative legis- lation. FROM PERSONAL SERVICE CORPORATIONS 817 The courts have held with reference to curative statutes that if the defect is in the nature of the act itself, it cannot be obviated by a subsequent act/" The following case, however, illustrates the injustice of this section : During 1918, 1919, 1920, A owned all of the stock of a corporation which earned the following profits : 1918 $200,000 1919 250,000 1920 300,000 A dies in the early part of 1921 and his estate on account of the personal nature of the business decides to sell the stock of the corporation. Prior to A's death he had withdrawn and paid taxes on all of the profits each year because the business did not need capital. With the death of A, the corporation lost its chief income- producing factor. The estate of A sold the stock for $50,000 to B, C and D, who had been faithful employees for many years. These employees had been in frequent contact with A's clients, and believed that they could continue the business. Assume that in 1922 the courts hold that it was an error to have taxed A as a stockholder and instead the corporation should have been taxed. The shocking result is that the faithful employees, B, C and D, are deprived of the earnings of the corporation. The corporation would probably be liable for the following taxes : 1918, $100,000; 1919, $80,000; 1920, $100,000; total, $280,000. A legally withdrew all of the profits up to 192 1. The estate therefore might collect a large refund on account of receiving credit for the normal tax now to be paid Ijy the cor- poration. B, C and D have no ground for an action against the estate. Exit B, C and D ! " Cooley, Constitutional Piinitatioiis J82 (ylh edition), page 544. 8i8 INCOME Returns of Personal Service Corporations Generally speaking, all of the provisions of the 192 1 law relating to returns apply alike to all classes of taxpayers. Both the stockholders and the corporations have to make returns. The return of a personal service corporation is, however, as in the case of a partnership, merely an informa- tion return. The Commissioner has extended the time for filing personal service corporation returns for the year 192 1 until May 15, 1922.^® This extension does not apply to the members of personal service corporations. It will be necessary for them to apply for individual extensions unless a general extension is made. Regulations. Every personal service corporation must make a return of income regardless of the amount of its net income. It shall be made for the taxable year of the personal service corporation ; that is, for its annual accounting period (fiscal year or calendar year, as the case may be), regardless of the taxable year of its stockhold- ers. For the calendar year 1921 the return shall be made on Form 1065. If the personal service corporation makes any change in its accounting period, it will render the return in accord- ance with the provisions of section 226 of the statute and article 431. The return of a personal service corporation covering any period be- ginning prior to January i, 1922, should state specifically (a) the items of its gross income enumerated in section 213 of the statute; (6) the deductions enumerated in section 214 of the statute, other than the deduction provided in paragraph (11) of subdivision (a) of that sec- tion; (r) the amounts specified in subdivisions (a) and (b) of section 216 of the statute received by the personal service corporation; (d) the amount of any income, war profits, and excess profits taxes of the personal service corporation paid during the taxable year to a foreign country or to any possession of the United States, and the amount of any such taxes accrued but not paid during the taxable year; (e) the amounts distributed by the corporation during its taxable year, vi^ith the dates of distribution and the names of the distributees; (/) the names and addresses of the stockholders of the corporation and their respective shares in such corporation at the close of its taxable year, and on December 31, 1921 ; (g) such facts as tend to show whether or not the corporation is a personal service corporation with reference to any period beginning prior to January i, 1922; and (h) such other T. D. 3272, dated January 19, 1922. FROM PERSONAL SERVICE CORPORATIONS 819 facts as are required by the form. Earnings attributable to the calen- dar year 1922 and subsequent years are taxed to the personal service corporation in the same manner as the earnings of ordinary corpora- tions are taxed (Art. 624.) .... An individual stockholder of a personal service corpora- tion is subject to tax much like a member of a partnership upon his distributive share of the net income of the corporation earned on or after January i, 1918, and prior to January i, 1922. The net income of a personal service corporation attributable to the period prior to January i, 1922, as in the case of a partnership, shall be computed in the same manner and on the same basis as the net income of an in- dividual, except that the deduction of contributions or gifts is not permitted (Art. 336.) A stockholder of a personal service corporation is required to include in his gross income for each taxable year up to and includ- ing that taxable year within which falls the end of the last taxable period of the personal service corporation prior to January i, 1922: (a) Any dividends paid by the corporation in such year out of earn- ings or profits accumulated since February 28, 1913, and before Jan- uary I, 1918; (b) his share of any distribution made by the cor- poration in such year out of earnings or profits accumulated since the close of its taxable year ending with or during his next preceding tax- able year; and (c) his distributive share of the undistributed net in- come of the corporation for its taxable year ending with or during his taxable year provided he was at the close of its taxable year a stockholder in the corporation, notwithstanding he might since have ceased to be a stockholder (Art. 338.) Former stockholders of personal service corporations to whom distributive shares were assigned in the returns of the corporations, who reported such shares in their individual returns, should be careful when disposing of their stock to keep this fact in mind. Ordinarily Vi^hen shares of stock are acquired the purchaser or donee is on notice that only the normal tax has been paid on the corporation's earned surplus account. In the case of a personal service corporation the surtax also will have been paid by or imposed on someone else from January i, 19 18, to the end of the taxable year next preceding the transfer of the stock (but not beyond December 31, 1921). Personal service corporations with fiscal years ending in 1922. — One of the many evils of constant tinkering with 820 INCOME tax laws is the necessary adjustments which follow changes in rates. This problem confronts taxpayers in dealing with personal service corporations which have fiscal years beginning in 1 92 1 and ending in 1922. Prior to the change in the 192 1 law, the procedure for reporting in the stockholders' return income from a personal service corporation was complicated. Not only the gross distributive shares of accrued income had to be reported but dividends declared, and the period in which the earnings were accumulated were factors to be noted and reported. Law. Section 218. .... (d) Personal service corporations shall not be subject to taxation under this title, but the individual stock- holders thereof shall be taxed in the same manner as the members of partnerships. All the provisions of this title relating to partnerships and the members thereof shall so far as practicable apply to personal service corporations and the stockholders thereof: Provided, That for the purpose of this subdivision amounts distributed by a personal ser- vice corporation during its taxable year shall be accounted for by the distributees; and any portion of the net income remaining undistributed at the close of its taxable year shall be accounted for by the stock- holders of such corporation at the close of its taxable year in propor- tion to their respective shares Fiscal years of personal service corporations. — Beginning January i, 1922, personal service corporations are taxed as ordinary corporations. In order to take care of the transition period — the change of basis from personal service corporation to regular corporation — the following provision was inserted in the 1921 law : Law. Section 218 (d) .... In the case of a personal ser- vice corporation having a fiscal year beginning in 1921 and ending in 1922, amounts distributed prior to January i, 1922, to its stockholders out of earnings or profits accumulated after December 31, 1920, shall be taxed to the distributees; and the stockholders of record on Decem- ber 31, 1921, shall be taxed upon their distributive shares of the differ- ence (if any) between such distributive profits and the portion of the corporation's net income assignable to the calendar year 1921, deter- mined in the manner provided in clause (i) of subdivision (c) of section 205 of this Act. FROM PERSONAL SERVICE CORPORATIONS 821 Fiscal years 1920-192 i. — The treatment of partnership income ilhistrated in the preceding pages, ''° in the case of hscal years ended in 1921, is appHcable to personal service corpora- tions with fiscal years 1920-192 1. Regulation. In the case of a personal service corporation havin.s: a fiscal year beginning in 1920 and ending in 1921, the corporation must make a return of income on Form 1065. The income for such year is not taxable to the corporation, but is taxable to the sharehold- ers in a manner similar to that in which the earnings of partnerships are taxed (Art. 337.) Fiscal years 1921-1922.- — Two returns must be filed for fiscal years ending in 1922. Regulation In the case of a personal service corpo- ration having a fiscal year beginning in 192 1 and ending in 1922, the return must be filed both on Form 1065 and on Form 1120. The net income attributable to the calendar year 1921 is that portion of the net income reflected upon Form 1065 (computed as if the fiscal year were the calendar year 1921), which the part of the taxable period falling within the calendar year 1921 bears to the entire period; and this amount is taxable to the shareholders of the corporation at the rates in effect as of December 31, 1921. The income attributable to the calendar year 1922 is that portion of the net income re- flectd upon Form 1120 (computed as if the fiscal year were the calendar year 1922), which the part of the taxable period falling within the calendar year 1922 is of the entire period: and this amount is taxable to the corporation as the income of ordinary corporations is taxed. (Art. 337.) The statement in the foregoing regulation "at the rates in effect as of December 31, 1921," is apt to be confusing. It does not mean that the personal service stockholder must take up in his 192 1 return his share of earnings of the corporation undistributed at December 31, 192 1. He takes this up in his 1922 return. Example Assume a personal service corporation with fiscal year ending March 31, 1922: (i) Net income for full fiscal year computed under the law as " See page 791. ^ 822 INCOME applicable to the calendar year 1921 (to be reported on form 1065 ) $40,000 (2) Net income for full fiscal year computed under the law as applicable to the calendar year 1922 (to be reported on form 1 120) $36,000* (3) Net income attributable to 1921 (3^ of $40,000) $30,000 (4) Net income attributable to 1922 (^ of $36,000) $ 9,000 * Difference in net income under the 1921 law (as between 1921 and 1922) may arise from "wash sales" (see page 591) capital gains (see page 627), etc. Assume further that the net income of the personal service cor- poration for the fiscal year ended March 31, 192 1, was $50,000. If the entire stock was owned by A, a single individual (reporting on the calendar year basis), and no dividends had been paid, in his 1921 return he would report $50,000, representing his "share of the un- distributed net income of the corporation for its taxable year ending with or during his taxable year.''"" If the corporation on December 15, 1921, had paid a dividend of $20,000. A would have to report same in his 192 1 return in addition to the $50,000 referred to above. Income to be reported by stockholder of personal service corporation. — • Regulation In the case of a personal service corpora- tion having a fiscal year beginning in 1921 and ending in 1922, amounts distributed prior to January i, 1922, to its stockholders out of earnings or profits accumulated during its current taxable year are taxable to the distributees and should be reported in the personal returns of such distributees, and the stockholders of record on December 31, 1921, of such personal service corporation must report as income their distributive shares of the difference (if any) between such dis- tributive profits and the portion of the corporation's net income as- signable to the calendar year 1921, determined in the manner provided in section 205 (c) (i) of the statute and articles 334, 335, and ^T^y. The earnings of the personal service corporation attributable to the period subsequent to December 31, 1921, are taxable to the stock- holder only when distributed, as in the case of dividends of ordinary corporations. (Art. 338.) The words "distributive profits" in the last clause, second paragraph, of subdivision (d), section 218, quoted on page 820, read, in the House bill, "distributed profits." When the House bill was amended l)y the Senate, the above quoted clause °" Art. 338. FROM PERSONAL SERVICE CORPORATIONS 823 was carried over verbatim, except that the words "distributed profits" were changed to "distributive profits." (This appar- ently is a misprint and was not intended to be changed.) If we read the words as "distributed profits" the meaning will be made clear. Example In the illustration given above assume that A is the sole stock- holder at December 31, 1921. Then he must report in his 1922 calen- dar year return his "distributive share" of: The portion of the corporation's net income as- signable to the calendar year 1921 $30,000 Less: Profits distributed (dividend paid Decem- ber 15, 1921 ) 20,000 Taxable at 1921 rates $10,000 The $10,000 taxable at 1921 rates represents A's "distributive share of the difference .... between such distributed profits and the portion of the corporation's net income assignable to the calendar year 1921," referred to in article 338 quoted above. Prerequisites of a Personal Service Corporation The language defining a personal service corporation is very clear. The 1921 law re-enacted the definition of the 1918 law without any change. Law. Section 200 (5) The term "personal service cor- poration" means a corporation whose income is to be ascribed primarily to the activities of the principal owners or stockholders who are them- selves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or borrowed) is not a material income-producing factor; but does not include any for- eign corporation, nor any corporation 50 per centum or more of whose gross income consists either (i) of gains, profits, or income derived from trading as a principal, or (2) of gains, profits, commissions, or other income, derived from a Government contract or contracts made jctween April 6, 1917, and November 11, 1918, both dates inclusive. The following illustrations used by Mr. Kitchin when the 1918 law was under consideration, may be regarded as an authoritative expression of the intention of Congress. ^^ '^^Congressional Record, September 18, 1918, page 11329, but this was said before the provision was inserted eliminating "traders" from the scope of the definition. 824 INCOME An insurance agency that writes insurance on commissions and re(|uires no capital; a corporation of architects, which requires no capital ; a lawyers' guaranty title company that looks up titles and requires no capital ; any company where the earnings may be ascribed primarily to personal services and in which capital is not a material income-producing factor where it (capital) is not actually required — where the business does not require them to have capital. The intention of the lawmakers is indicated also by sub- sequent statements. The following explanation was made on March i8, 1920, by Mr. Kitchin i"^- The section provides that a personal service corporation is a corporation whose income is to be ascribed primarily to the activities of the principal stockholders or owners who are themselves regu- larly engaged in the active conduct of the affairs of the corporation and in which capital invested or borrowed is not a material income- producing factor. It seems that there is nothing in the statute pre- venting an accumulation of surplus or profits. It may have a thou- sand stockholders, but 4 men may own, say, 75 or 60 per cent of the stock, and if those 4 men, say, the president, the secretary, the manager, and supervisor, or whatever they may be, give their active service to it, and you can attribute the profits they may make, or sub- stantially all of their profits, to their services, then it is a personal service corporation under that section. If from the accumulated profits or surplus any substantial part of its income was derived, perhaps this of itself would take it out of the personal service cor- poration class. The regulations and rulings of the Treasury have deviated more and more from legislative intent. It was to be expected from these expressions that the controlling test would be found in an answer to the question: 'Ts capital (invested or borrowed) a material income-producing factor?" No rule can be laid down which can be used as an infallible answer to the question. Each taxpayer who believes that he may claim the benefit of the section is entitled to have his claim considered on its merits. i °*' Hearings before tlie Committee on Ways and Means, House of Rep- resentatives, March 18 and 19, 1920, page 38. FROM PERSONAL SERVICE CORPORATIONS 825 Regulation. The term "personal service corporation" means a corporation, not expressly excluded, the income of which is derived from a profession or business (a) which consists principally of ren- dering personal service, (b) the earnings of which are to be ascribed primarily to the activities of the principal owners or stockholders, and (c) in which the employment of capital is not necessary or is only incidental. No definite and conclusive tests can be prescribed by which it can be finally determined in advance of an examination of the corporation's return whether or not it is a personal service corporation. In the following articles are laid down the general principles under which such determination will he made. (Art. 1523.) Tliis article denotes a direct departure from the law. The law states that capital must not be a "material income-produc- ing factor." In (c) we find that capital of any kind must be unnecessary or only incidental. Under the law capital, so long as it is not inaterial, may be employed. In each example cited by Mr. Kitchin some capital would be necessary. It seems entirely to have escaped the attention of the Treasury that the intention of the law is clear enough. Many protests were made under the 191 7 law regarding the hardships suffered by owners of closely held corporations wherein the capital was out of proportion to the business done or income earned. So-called small corporations were afforded relief under section 302. But this was not considered fair to those corporations in which capital is not material and compensation for personal services is a substantial factor. Section 218 fe)'^' is not and was not intended to be used as an exclusive remedy. It was expressly intended to be an in- clusive remedy. It should be administered liberally. If the rulings hereinafter discussed are illustrative of all others which have been rendered it may be expected that the courts will be asked to grant relief in many cases. Reduction in tax when part personal service corporation. — When any substantial part of the income of a corporation is from fees or personal services of any kind, it is the intention of the law to afford relief. '^^'■1918 law. The Cdrre.sponding .section of tlie H)2i law is 218 (d). 826 INCOME If it can qualify as a personal service corporation no ex- cess profits tax is payable. If it cannot so qualify and capital is out of proportion to the net income or other unusual condi- tions exist, relief can be secured under sections 327 and 328.^* If at least 30 per cent of the total net income is from per- sonal services and the remainder of the net income is from non-personal service activities, the part of the net income which is from personal services will be taxed at a less rate than if the entire income were taxed at the graduated excess profits tax rates." When "trading" corporations cannot qualify. — When 50 per cent of the gross income of a corporation consists of "gains, profits or income derived from trading as a principal" such corporation cannot qualify as a personal service corpora- tion.'' Many close corporations carry on extensive business with little invested capital of their own. In some cases the funds necessary to carry on the business are derived from borrowed money and in other cases the trading is done as broker or agent. The reference in the law is to buying and selling on one's own account, which usually means taking title to goods and reselling them. It has no reference to certain types of brokerage and commission houses which do not take title to the property they sell and do not have a substantial amount of invested capital. In general, trading is any kind of commercial activity wherein buying and selling of commodities are con- cerned. SelHng the product of one's brains or skill, or selling one's services would appear not to be "trading" in the strict sense of the section. Selling anything else would seem to be trading. Ruling. Section 200 of the Revenue Act of 1918 excludes from personal service classification a corporation 50 per cent or more of " See Excess Profits Tax Procedure, 1921. ^'^ Section 303, 1918 law, which was re-enacted without change in the 1921 law. For illustration and comment, see Excess Profits Tax Procedure, 1921. " Section 200. FROM PERSONAL SERVICE CORPORATIONS 827 whose gross income consists of gains, profits, or income derived from trading as a principal. It does not necessarily follow, however, that if 50 per cent or more of the gross income was derived from the personal service phase of the business, that the corporation may claim personal service classification. (C. B. i, page 14; O. D. i.) There is no provision of the law which prohihits such a claim being made. If the company can meet the other tests, it is entitled to be classified as a personal service corporation. "Trading" corporations may qualify. — Great care was taken in writing section 200. If there had been the slightest thought in the minds of the framers of the law that in no case should trading corporations be permitted to qualify as per- sonal service corporations it would have been extremely easy to bar them. If it had been intended to exclude all corpora- tions in which some trading is carried on, the provision cover- ing trading would have read something like this : "but does not include .... any corporation, 10 per centum or more of whose gross income consists either ( i ) of gains, profits or income derived from tradings as a principal " But we find that after giving long consideration to the subject the restriction as to trading gains, profits or income is 50 per cent or more. In other words, practically one-half of the income may be from trading and the corporation still may quahfy. The w^ords "trading as a principal" extend and do not limit the privileges. It is a fair inference from these words that all trading not as a principal is prima facie evi- dence of qualification as a personal service corporation. Trading as a principal means buying and selling commodi- ties on one's own account. Corporation with substantial capital may qualify. — A de- tailed description of the kind of corporation that may qualify in the personal service class is given in the following: Ruling. The business of the M corporation is insurance bro- kerage and average adjusting, principally in connection with marine insurance. It was formed by a consolidation of several firms engaged 828 INCOME in the same line of business. None of these firms contributed any capital or any tangible assets except some office furniture. Both preferred and common stock were issued in comparatively large amounts. The preferred stock was issued to the directors at par in order to secure funds for payment of expenses and advances to directors in anticipation of earnings. The common stock was issued to the members of the constituent firms for an arbitrary amount merely as a basis for the apportionment of future earnings. It rep- resented no tangible property and bore no relation to any estimated value of good will. No common stock could be held by anyone not an officer, director, or employee of the company. All the directors are actively engaged in the business of the cor- poration. No substantial amount of capital is employed to lend to customers, or to buy or carry goods for the corporation or to buy insurance for its clients; nor are the accounts of its clients or cus- tomers financed or carried to any substantial extent. Ninety-five per cent of the gross income is derived from personal services ren- dered by the owners or principal stockholders of the corporation. Held, that this corporation is a personal-service corporation within the meaning of section 200 of the Revenue Act of 1918, and that its excess-profits tax for 1917 should be computed at the 8 per cent rate imposed by section 209 of the Revenue Act of 1917. . . . . (C. B. 2, page 17; A. R. R. 46.) In the foregoing case the corporation showed "accounts receivable 6X dollars, cash 24X dollars, while its accounts payable are 40X dollars." There can be no doubt that the corporation was entitled to classification as a personal service corporation, but it is difficult to follow the reasoning under which it was held to be qualified and the reasoning in some of the cases which will be discussed hereafter, in which the items of accounts receivable and accounts payable are held to be evidences of dealing in something other than the services of the principal stockholders. Holding companies. — Regulation A corporation can not be considered a personal service corporation when another corporation (not itself a personal service corporation) owns or controls substantially all of its stock or when substantially all of its stock and of the stock of another corporation (not itself a personal service corporation) form- ing part of the same business enterprise is owned or controlled by the same interests. (Art. 1524.) FROM PERSONAL SERVICE CORPORATIONS 829 Loss OF SUBSIDIARY HOW TAKEN UP BY PARENT COM- PANY. Ruling. In view of the fact that personal service corporaticftis are not required to file consolidated returns, a profit realized or loss sustained by a personal service corporation, attributable to its owner- ship of stock in another personal service corporation, should be accounted for in the same manner as in the case of an individual stockholder. Where the business of a personal service corporation results in an operating loss, such loss will be divided among the stockholders at the close of its taxable year in proportion to their respective shares, and will constitute an allowable deduction in their returns of annual net income. (C. B. 3, page 198; O. D. 581.) I. What constitutes rendering of personal service? — (a) Services must be rendered principally by the STOCKHOLDERS. Regulation. In order that a corporation may be deemed to be a personal service corporation its earnings must be derived princi- pally from compensation for personal services rendered by the cor- poration to the persons with whom it does business. Merchandising or trading either directly or indirectly in commodities or the services of others is not rendering personal service. Conducting an auction, agency, brokerage or commission business strictly on the basis of a fee or commission is rendering personal service. If, however, the corporation assumes any such risks as those of market fluctua- tion, bad debts, failure to accept shipments, etc.. or if it guarantees the accounts of the purchaser or is in any way responsible to the seller for the payment of the purchase price, the transaction is one of merchandising or trading, and this is true even though the goods are shipped directly from the producer to the consumer and are never actually in the possession of the corporation. The fact thai earnings of the corporation are termed commissions or fees is not controlling. The fact that a commission or fee is based on a differ- ence in the prices at which the seller sells and the buyer buys raises a presumption that the transaction is one of merchandising or trading, and it will be so considered in the absence of satisfactory evidence to the contrary. (Art. 1525.) The foregoing regulation provides that if a corporation is in any way responsil)le to the seller for the payment of the purchase price, the transaction is one of merchandising or trading. 830 INCOME The Treasury cannot, by regulation or otherwise, change the law or, in the absence of clear statutory authority, lay clown different tests for the determination of wdiether one is "trading as a principal" than the general law recognizes and applies. \\'hen Congress used the expression "trading as a principal," it will, under the most elementary rules of statu- tory construction, be presumed to have used it in its accepted legal sense. The mere fact that one, who is in fact an agent, agrees to pay, or becomes otherwise responsible for, the debts of his principal, does not constitute him the principal ; nor would it make him a "trader" in any true sense. The Committee on Appeals and Review has held that a taxpayer who is engaged in the brokerage business is entitled to be taxed as one "not having more than a nominal capital" under the Act of 191 7, even though it might be sued on the contracts which it entered into on behalf of its principals.^^ The true test is whether or not a given corporation is really trading as a principal or simply acting as an agent. A number of facts and circumstances may enter into the determination of that question in any given case. One of these circumstances may very well be the fact that the corporation is responsible for the debts which it contracts, presumably on behalf of an- other, but that is not an inclusive or conclusive test. Nor. in view of the well-recognized rule of law, that under certain circumstances an agent may make himself personally respon- sible for the obligations of the principal — upon which the principal is also liable — without changing his legal status as an agent, can it be considered a very material one. It will be noted that any agency or brokerage business conducted strictly on the basis of fees or commissions is deemed to be rendering personal service, but that any trading in commodities or the services of others is not rendering per- sonal service. This is hardlv consistent, because most brokers C. B. 4, page 20; A. R. R. 500. See page 836. FROM PERSONAL SERVICE CORPORATIONS 831 use the services of employees, in which case there is a trading in such services. The Treasury illustration quoted in Excess Profits Tax Procedure, 192 1, pages 87, 88, deals with a cor- poration which renders engineering services and assumes an in- come of $60,000 therefrom. It may reasonably be assumed that the fees paid for services are for the services of others than the principal stockholders. The language of the statute would seem to be broad enough to include as personal service cor- porations those which trade in the services of others. In specific cases the Treasury has held that corporations may not be taxed as personal service corporations in the fol- lowing circumstances : if a corporation deals in the services of others who are connected with the corporation not through stock ownership but merely as employees in branch offices, etc.r/"^ if a corporation assumes risks of market fluctuations, bad debts, etc., or if it guarantees or is in any way responsible to the seller for payment of the purchase price;"'* if the busi- ness conducted is a commercial enterprise ;"° if a freight- for- warding business advances the necessary costs of transporta- tion for the concerns with which business is donef^ if a so- called commission business takes title to the merchandise sold, is liable to the consignor and rebills the merchandise. *'^ A corporation which obtained "selling contracts covering lots, tracts and other parcels of land"^^ disposed of on a com- mission basis, claimed assessment under section 209 of the 191 7 excess profits tax law, on the ground that it had only "nominal capital." It made no purchases on its own account and did not finance real estate operations. It had capital stock paid in of $2,000, and some earned surplus. Ruling The taxpayer contends that it requires and employs no more than a nominal capital in the conduct of its business, that the character of its business is such that capital is not required, °'C. B. 2, page 20; A. R. M. 59. ^"C. B. 2, page 19; A. R. M. 50. ""C. B. I, page 14; T. B. R. 58. "C. B. I, page 13; A. R. R. 7. °=C. B. 2, page 23; A. R. R. 23; and C. B. 2, page 20; A. R. M. "^q. " C. B. 4, page 17 ; A. R. R. 464. 832 INCOME and that its success is due to and its net income is derived solely from the activities of its ofificers, all of whom are stockholders. To this contention the Committee does not agree for the reason that it is shown that in the conduct of its husiness the corporation does re- quire capital and that its income is derived in a large part from ser- vices rendered by others. .... In view of the fact that the said corporation was ultra- conservative in its capitalization and the further fact that the amount of capital it had invested in the business was insufficient at times to meet the needs of that business and v^as less than normal as com- pared with the amount of business transacted and as compared with the amount of capital employed by other concerns doing a similar business, the Committee recommends that the case be returned to the Unit for adjustment and assessment of excess profits tax under the provisions of section 210 on the basis of the average percentages shown on the data sheet submitted to the Committee. ( C. B. 4, page 17; A. R. R. 464.) The following have been held by the Treasury to be per- sonal service corporations and are taxed as .such: a corpora- tion which conducts a commercial school but does not take students as boarders, the principal owners of which devote all their time to preparation of courses, inspection of lessons, etc. ;"* a corporation whose business is the sale of real estate for clients and the collection of rents from property listed with it, whose entire income comes from commissions on business derived from the activity of the principal owners ;^'^' an agency which acts as consignee agent in the United States for a for- eign corporation acquiring no title to the products handled but deriving its income from commissions on sales made by its principal st(jckholders."" (b) The business must be conducted principally BY THE STOCKHOLDERS. Regulation. In determining whether a corporation is a per- sonal service corporation, no weight can be given to the fact that it renders personal services unless (a) the principal owners or stock- "C. B. 2, page 16; A. R. R. 24. ""^ C. B. 3, page 21 ; A. R. R. 210. "" C. B. 2, page 24; A. R. AI. 420; and for a similar case see C. B. 4, page 20. FROM PERSONAL SERVICE CORPORATIONS 833 holders are regularly engaged in the active conduct of its affairs and are engaged in such a manner that the earnings are to be ascribed primarily to their activities, and (b) its affairs are conducted prin- cipally by such owners or stockholders. (Art. 1527.) The statute does not require (and the Committee on Ap- peals and Review has so held) that the income shall l)e due entirely but only primarily to the activities of the principal stockholders. It has been recently decided by the Committee that a corporation doing a stevedoring business ma}- be entitled to personal service classification." 2. To what extent must the earnings be derived from services rendered by the stockholders? — (a) A NON-PERSONAL SERVICE ELEMENT MAY BE PRESENT IF IT IS NEGLIGIBLE, Regulation. It frequently happens that corporations are en- gaged in twfo or more professions or businesses which are more or less related, one of which does not consist of rendering personal service. Thus an engineering concern may also engage in contract- ing, which amounts to trading in materials and labor, a brokerage concern may guarantee some of its accounts, a photographer may sell pictures, frames, art goods and supplies, or a dealer in a com- modity may furnish expert advice or services with respect to its installation, use, etc. In such case the corporation is not a personal service corporation unless the non-personal service element is neg- ligible or merely incidental and no appreciable part of its earnings are to be ascribed to such sources. (Art. 1526.) An advertising agency which is incorporated, the principal owners of which are personally engaged in the business, al- though capital is employed to carry the accounts of cus- tomers, should be classed as a personal service corporation. In such a case capital would be no more than incidental and would ncjt be a material income-producing factor. Income from mere ownership of property invalidates CLAIM. Rulings. A claim for assessment as a personal service corpora- tion should be denied where the income of the corporation is derived entirely as a result of the ownership of certain property (such as "'Bulletin 41-21-1858; A. R. R. 463. See page 834. 834 INCOME patents) and is in no sense derived from the personal activities of any of tiie stockholders. ((". B. J, page 13; T. B. M. 9.) A sanitarium owned and operated by doctors, who in addition to selling their services derive income from the buildings and grounds by housing patients, can not be termed a corporation within the per- sonal service class. (C. B. i, page 15; O. D. 2.) (b) Earnings are not derived from personal ser- vices IF the principal duties of the stockholders are TO supervise a force of employees. Regulation. Where the principal owners or stockholders do not render the principal part of the services, but merely supervise or direct a force of employees, the corporation is not a personal service corporation. If employees contribute substantially to the services rendered by a corporation, it is not a personal service cor- poration unless in every case in which services are so rendered the value of and the compensation charged for such services are to be attributed primarily to the experience or skill of the principal owners or stockholders and such fact is evidenced in some definite manner in the normal course of the profession or business. The fact that the principal owners or stockholders give personal attention or render valuable services to the corporation as a result of which its earnings are greater than those of a corporation engaged in a like or similar business, the principal owners or stockholders of which do not devote personal attention to the management or supervision of its affairs, does not of itself constitute the corporation a personal service corporation. (Art. 1528.) Ruling The Bureau has uniformly taken the position, and the Committee thinks correctly, that the business of stevedoring is primarily trafficking in the labor of others, and it therefore recom- mends that the action of the Unit in assessing tax under section 2io rather than under section 209 be approved. (C. B. 3^ page 22; A. R. R. 213O That is to say, a corporation engaged primarily in the trad- ing in labor of others should not be classed as a personal serv- ice corporation. The Committee has held, however, that the following facts do not constitute general stevedoring business : Ruling. A corporation, the stockholders of which are efficiency engineers in the stevedoring line, acts as consultants to general steve- dores, and has a contract with a foreign government under which the longshoremen employed by the company receive the full amount for^ FROM PERSONAL SERVICE CORPORATIONS 835 their labor which was received by the corporation by way of ad- vances from the foreign government to meet the weekly pay roll. The income is ascribed primarily to the activity of the sole stockholders. Capital is not a material income-producing factor. The corporation is therefore entitled to classification as a personal service corporation. (B. Digest 41-21-1858; A. R. R. 463.) It is apparent in the foregoing case that the company had pay-rohs which imphes "trafficking in the services of others" and that it depended on "advances" to meet the pay-rolls. Probably it was legally liable to the employees if the "ad- vances" were not received. The company undoubtedly is a personal service corporation, but so are others similarly situ- ated which have been denied the classification. 3. To what extent may capital be used to conduct the business? — (a) Capital must not be a material income-produc- ing FACTOR. Regulation. In determining whether a corporation is a per- sonal service corporation, no weight can be given to the fact that the invested capital of the corporation for the purpose of the war profits and excess profits tax or the actual investment of the principal owners or stockholders is comparatively small. The test established by the statute with respect to capital is entirely different. That test is the nature of the profession or business as indicated (o) by the kind of services it renders and (6) the extent to which capital is required to carry on such profession or business. If the use of capital is necessary or more than incidental, capital is a material income-producing factor and the corporation is not a personal service corporation. No corporation is a personal service corporation if it carries on business of a kind which ordinarily requires the use of capital, irrespective of whether the owners or stockholders have actually invested a substantial amount of capital. (Art. 1531.) As stated on page 824, the law expressly permits the use of capital. The limitation is that it must not be material. The regulation is framed to exclude as many as possible not- withstanding the effort of the lawmakers to include all that can reasonably qualify. Until recently the Income Tax Unit has held that the 836 INCOME mere fact that a company might be hable under an obHgation should preckide a taxpayer from a classification of a personal service corporation. The Committee has disposed of this point in a sensible wa}'. Ruling^ The M corporation was a broker in metals and employed onl)' a nominal capital. No advances were made to the manufacturer and collections from the purchaser were only transmitted through the broker. Although the corporation was liable to be sued under its contracts with the purchaser the Committee considers that the nominal capital of the corporation clearly establishes the fact that it was contemplated it should not be held responsible except by way of personal service to both buyer and seller. Accordingly the Com- mittee recommends that assessment of the excess profits tax be made in accordance with the provisions of section 209 of the Revenue Act of 1917 (C. B. 4, page 20; A. R. R. 500.) (b) There must not be a substantial amount of CAPITAL ACTIVELY EMPLOYED, WHETHER SECURED DIRECTLY OR INDIRECTLY, Regulation. The term '"capital" as used in section 200 of the statute .... means not only capital actually invested by the owners or stockholders, but also capital secured in other ways. Thus if capital is borrowed either directly as shown by bonds, debentures, certificates of indebtedness, notes, bills payable or other paper, or indirectly as shown by accounts payable or other forms of credit, or if the business of the corporation is in any way financed by or through any of the owners or stockholders, these facts will be deemed evidence that the use of capital is necessary. If a substan- tial amount of capital is used to finance or carry the accounts of clients or customers, it will be inferred that because of competition or other reasons such practice is necessary in order to secure or hold business which otherwise would be lost, and that the corporation is not a personal service corporation. If a corporation engaged in an agency, brokerage or commission business regularly employs a sub- stantial amount of capital to lend to principals, to buy and carry goods on its own account, or to buy and carry odd lots in order that it may render more satisfactory service to its principals or customers, it is not a personal service corporation. In general the larger the amount of the capital actually used the stronger is the evidence that capital is necessary and is a material income-producing factor and that the corporation is not a personal service corporation. (Art. 1532.) FROM PERSONAL SERVICE CORPORATIONS 837 Generally speaking, the test is not the small amount of capital employed, but the nature of the business as indicated by the kind of services rendered, rather than by the extent to which capital is required. If capital is employed, but is not needed for the conduct of the business, the size of the capital alone would not prevent a corporation from being classed as a personal service corporation. The test is, would the capital without the personal service element produce the income which has been earned? To constitute a "personal service corporation" no definite percentage of stock need be held by those conducting the busi- ness. — Regulation. No definite percentage of stock or interest in the corporation which must be held by those engaged in the active con- duct of its affairs in order that they may be deemed to be the prin- cipal owners or stockholders can be prescribed as a conclusive test, as other facts may affect any presumption so established. No cor- poration or its owners or stockholders shall, however, make a return in the first instance on the basis of its being a personal service cor- poration unless at least 80 per cent of its stock is held by those regu- larly engaged in the active conduct of its affairs. (Art. 1529.) The regulations do not require that at least 80 per cent of the stock of the corporation must be held by those regu- larly engaged in the active conduct of its affairs, but do stipulate that unless 80 per cent of the stock is so held the corporation must first make the corporation return and sub- sequently make application for the privilege of being classed as a personal service corporation. Change of ownership does not take a corporation out of the personal service class. — Regulation. The fact that the owners or stockholders of the corporation may change during the course of the taxable year does not take a corporation which is normally in the personal service class out of that class. Frequent changes in the ownership of any substantial interest or number of shares are, however, evidence bear- ing on the question as to whether the principal owners or stockholders are actively engaged in the conduct of the affairs of the corporation. 838 INCOME The incapacity, retirement, or death of a principal owner or stock- holder who has been actively engaged in the conduct of its affairs will not be deemed to make any change in the status of the cor- poration during a reasonable time thereafter. (Art. 1530.) Personal service corporation entitled to net loss provision. — If a personal service corporation shows a net loss for the year 1921, the same may under certain conditions be applied against the succeeding year.**^ Credits allowed stockholders of personal service corpora- tions. — Regulation. A stockholder of a personal service corporation is entitled to credit for the purpose of the normal tax only for amounts received in distribution of earnings or profits of the corporation ac- cumulated since February 28, 1913, except such amounts as represent earnings of the personal service corporation accumulated after De- cember 31, 1917, and prior to January i, 1922, which would have been taxed directly to the stockholder In addition to the credits ordinarily allowed to an individual,* a stockholder of a personal ser- vice corporation is entitled relative to income properly allocated to the period beginning with January i, 1918, and ending with December 31, 1921, to the following credits: (a) A credit against net income for the purpose of the normal tax only of his proportionate share of such dividends and interest allowed as credits by section 216 as are re- ceived by the personal service corporation, and (b) a credit against income tax of the stockholder's proportionate share of income, war profits, and excess profits taxes of the personal service corporation paid or accrued during the taxable year to a foreign country or to any possession of the United States, subject to the limitations of section 222 of the statute. (Art. 339.) Foreign corporations cannot be classed as personal service corporations. — Even though a foreign corporation doing business in the United States derives all its income from tKe activities of its principal owners, it cannot be classed as a personal service corporation. Under 1918 and 192 1 laws, all foreign corporations (whether personal service or not) are taxed under sections 327 and 328. Section 204. See page 804. J FROM PERSONAL SERVICE CORPORATIONS 839 Corporations with large government contracts may not qualify. — When 50 per cent or more of the gross income of a corporation is derived from "gains, profits, commissions or other income derived from a government contract or contracts made between April 6, 191 7, and November 11, 1918," it cannot qualify as a personal service corporation.®" This would include engineering and other corporations whose activities were devoted to government work during 1918.'^'' Corporations which do not distribute earnings may be classed as personal service corporations. — The attempt to im- pose in the 19 18" law a penalty tax on the undistributed profits of all corporations was very properly defeated. The 1 92 1 law renews previous attempts to tax undistrib- uted profits,"" though by a somewhat different procedure. The new law provides that if the stockholders of a corporation, which is used to prevent the imposition of the surtax, "agree thereto, the Commissioner may, in lieu of all income, war profits and excess profits taxes imposed upon the corporation for the taxable year, tax the stockholders or members of such corporation upon their distributive shares in the net income," in the same manner as the partners of a partnership are taxed. ^^ Computation of tax when corporation is partly a personal service corporation. — Section 303 provides that if at least 30 l)er cent of the net income of a corporation is derived from a business, which if constituting its sole business would bring it within the class of personal service corporations, the tax upon that part of the income shall be computed separately. Such a corporation is subject to the excess profits tax (but not "' Section 200. '"For definition of government contract, see section i, 1921 law. " See Chapter XXXV for discussion of the 1917 law. '■'Section 220. See C'hapter XXXV. " [Former Procedure] Under the 1918 law (section 220) if a corpora- tion was used to evade the surtax, the stockholders tliereof were taxed in the same manner as stockholders of a personal service corporation. The stockholders had no right of election. 840 . INCOME later than December 31, 1921, as of which date it is repealed). Tt should be noted on this point, however, that in computing the tax there must be ascribed to the personal service part of the business the same amount of capital which is normally required by corporations which have been deemed to be per- sonal service corporations not subject to the excess profits tax/* Status of stockholders in personal service corporation. — The surplus accumulated prior to January i, 1918, by a cor- poration designated under the 1918 and 1921 laws as a per- sonal service corporation, w^ill have been subjected to the nor- mal income taxes imposed between March i, 191 3, and De- cember 31, 1917. The status of the surplus follows any trans- fers of shares of capital stock — that is, dividends declared be- fore or after the transfer were free from the normal tax whether paid to a new or to an old stockholder. In 1921 the purchaser of shares of stock of a personal service corporation W'Ould certainly be free from the normal tax on dividends de- clared out of surplus accumulated prior to January i, 1918, and would be free from the surtax as well on dividends declared from earnings accumulated after January i, 1918, but prior to the current year. Because of the fact that all earnings between January i, 1 91 8, and December 31, 1921, are subjected not only to nor- mal tax but also to personal surtax, regardless of whether distributed or not, whereas only normal tax has been paid on the undistributed earnings accumulated prior to that date, it is important that the corporation's books show a clear line of demarcation between the surplus or undistributed profits accumulated respectively prior to and subsequent to January I, 1918. Ruling. A stockholder of a personal-service corporation having reported in his individual return for the taxable year his distributive share of the undistributed net income of the corporation for such See Excess Profits Tax Procedure, 1921. FROM PERSONAL SERVICE CORPORATIONS 841 taxable year should not again report such income when it is actually received in a subsequent year, neither will it be necessary to make any notation respecting such profits in the return for the subsequent year. (C. B. i, page 174; O. D. 141.) Personal service corporations should declare at once in dividends the earnings which have accumulated during the period January i, 19 18, to December 31, 1921. These profits have already been subjected to both the normal and surtax for these various years. If these profits are not declared in dividends, a personal service corporation will soon be in a position where the more recently accumulated profits must be declared in dividends before these "tax-free" profits may be withdrawn by the stockholders.''^ Amended returns and claims when establishing personal service status. — Ruling. A corporation filing returns on Form 1120 and subse- quently desiring to establish its status as a personal service corpora- tion should adopt the following method of procedure: It should file amended returns on Form 1065 accompanied with claim for refund on Form 46 for the tax or installments thereof paid. The individual members of the corporation should also file amended returns accompanied with claims in abatement, Form 47, covering the additional assessment shown by such returns. In the event that the corporation is found to be taxable under sections 230 and 301 of the Revenue Act of 1918, the claim for refund will be disallowed. In case the corporation establishes a per- sonal service status, the claim for refund will be allowed for the tax paid by the corporation, and the claims in abatement will be dis- allowed and assessment made to the extent of the additional tax shown to be due on the amended individual returns. Where the procedure is adopted, 'however, the installments of tax which become due prior to determination of the status of the corporation as shown by its return, as originally filed, must be paid on or before the due dates. Such installments are not subject to either abatement or credit, but can only be covered by supplemental claim for refund. (C. P». 3, page 198; O. D. 614.) For a detailed discussion, see page 713. PART III DEDUCTIONS CHAPTER XXV DEDUCTIONS AND CREDITS— GENERAL Method of treatment. — The statute specifies the particular deductions and credits which may be subtracted from gross income to determine taxable net income or from the tax as ascertained under certain sections to determine the net tax to be paid. These deductions and credits are listed separately in the law and differ somewhat with the character of the tax- payer — whether a corporation, a personal service corporation or an individual, or whether a resident or a non-resident. In this book all the peculiarities relating to non-resident aliens, including deductions, are relegated to a special chapter (XXXVI). The deductions and credits allowed to others than non-resident aliens, whether individuals or corporations, are consolidated and are treated topically in the series of chap- ters which follows. This method of treatment is convenient because most of the deductions apply with equal force to individuals and corporations. Often the wording is exactly the same and in such cases repetition is avoided, for only one construction can be placed upon it. Where there is any vari- ance in the deductions the fact is noted and the comments separated within the chapter, care being taken to make clear the limited application of the statements which relate only to corporations or only to individuals. Since the law is printed in full in the Appendix and since all the provisions relating to deductions are quoted verbatim under the various individual topics in the succeeding chapters, it is not necessary to give here the various lists of allowable deductions. For these the reader is referred to sections 214 (a) and 234 (a) of the statute. , Deductions limited to those specified in the statute. — While the tax is levied on "net income received," that term is not 845 846 DEDUCTIONS the usual "net income"' of the accountant's vocabulary. It is a resultant obtained Ijy subtracting from gross income, as de- termined in the particular manner described in the preceding chapters, certain specified deductions which are discussed in the chapters which follow. In the language of the regula- tions : Regulation. Net income is that portion of the gross income which remains after all proper deductions have been taken into account. The net income of corporations is determined in general in the same manner as the net income of individuals, but the deduc- tions allowed corporations are not precisely the same as those allowed individuals (Art. 531.) The law expressly excludes certain items usually regarded as legitimate deductions from income, and the Treasury has held that some other items of ordinary expenses are not al- lowable. Some of these restrictions apply both to individuals and to corporations. Others apply merely to one or the other. Neither individuals nor corporations, for example, may deduct special assessments of certain types or interest on money bor- rowed to purchase certain tax-exempt securities. On the other hand, an individual may deduct charitable contributions to a limited extent, while a corporation may not. Again, an individual may not deduct personal expenses, which makes it necessary to define personal expenses very carefully, while a corporation, of course, is presumed to have no "personal" ex- penses. Taxes imposed on an individual's residence and in- terest on money borrowed for personal use are not considered personal expenses. Moreover, under the 1918 and 1921 laws an individual can deduct the net loss sustained by any "cas- ualty" which happens to his automobile or other property (such as a stock of liquors), a loss which is nothing more than a per- sonal or living expense. Furthermore, individuals may deduct the interest paid on loans which are used to defray personal expenses. Inconsistencies such as these give rise to most of the complications encountered in drawing up returns. Those charged with the preparation of returns should carefully study DEDUCTIONS AND CREDITS— GENERAL 847 the ])rovisions of the law bearing on deductions and be pre- pared to pass on the propriety of including or excluding the various items of expenditures which have been made.^ Deductions may be determined by accrual method. — Law. Section 212 (b) The net income shall be com- puted upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the com- putation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income Section 200 The term "paid," for the purposes of the deductions and credits under this title, means "paid or accrued" or "paid or incurred," and the terms "paid or incurred" and "paid or accrued" shall be construed according to the method of accounting upon the basis of which the net income is computed under section 212; .... If the taxpayer keeps no regular books of account, and if he does keep books, but on the basis of cash receipts and payments, he must claim his deductions on the basis of cash actually paid out. In all cases where it is possible to do so, the taxpayer should keep his books on an "accrual" basis. If this method, which is now specifically authorized by the regu- lations, is once adopted it must be followed in subsequent years. The application of the accrual method is thus described in the regulation: Regulation, (i) Approved standard methods of accounting will ordinarily be regarded as clearly reflecting income. A method of accounting will not, however, be regarded as clearly reflecting income unless all items of gross income and all deductions are treated with reasonable consistency All items of gross income shall be in- cluded in the gross income for the taxable year in which they are received by the taxpayer, and deductions taken accordingly, unless in order clearly to reflect income such amounts are to be properly ac- counted for as of a different period (Art. 23.) ' The form of reconcilement statement which will be found in Excess Profits Tax Procedure. Uj2i. ChaptiT XV, affords a mcTins of preventin.t,' the omission of any allowable deduction in the books, and as to classihca- tion it calls attention to any omission of allowable items not in the books. 848 DEDUCTIONS Each year's return must be complete within itself. — Regulation. Each year's return, so far as practicable, both as to gross income and deductions therefrom, should be complete in itself, and taxpayers are expected to make every reasonable effort to ascertain the facts necessary to make a correct return (Art. III.) The foregoing principle is discussed in the chapters which follow. The intention is to impose no unreasonable restric- tions on taxpayers whi) follow good accounting principles. The new article omits the provision that losses from theft or embezzlement are deductible in the year of occurrence. This is in accordance with article 126. Ruling. Where a corporation engaged in buying and selling real estate purchases a piece of property and holds it for a profi':, the interest, taxes, and ordinary repairs incident to the property lepre- sent charges for the year in which paid or are so charged upon the books as to represent liabilities of the corporation and are allowable deductions in computing net income even though in excess of the gross income derived from the property. Such charges are not capital expenditures if the corporation lias any income from which to deduct them and they should not be added to the cost of the property in determining the amount of gain or loss arising from its sale except to the extent that the corporation has no gross income from any source against which to deduct such expenditures for the taxable year in which they were made. (C. B. 2, page 112; O. D. 398.) The principle of each return being complete in itself is sub- stantialh' modified by section 204 of the 192 1 law, which allows net losses to be used to reduce the taxable income of the next t\\o succeeding years. See Chapter XXIX. Amended returns may be made to adjust items applicable to prior years. — Ruling. A corporation during its fiscal year ended May 31, 1919, sold certain goods, the weight and grade of which were guaranteed by contract. At the close of that fiscal year a number of claims involving shipments not conforming to specifications were in process of adjustment, settlement of which was made during the ensuing fiscal year. Inasmuch as the corporation's liability is not in dispute and the amount thereof is merely an accounting detail to be determined under an existing contract or agreement and in accordance with a DEDUCTIONS AND CREDITS— GENERAL 849 recognized method of procedure the Committee is of opinion that such adjustments are applicable to the year in which the sales were made and hence properly deductible in the return of the corporation for its fiscal year ended May 31, 19 19. (C. B. 3, page 147; A. R. R. 275.) These regulations must be reasonably construed. All busi- ness concerns and all individuals have items of receipts and expenses which cannot be incorporated in books of account prior to closing time. In the well-managed concern the amounts are usually insignificant and when subsequently ascer- tained they are entered as current items in the succeeding period. If the amounts are large the treatment is different and adjustment of the accounts of the prior period and the filing of amended returns are in order, but after the accounts for a fiscal year are once closed there should be no reopening unless it is a matter of substantial importance. This interpretation is apparently in accord with the gen- eral rule laid down in another regulation for the inclusion or exclusion of insignificant amounts in one year or another. It does not disturb the clear reflection of income. Regulation The time as of which any item of gross income or any deduction is to be accounted for must be determined in the light of the fundamental rule that the computation shall be made in such a manner as clearly reflects the taxpayer's income. If the method of accounting regularly employed by him in keeping his books clearly reflects his income, it is to be followed with respect to the time as of which items of gross income and deductions are to be accounted for. If the taxpayer does not regularly employ a method of accounting which clearly reflects his income, the com- putation shall be made in such manner as in the opinion of the Commissioner clearly reflects it. (Art. 22.) The regulation quoted on page 109 (article iii) makes it plain that the taxpayer may file amended returns on his own initiative. Tlie Commissioner, in turn, may on his part re- (juire such returns. Regulation If in the opinion of the Commissioner such information indicates that the returns for any previous years did not reflect the true income, amended returns for such years will be required (Reg. 45, Art. 23.) 850 DEDUCTIONS It is the desire of the Treasury to obtain returns which accurately reflect for a given year the actual income and the actual expenses applicable to that year. The Treasury ac- cepts or requires amended returns, if based on meritorious grounds, whether or not the outcome is favorable to the gov- ernment. The action of some inspectors would lead one to believe that amended returns are in order only when the net result is against the taxpayer, but the responsible officers of the Treasury maintain no such attitude. Desirability of good records. — Most individuals keep poor accounts or none at all. It is desirable from almost ever}' point of view to keep careful financial records, and the income tax levied at the present high rates makes it almost imperative that this be done. It is important from the point of view of the government in order that no taxable items may be missed. It is important from the point of view of the individual in order that his burden may not be inequitably large as com- pared with his neighbor's. But since most individuals find it easier to recall all the items of their income than of their ex- penditure, they usually do not avail themselves of all allowable deductions. In other words, the keeping of careful records in this case will work out more to the advantage of the taxpayer than to that of the government ; but it will also result in the tax being more equitably spread, which is an advantage from every point of view. Accounts of partnerships and corporations are, as a rule, better kept than those of individuals. They are, of course, supposed to include all items which can be claimed as allowable deductions. The items disallowed by the law and regulations are discussed in detail in the chapters which follow. If the accrual method is used all items of deductions, minus those specifically forbidden, as taken from the record of expenses or liabilities, should yield the proper result. If the accrual method is not followed, the taxpayer must depend upon his cash account. CHAPTER XXVI DEDUCTIONS FOR EXPENSES General The 1921 law re-enacts the provision of the 19 18 law re- garding deductions for expenses. The new law specifically permits individuals to deduct traveling expenses.^ The chief problems of procedure connected with deduc- tions for expenses are occasioned by the presence of certain restrictions in the law itself. First of all, the statute forbids the deduction of personal living expenses.^ This is quite necessary and proper, but it involves the difficult task of estab- lishing a sharp line of demarcation between business and liv- ing expenses. Gifts,' in the next place, are not generally de- ductible ; but in many cases it is not easy to determine whether a payment, nominally a gift, is not more truly an expense. The law does not permit the deduction of capital expenditures ex- cept in the form of depreciation allowances, and here once more it is necessary to set up a series of distinctions between this type of expenditures and business expenses proper. Again, care must be taken not to allow any distribution of profits under the guise of business expense. Other difficulties are caused by the prohibition of certain expenditures as contrary to public policy and by the necessity of taking a position on the question of insurance — as to how far expenses are deduc- tible which seek to safeguard the income from risks of various sorts. In this chapter the first general section is devoted to the * See page 864. 'This rule is considerably modified if section 214 (a-6) (allowing for losses arising out of casualties) is interpreted to cover ordinary accidents to personal property, the use of which has always been regarded as private or family expense. " Sec Chapter XXXIV, "Deductions for Gifts and Donations." 851 852 DEDUCTIONS establishment of the distinction between business and personal expenses and is consequently applicable to individuals only. The remainder of the chapter deals with various specific types of expenses and, unless otherwise specified, applies alike to individuals, partnerships and corporations. In the case of many of these expenses the deductibility of a particular item becomes a complicated question involving several of the dis- tinctions referred to in the preceding paragraph, as, for ex- ample, when a salary must be shown to be not a gift, a per- sonal expense, a distribution of profit, a distribution of assets or a payment for property.* Expenses which are deductible. — Law. Section 214. [Individuals] (a) That in computing net income there shall be allowed as deductions: / (i) All the ordinary and necessary expenses paid or incurred dur- ing the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments re- quired to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the tax- payer has not taken or is not taking title or in which he has no equity;* Section 234. [Corporations] (a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions: (i) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for per- ' See page 870. [Former Procedure] Sections 214 (a-i) and 234 (a-i) of the 1921 law are identical with those in the 1918 law, except for the addition of the provision in the former relating to traveling expenses. 1916 Law. Section 5. [Individuals] "(a) .... First. The neces- sary expenses actually paid in carrying on any business or trade, not includ- ing personal, living, or family expenses ;" Section 12. [Corporations] "(a) .... First. All the ordinary and necessary expenses paid within the year in the maintenance and operation of its business and properties " 'For comment on last two lines which were added by the 1916 law, see Chapter XXVII, "Deductions for Interest." FOR EXPENSES 853 sonal services actually rendered, and including rentals or other pay- ments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity ; The principle underlying the deductions for expenses was well expressed in a ruling under the 1913 law, as follows: Ruling. Only those expenses which are incurred in earning income which is subject to tax under the income tax law constitute allowable deductions in computing' net income taxable under the law. (T. D. 2137, January 30, 1915.) In general, there has been adherence to the foregoing prin- ciple. In some cases, however, expenses which have been in- curred in earning taxable income have not been allowed. Restrictions on expense deductions. — The restrictions on deductions for expenses are the following :*' Law. Section 215. [hidividualsl That in computing net in- come no deduction shall in any case be allowed in respect of — (i) Personal, living, or family expenses; (2) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any prop- erty or estate; (3) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made;^ or (4) Premiums paid on any life insurance policy covering the life of any officer or employee, or of any person financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or indirectly a beneficiary under such policy. ^ .... Section 235. [Corporations! That in computing net income no deduction shall in any case be allowed in respect of any of the items specified in section 215. Accrued expenses may be deducted, — When the accounts of a taxpayer are kept on the accrual basis all expenses in- curred to the end of the taxable year, whether paid or not are '[Former Procedure] These provisions are identical with those of the 1918 law. ' See Chapter XXXI, "Depreciation." ' See page 894. 854 DEDUCTIONS " " ' allowable deductions and should be entered in the books. It is, however, most reprehensible to enter accrued items of expenses unless all items of accrued income are also entered. The term "expenses .... incurred" must be taken in its usual commercial sense. It would be improper for a concern to enter as an accrued expense at the end of the taxable year any items of which the business had not received the benefit. An office telephone company sent out notices on December 27, 1918, to the effect that the signing of a contract for its service was sufficient to warrant the inclusion of the liability thereby incurred as an allowable expense in the 1918 accounts. The statement was incorrect. In the first place, if the equip- ment was a capital expenditure it could not be deducted as an expense, and, in the second place, if it was an allowable expense item it should not be allowed until the business received the benefit, which could not occur before the year in which the service was actually installed. Business Expenses Distinguished from Personal Expenses Definition of "business or trade." — The law specifies that an individual must not include "personal, living or family ex- penses" in his computation of deductible expenses. He may subtract under this head merely "the ordinary and necessary expenses paid or incurred .... in carrying on any trade or business."^ "Business" and "trade" are used synonymously and have been defined as follows in an old regulation : Ruling. That which occupies and engages the time, atten- tion and labor of anyone for the purpose of liveHhood, profit or im- provement; that which is his persona] concern or interest; employ- ment, regular occupation, but it is not necessary that it should be his sole occupation or employment. (T. D. 1989. June 2, 1914.) It is apparent that this definition is broad enough to in- clude professions of all types, ^^ as well as various avocations • Section 214 (a-i). '"The excess profits tax law of October 3. 1917, specitically included professions within the definition of "trade" and "business." (See sec- tion 200.) FOR EXPENSES 855 aiui "side-lines."'^ Moreover, it is not neeessary for a person to own a business in order to be in business or to have business expenses. Salaried officers and employees and persons re- ceiving their remuneration on a commission basis often have business expenses which are necessary and are allowable as deductions. Recognition of this is found in the original edi- tion of Regulations 45.^" Regulation Amounts paid from a salary received for all services rendered and expenses incurred are deductible as business expenses wrhen the expenditures are occasioned by the services in respect of which the salary is paid (Reg"- 45, Art. 292.) In the April 17, 1919, edition of the regulations the state- ment was omitted. The omission, however, cannot operate to deprive anyone of a deduction for business expenses which the law permits. The circumstances of each case are considered by the Treasury in deciding whether expenditures are business or per- sonal. Office rent paid by a taxpayer whose income is derived principally from investments, is deductible if it can be shown that such rent is ordinary and necessary. ^^ Expenses incurred in making a trip to Washington in connection with the assess- ment of additional tax by the Treasury have been held to be deductible.^* Rental of a safe deposit box is held to be deducti- ble only when used in connection with trade or business.^^ "Personal expenses" defined. — In a case involving the ques- tion, whether or not transportation paid by a commuter is a deductible expense, the solicitor has very aptly defined personal expenses. . Ruling "Business expenses," as defined in article loi, Regulations 45, includes all items entering into what is ordinarily " See C. B. 4, page 119; O. D. 805. "The preliminary edition of these regulations was issued soon after the enactment of the 1918 law. "C. B. 4, page 123; O. D. 877. " C. B. 4, page 123; O. D. 849. " Telegram to Guaranty Trust Co., signed by Commissioner Wm. M. Williams, dated March 8, 1921. 856 DEDUCTIONS known as the cost of goods sold, together with selling and manage- ment expenses. In short, every necessary item of expense in con- ducting business, incurred primarily because of and solely in the furtherance of the business engaged in, is held to be an ordinary and necessary business expense. To what extent can this definition of business expenses be applied? Does it include any and all expenses which in any way bear upon or have a relation to or a connection with the business engaged in by the individual? Obviously, amounts paid out for medical attention necessary for the upkeep of the body and the preservation of health are personal and have no connection with business. Likewise, sums paid to the grocer, to the tailor, amounts paid for insurance and house rent. These expenses arise independently of business. The test, therefore, is whether an expense is incurred primarily because of business as the immediate cause inducing the expenditure. .... Obviously, an individual is free to fix his residence wher- ever he chooses. He fixes it according to his personal convenience and inclinations, as a matter separate and apart from business. Any expense, therefore, incident to such residence as fixed by the individ- ual is a matter personal to him It is therefore held that the cost of transportation paid by a sal- aried employee living at a distance from his employment, in order to go to and return from sucli employment, is not deductible as a busi- ness expense within the meaning of the Revenue Acts of October 3, 1913, September 8, 1916, as amended, and February 24, 1919. (C. B. I, page loi ; S. 1048.) The foregoing ruling liolds that traveHng expenses, when incurred in connection witli a taxpayer's duties, are allowable deductions. The ruling is sound. It is difficult, however, to distinguish between occasional and frequent business expenses. If trips were made monthly, apparently the expense would be allowed; when trips are made daily the expense is not allowed. The principle does not seem to be logical. It would seem to be more logical to confine "personal, living and family expenses" to those which are expended whether or not a per- son is in business. If a person engages in business and is required to incur business expenses, the additional cost should be treated as a deduction from gross income. The solicitor (in Opinion 1048) falls into an error when he states that "obviously an individual is free to fix his residence wherever he chooses." In the case of the Congressman's secretary he FOR EXPENSES 857 was required to fix it in VVasliingtonJ'"' Only when one enjoys a "lazy" income is one free to live where one likes. The author would like to see a court decision on the deductibility of the commuters' railroad fares. Theory underlying the segregation of business expenses. — In the opinion of the author the exact line between personal and business expenses can be determined with theoretical ac- curacy by ascertaining whether or not the various items would have been expended had the taxpayer's income been derived from some source, other than business, which required no out- lay for business expenses. For example, if a salesman or other employee receives a salary of $3,000 per annum, the query should be propounded: "What would his personal, liv- ing or family expenses be if his income of $3,000 were de- rived from investments?" Theoretically he should be per- mitted to deduct any additional expenses incurred over and above those which he would pay if he were free to live wherever he chose and in any manner he chose within the limitations of his $3,000 investment income. If in order to earn his salary he must purchase books, attend lectures and incur similar expenses, they should be proper deductions. If he must belong to a luncheon club and entertain at his own expense prospective or actual customers, the dues and other charges of the club should be considered as business expenses and therefore as allowable deductions. If, to be within reach of his place of business, he must live in a community where rents are high, this additional amount should be considered a business expense, as should also the cost of his coninuitation ticket on the railway. There are, however, apparent difficulties in applying in practice the theoretical distinction worked out in the pre- ceding paragraph. Moreover, the specific provision of the law forbidding the deduction of actual "personal, living or family expenses" complicates the situation, for, as a matter of See ruling (C. B. 4; O. D. 8O5). page 865. 858 DEDUCTIONS fact, items which would ordinarily be classified as "family" and "personal" expenses (such, for example, as house rent) may be and often are at the same time true business expenses as ascertained by the test given above. The law forbids the deduction of the higher rent which A pays to be near his work and the regulations forbid the deduction of the commutation fare of B who prefers to spend time and railway fare rather than rent in order to secure accessibiHty to his business. ^^ Theoretically both deductions should be permitted. To work out a complete solution it is necessary both to change the law, in order to recognize certain "living" expenses as business ex- penses, and to liberalize the present regulations." Importance of precise distinction. — The importance of distinguishing carefully between business and personal ex- penses and of securing a full deduction of the former is greatly emphasized by two elements in the situation. The first is that "unearned" income, which at present is taxed at the same rates as business income, often has no business expenses at- tached to it and consequently runs no danger of excessive taxation through failure to deduct such expenses. If business " See ruling, page 865. " The situation has been partly met in England by the establish- ment of allowances roughly equivalent to annual business expenses of this sort which are difficult to determine exactly, a practice permitted under the following section of the British Act of 1918 (8 & 9 Geo. 5, C. 40) : "Where the Treasury are satisfied with respect to any class of per- sons in receipt of any salary, fees, or emoluments payable out of the public revenue that such persons are obliged to lay out and expend money wholly, exclusively, and necessarily in the performance of the duties in respect of which such salary, fees, or emoluments are pay- able, the Treasurx' may fix such sum, as in their opinion represents a fair equivalent of the average annual amount laid out and expended as aforesaid by persons of that class, and in charging of the tax on the said salary, fees, or emoluments, there shall be deducted from the amount thereof the sums so fixed by the Treasury; provided that if any person would, but for the provisions of this rule, be entitled to deduct a larger amount than the sum so fixed, that sum may be deducted instead of the sum so fixed." (Sch. E, Rule 10.) It may be that a fairly satisfactory solution of the problem in this country can be found by following the lines suggested in this law. FOR EXPENSES 859 Expenses arc not completely deductible, business income stands at a still greater disadvantagCj as compared with funded income, than is intended when the rates on both earned and unearned incomes are the same. In the opinion of the author the failure to tax unearned income at a higher rate than earned income in itself constitutes a sufficiently great dis- crimination without adding to it in this manner. The other elerrient which emphasizes the desirability of carefully segre- gating business expenses is the fact that the average citizen of the United States is not given to a close analysis of his personal expenditures. He thus is apt to be taxed excessively, unless his attention is called to the importance of accurate accounts. Moreover, knowledge of one's personal expendi- tures undoubtedly leads to greater economy and increased savings. This, in tuni, means larger amounts available for future income taxation, a fact which should not be overlooked by taxing authorities in framing regulations governing de- ductions for expenses. Suggestion for segregating business expenses. — Where business expenses are intermingled with personal expenses, it is sometimes helpful to approach the problem in a negative fashion — that is, to ascertain first the amounts paid for per- sonal, living and family expenses (items which are not de- ductible) and to assume tentatively that the remainder repre- sents business expenses. With such an assumption in mind the examination of the charges composing this remainder often reveals deductible items not otherwise apparent." In the paragraphs which follow various items officially classified are cited as illustrative of allowable deductions. So long as good faith is observed in the inclusion of an ex- pense item, it is not likely to arouse objection. '* The remainder, determined in the negative manner thus described, would, of course, not be an item acceptable to the tax authorities. The suggestion is made merely as a method of discovering deductible items which can be consolidated into a positive total of business expenses, suitable for use in the return. 860 DEDUCTIONS May personal expenses be deducted as casualties? — Sec- tion 215 provides that "no deduction shall in any case be al- lowed in respect of (a) personal, living or family expenses." But under deductions this statement appears : Law. Section 214. (a) That in computing net income there shall be allowed as deductions: .... (6) Losses, sustained during the taxable year of property not connected with the trade or business (but in the case of a nonresident alien individual only property within the United States) if arising from fires, storms, shipwreck, or other casualty, or from theft, and if not compensated for by insurance or otherwise; .... It is claimed that the allowable deduction for a cas- ualty to property "not connected with the trade or business" would extend to net losses sustained on private automobiles. li so, the deduction would also extend to the breakage of statuary and ornaments in one's home, to eyeglasses and per- haps to children's toys. The author is of the opinion that section 215 is control- ling as to all items which the taxpayer ordinarilv reeards as "personal, living or family expenses," and therefore section 214 (a-6) includes only losses arising from such casualties as could not be regarded as personal, living or family expenses. If a residence burns down, the loss not covered by in- surance is deductible. The test should be whether or not there has been a property loss, and no deduction should be per- mitted which cannot reasonably be so construed. In most cases ta.xpayers have three classes of expenditures: (i) ex- penses connected with business or trade; (2) expenses involved in investments and transactions entered into for profit; (3) personal, living or family expenses. Losses arising, out of class (2) are fully deductible under the 1921 law. The resi- dences of taxpayers may be said to l)e in a class by themselves, but items which the taxpayer himself has always regarded as in class (3) should not be taken out of that class except for a sound economic reason. The author does not believe that such a reason exists. While it can hardly be said that the wording of the sec- FOR EXPENSES 86l tions is ambiguous, yet the intention of the framers of the law is an important factor, and it may be assumed without investigation that there was no intention on their part of com- pletely reversing all former procedure and permitting the de- duction of such an item as a loss arising from the puncture of an automobile tire. Wages for personal service. — The law does not permit a deduction for wages paid to those in domestic service, nor to those, such as dressmakers and others, who produce articles consumed in the taxpayer's family, but wages paid to those who help to produce the income may be deducted. This rule is broad enough to include in most cases the salary of a private secretar}'. The distinction drawn in the 1918 edition of the Income Tax Primer is suggestive : Ruling. I employ a man to assist me in operating my farm and a wom.an to assist about the house. Is the compensation paid to each allowable as a deduction? Unquestionably, as to the amount paid to the male employee, but a line must be drawn as to the amount paid to the female employee. If her time is employed entirely in taking care of milk and cream produced for sale, in the production of butter, cheese, etc., the care of milk cans and churns, or, if a separate table is maintained for laborers employed on the farm and her services are used entirely in the prepa- ration and serving of the meals furnished the laborers and in caring for their rooms, the compensation paid her constitutes an allowable deduction. If, however, she is employed to assist in caring for the farmer's own household, no deduction can be claimed. {Income Tax Primer, 1918, question 60.) Wages paid to children. — Regulation The father is legally entitled to the services of his minor children, any allowances which he gives them, whether said to be in consideration of services or otherwise, are not allow- able deductions in his return of income -" (Art. 291.) The 1918 edition of the Income Tax Primer, in addition to °" [Former Procedure] Article 8 of Regulation 2i, 1918, reads: "As a rule, allowances which he gives them .... are not allowable de- ductions . . . ." The present regulation is more emphatic in the denial of this item. S62 DEDUCTIONS affirming the above rule, makes the positive statement that compensation paid to a child who has attained his majority may be deducted if of the nature of a business expense. ^^ Under the British practice, if any of the children or other relatives, except the wife, of a trader earn their livelihood in his employ, and if the trader provides their board and lodging as part of their remuneration, the expense thereof may be charged in his accounts as a trade expense irrespective of the age of the employee. On the other hand, if he withdraws some of his goods for domestic use, he should make an allowance therefor in his return of income. Business expenses of the professional man. — Many law- yers, doctors and other professional men keep fairly accurate records of income, but are not careful to separate personal and living expenses from those incurred in producing their income. If care is taken to assemble all items of taxable in- come, equal care should be taken to compile a schedule of allowable deductions from income. The official procedure in deducting professional expenses is outlined in the regulations in this language: Regulation. A professional man may claim as deductions the cost of supplies used by him in the practice of his profession, ex- penses paid in the operation and repair of an automobile used in making professional calls, dues to professional societies and subscrip- tions to professional journals, the rent paid for office rooms, the ex- pense of the fuel, light, water, telephone, etc., used in such offices, and the hire of office assistants. Amounts currently expended for books, furniture, and professional instruments and equipment, the use- ful life of which is short, may be deducted. 22 .... (Art. 104.) Under this new article professional men may deduct cur- rent expenditures for books, etc., if the life of such articles is short. Ruling. Expenses incurred by doctors in taking post-graduate courses are deemed to be in tlie nature of personal expenses and not deductible. (B. 31-21-1755: O. D. 984.) ^Income Tax Primer, 1918, question 61. ■" See pages 868, 869. FOR EXPENSES 863 Expenses incurred hy school teachers attending summer school have been held to be personal. ^^ A professional singer may not deduct amounts paid to a specialist in the care of his throat." Depreciation on property "of a permanent char- acter.'' — Property "of a permanent character," expenditures for which may not be deducted as business expenses, is, of course, subject to depreciation. Earlier rulings specifically stated that depreciation allowances might be claimed for it.*' In order to secure the benefit of the deduction of the entire cost in the case of such items as professional books it is necessary merely to ascertain the aggregate cost of such books and to spread the cost over their effective or serviceable life. If a technical book is obsolete at the end of one year the depreciation allowance for the year will be its whole cost. Roughly speaking, after a library is once established the cost of additions is probably less than actual depreciation; therefore it will probably work to the advantage of the tax- payer to be precise in dealing with this item. But substantial justice will be done to the government and taxpayer alike if the ordinary purchases of professional and business books are treated as necessary expenses and the question of deprecia- tion is ignored. When office is in rented residence. — In case a pro- fessional man lives in a rented house and uses a portion of it for professional or business purposes the Treasury holds that the proportion of the rental paid which is chargeable to the rooms so used may be deducted as a business expense. Regulation In the case of a professional man who rents a property for residential purposes, but incidentally receives there clients, patients, or callers in connection with his professional work (his place of business being elsewhere), no part of the rent is de- ductible as a business expense. If, however, he uses part of the house "C. B. 4, page 209. "*B. 37-21-1819; O. D. 1032. ^'Income Tax Primer, 1918, question 59. 864 DEDUCTIONS for his office, such portion of the rent as is properly attributable to such office is deductible (Art. 291.) The above ruling, refusing to permit the deduction of a portion of the rent of a residence used partly for business purposes in case "the place of business" is elsewhere, appears to raise the question as to whether or not a professional man may have more than one place of business. The regulation apparently assumes in the phrase, "the place of business being elsewhere," that he can have only one place of business. As a matter of fact he may have several. In case the expenses of the additional quarters are "necessary" to the practice of the profession, they are certainly deductible under the law. When office is in owned residence. — No definite rul- ing appears to have been issued covering the case of the pro- fessional man who owns his residence and uses part of it as his place of business, but there is no doubt about the pro- priety of deducting in such a case the proper proportion of the depreciation, repairs, fuel, light, water, telephone, etc. Traveling expenses. — Law. Section 214. [Individuals] (a) That in coirtputing net income there shall be allowed as deductions: (i) .... traveling expenses (including the entire amount ex- pended for meals and lodging) while away from home in the pursuit of a trade or business; .... Regulation. Traveling expenses, as ordinarily understood, in- clude railroad fares and meals and lodging. If the trip is undertaken for other than business purposes, such railroad fares are personal ex- penses and such meals and lodging are living expenses. If the trip is solely on business, the reasonable and necessary traveling expenses, including railroad fares, meals, and lodging, become business instead of personal expenses, (a) If, then, an individual, whose business requires him to travel, receives a salary as full compensation for his services, without reimbursement for traveling expenses, or is employed on a commission basis with no expense allowance, his traveling ex- penses, including the entire amount expended for meals and lodging, are deductible from gross income. (&) If an individual receives a salary and is also repaid his actual traveling expenses, he shall include in gross income the amount so repaid and may deduct such expenses. FOR EXPENSES 865 (f) If an individual receives a salary and also an allowance for meals and lodging-, as, for example, a per diem allowance in lieu of subsis- tence, the amount of the allowance should be included in gross income and the cost of such meals and lodging may be deducted therefrom. A payment for the use of a sample room at a hotel for the display of goods is a business expense. Only such expenses as are reasonable and necessary in the conduct of the business and directly attributable to it may be deducted. A taxpayer claiming the benefit of the deduc- tions referred to herein must attach to his return a statement show- ing (i) the nature of the business in which engaged; (2) number of days away from home during the taxable year on account of business; (3) total amount of expenses incident to meals and lodg- ing while absent from home on business during the taxable year; (4) total amount of other expenses incident to travel and claimed as a deduction. Claims for the deductions referred to herein must be substantiated, when required by the commissioner, by records showing in detail the amount and nature of the expenses incurred. Commuters' fares, are not considered as traveling expenses and are not deductible. [Art. loi (a).] The 1 92 1 law merely confirms a deduction which under any reasonable interpretation was fully allowable under all previous laws. Under the 1918'^* and prior tax laws, the regu- lations provided thjit the amount expended as business travel- ing expenses should be reduced by any saving of personal ex- penses, the reduced amount being a proper deduction from gross income. To properly determine anv saving was a diffi- cult task and a great inconvenience. Ruling. Amounts expended during the taxable year by a secre- tary to a Member of Congress and by his assistants for railroad fares, in making trips from their homes to Washington and return in connection with their duties, may be claimed as a deduction in com- puting their net income. Such expenditures incident to trips made for purely personal reasons are not deductible. (C. B. 4, page 212; O. D. 865.) Any expenditures for traveling other than in the pursuit of a trade or business are not deductible under any of the tax laws. If a taxpayer who claims, say, $500, for five trips from New York to Chicago and return during 192 1 is called upon "'° [Former Procedure] See Art. 292, Reg. 45, as amended by T. D. 3146. See Income Tax Procedure, 1021, pages 672, 673. 866 DEDUCTIONS for proof, it would probably be a sufficient compliance with the law to prepare an affidavit setting forth that the trips were exclusively on business, that the railroad fares were so much and that meals and other necessary expenses aver- aged so much a day. The test will be, what a jury would allow, and it would not be necessary to produce vouchers be- cause good business practice does not call for the securing of receipted bills for meals and similar expenses. The Treasury Department, however, is strict in requiring detailed informa- tion and w'ill disallow deductions which cannot be reasonably supported. Compromises will apparently not be made.^ Ruling. A taxpayer engaged in a business in 19 17 and 1918 which required him to spend a part of his time away from home but who failed to furnish the detailed information called for in article 292 of Regulations 45, 1920 edition, although requested to do so, is not entitled to claim as a deduction expenses incurred for meals and lodging in connection with carrying on such business. Treasury De- cision 3101 amending article 292, Regulations 45, has been superseded by Treasury Decision 3146 (Regulations 45, 1920 edition), in which no mention is made as to the effective date of the provisions of article 292. (B. Digest 29-21-1735; A. R. R. 572.) Expenses reimbursed may be ignored in returns. — Traveling or other expenses incurred in rendering services by the taxpayer, which are afterward refunded to him should be included in gross income and deduction claimed for actual expenses. [See article loi (a).] Traveling expenses which are not deductible. — Rulings. A Member of Congress may not deduct expenses in- curred in making trips of a personal nature to and from Washington, the expense of taking members of his family to or from Washington, living expenses while in Washington, or campaign expenses. (C. B. 4, page 211 ; O. D. 864.) Living expenses paid by a single taxpayer who has no home and is continuously employed on the road may not be deducted in comput- ing net income. (C. B. 4, page 212; O. D. 905.) .... Where a man makes a contract of employment with an employer in this country, and upon completion of such con- "I-2-19; A. R. R. 719. FOR EXPENSES 867 tract he makes a second contract with another employer in a foreign country, without allowance for travel expenses, the expenditure incurred in reaching such place of employment cannot be considered as an expense incurred in furtherance of a trade or business, but rather as an expenditure to fulfill a condition precedent to such employment in a trade or business and is therefore regarded as a personal expense and not deductible. The test is whether an expense is incurred primarily because of business as the immediate cause inducing the expenditure. (C. B. 2, page 157; O. D. 451.) The foregoing ruling is questionable. The expense is not the same as that of a commuter. The gross amount of the com- pensation to be collected in the foreign country is taxable. The cost of getting there arises from the income and would seem to be directly connected with that income. It is not a pleasure trip, but purely a business trip. If a business trip, the cost must be a necessary business expense and allowable under the law. In principle this expense is just as properly deductible as the expenses of a Congressman's secretary.^* Personal expenses of army officers and government offi- cials. — Regulation The cost of the equipment of an army officer to the extent only that it is specially required by his profession and does not merely take the place of articles required in civilian life is deductible. Accordingly, the cost of a sword is an allowable deduc- tion, but the cost of a uniform is not."° (Art. 291.) Ruling. Any amounts expended in purchasing furnishings and maintaining the residential portion of an embassy are considered personal expenses. Amounts expended in entertaining are likewise considered personal expense. While it is recognized that ambassadors do a certain amount of entertaining, Congress does not require it as one of the duties of the position or make specific appropriations for ™ See ruling (C. B. 4, page 212; O. D. 865), quoted on page 865. " [Former Procedure] The above ruling reverses the procedure formerly in force. The previous practice, which operated very un- fairly was prescribed in the following language: Regulation. The pay and allowance of army officers are based on the obligation of an officer to provide equipment and mounts as a personal expense. The cost of mounts and equipment is not therefore a deductible expense. (Reg. 33, 1918, Art. 8.) • For detailed criticism of this regulation see Income Tax Procedure, 1919, page 411. 868 DEDUCTIONS such entertainment. It is held that such expenditures are personal expenses and not business expenses, and are therefore not deductible. (B, 36-21-1802; O. D. 1020.) The foregoing ruling is not sound. The author hopes that it will be questioned by someone who, in order to properly ])erform his duties, has expended part of his salary for other than personal or family expenses. A business man deducts, and properly so, all similar e.xpenses. Clothing and personal equipment as a business expense. — Wherever clothing and other equipment, such as the uniforms and instruments of musicians, constitute business expenses because not adaptable to private use, the cost thereof is an allowable deduction. To the extent that uniforms serve to diminish one's living expenses no deduction is proper, but if an additional expense is incurred solely to enable one to earn a living, this cost is nothing more or less than a necessary business expense. This rule is in harmony with the regulation regarding actors' costumes. '^^ Automobiles used in part for business purposes. — Ruling. The Committee is unable to distinguish any essen- tial difference between expenses incurred in travel by railroad and those incurred in travel by automobile, where such travel by either conveyance is undertaken solely on account of business interests and. not for the personal pleasure of the taxpayer. Since railroad fares paid in connection with business trips are deductible as a necessary expense of the business, the Committee sees no reason why the expense of such trips, when made by automobile, should not fall within the same category. It is therefore the opinion of the Committee that such portion of the upkeep and operating expenses of a taxpayer's automobile as was occasioned by its use in the taxpayer's business is properly deductible as a business expense in the return of such taxpayer (C. B. 3, page 131 ; A. R. R. 266.) Perhaps the item of expense most difficult to apportion be- tw'een living and business is the upkeep of an automobile See Chapter XXXI. FOR EXPENSES • 869 which is used both for business and for personal purposes. The test is apparently simple enough. "Personal, living or family" expenses are not allowable deductions. Business ex- penses are allowable deductions. In the application of the test, however, interesting prob- lems sometimes arise. Often the apportionment is easily es- tablished, because the facts as to the relative use for the two purposes are clear; but in other cases the whole theory of what is business expense as compared with living expense is in- volved. For instance, a clerk lives some distance away from his place of employment. It takes him an hour to make the trip each way. He purchases an automobile and cuts down the time one-half. Is the upkeep of the automobile a neces- sary business expense? If he sleeps a half -hour longer each morning and reaches home a half -hour earlier each afternoon the automobile expense would appear at first glance to be 100 per cent personal. But suppose the added leisure increases his efficiency during work hours. Or suppose he spends an hour more each day at work and earns more money, all of which is taxable. On either of the last two suppositions that part of the automobile expense which is fairly chargeable to the daily trip would seem to be a reasonable and proper business ex- pense. Of course, the refinement cannot be carried beyond the point of practicability, and it must be admitted that ad- ministrative control of such deductions is difficult. If the deduction cannot stand the test of reasonableness, it should not be claimed. Premiums on certain insurance a personal expense. — Regulation. Insurance paid on a dwelling owned and occupied by a taxpayer is a personal expense and not deductible. Premiums paid for life insurance by the insured are not deductible (Art. 291.) Ruling. Premiums paid by a taxpayer on insurance taken out under the War Risk Insurance Act, whether or not the insurance is subsequently converted, are not deductible in computing net income under the Revenue Act of 1918. (C. B. 4, page 208; O. D. 828.) 870 ■ DEDUCTIONS Alimony and damages for breach of promise are personal expenses. — Regulation Alimony and an allowance paid under a sep- aration agreement are not deductible from gross income ^^ (Art. 291.)^^ Expenses incurred on account of a partnership. — Ruling. By the terms of a partnership agreement one of the members of the partnership is required to pay out of his own funds the compensation of one of the employees of the partnership who performs a part of the duties delegated to said member. Held, that the amount so paid constitutes a proper deduction in the income tax return of the member under section 214 (a) i of the Revenue Act of 1918. (C. B. 4, page 137; O. D. 947.) The above ruling under the 1918 law reverses a decision made by the Treasury under the 191 7 law, wherein business expenditures by an individual made in behalf of the partner- ship were not allowed. ^^ All expenses incurred by a partner in the furtherance of a partnership of which he is a member (for which he has not been reimbursed) are deductible as being necessary business expenses. Certainly if such expenditures are made for the purpose of promoting his interest in the firm, it cannot be said that they are personal expenses. Salaries, Wages, Commissions and Similar Compensation The authority for deducting salaries and wages is found in the following section of the law : Law. Section 214. (a) That in computing net income there shall be allowed as deductions: (1) All the ordinary and necessary expenses paid or incurred dur- ing the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; .... Gould V. Gould, 245 U. S. 151, 38 S. Ct. 53. 62 L. Ed. 211. ' See page 367. 'C. B. 3, page 130; O. D. 593. I FOR EXPENSES 871 Meaning of phrase "including a reasonable allowance for salaries." — The author has always contended^* that the Treas- ury has no power to decide whether the salaries paid in good faith by corporations to their officers are reasonable or other- wise. In the past the Treasury has attempted to determine on an arbitrary basis how much of the salary paid to a par- ticular officer was "reasonable" and has tried to disallow the deduction of anything in excess of the amount. The author's position on this matter, namely, that a salary payment is not subject to review by the Treasury, unless part of the payment is not really salary but a distribution of profits or assets, has been completely upheld by the courts in 1921. An appeal was taken by the Treasury in the Philadelphia Knitting Mills case^" (quoted in Income Tax Procedure, 1921) and a decision was handed down on June 13, 1921, by the United States Circuit Court of Appeals for the Third Circuit. ^^ The court said : Decision. In view of the proceedings below tlie question in- volved in the case is somewhat elusive. In our examination of these proceedings we find really two questions, one raised by the Government and seemingly abandoned ; the other raised by the court and ruled on. The question on which the Government seeks the opinion of this court is : Has the Government the right, under the cited provision of the Corporation Excise Tax Act of August 5, 1909, to inquire and determine whether a salary, paid by a corporation and deducted in its return as an "ordinary and necessary"' expense, is reasonable and fair compensation for the services rendered, and thereupon to revise the return and limit the deduction to what it considers a reasonable salary; and, in the event of dispute, to have a jury pass upon and decide the same ? Such a power in the Government, if it exists, must have been conferred by the statute. The statute provided for a tax at a named rate upon the net income of a corporation, to be ascertained by deducting from its gross income "all ordinary and necessary ex- penses." (Sec. 38.) The statute did not specifically make a salary an allowable deduction, though it was so construed by the Bureau of Internal Revenue when the salary is a "reasonable and fair com- '* Income Tax i'rocedurc, 1921, page 678 ct seq. " U. S. V. Philadelphia Knitting Mills Co., U. S. Dist. Ct., Eastern Dist. of Penna., No. 4832, November 5, 1920, 268 Fed. 270. This case was under the 1909 law. "273 Fed. 657. 872 DEDUCTIONS pensation for services rendered regardless of the amount of stock such officer maj'^ hold." We are asked to approve this executive con- struction of the statute as though it were part of it. In order not to beg the question, we must look to the statute alone to find the power which the Government asserts. Confining our inquiry to the statute, it appears that the" basis on which a salary may be allowed as a valid deduction is that it was in fact an "ordinary and necessary expense (of the corporation) actually paid in the maintenance and operation of its busi- ness." To be a necessary expense it must have been paid for services actually rendered. (Jacobs & Davies, Inc. v. Anderson, 228 Fed. 505, 506.) Whether services were rendered and whether also they were commensurate with the salary paid are matters of judgment and discretion reposed by general law in the board of directors of the corporation. As the board of directors is charged with the duty and clothed with the discretion of fixing the salaries of the corporation's officers, the Government had no right (until expressly granted by statute) to inquire into and determine wiiether the amounts thereof are proper, that is, whether they are too nnich or too little. But, while the amount of salary fixed by a board of directors is presumptively valid, it is not conclusively so, because the Government may inquire whether the amount paid is salary or something else. Admittedly the Government has a right to collect taxes on net income of a cor- poration based on profits after all ordinary and necessary expenses, including salaries, are paid. It has a right, therefore, to attack the action of a board of directors and show by evidence, not that a given salary is too much, but that, in the circumstances, the whole or some part of it is not salary at all but is profits diverted to a stockholding officer under the guise of salary and as such is subject to taxation. Of the same opinion was the learned trial judge, though in enter- ing judgment of nonsuit he raised and ruled upon a second question which was not whether the salaries paid were commensurate with the services rendered Init whether there was evidence which would sustain a finding that the sums paid were not all salaries but were part profits. i\\\ inquiry of this kind is directed to a fact; and, as in all cases turning on a fact, the attention of the trial judge is directed to the sufficiency of the evidence to establish the fact. The question of fact here was whether the money paid was all salary or part profits. The presumption arising from the action of the board of directors was that it was all salary. In order to overcome this presumption the burden was on the Government to produce evidence, not necessarily conclusive, but sufficient to raise a valid inference that some definite part of the compensation was not salary but was profits. i FOR EXPENSES 873 Whatever peculiar features there may have been in the case, the court found no difficulty in enunciating the essential prin- ciple which must govern the Treasury's procedure. "The presumption arising from the action of the board of directors was that it was all salary. In order to overcome this presumption the burden was on the Government to produce evi- dence, not necessarily conclusive, but sufficient to raise a valid inference that some definite part of the compensation was not salary but was profits." A clearer statement is impossible. Salaries voted by the board of directors stand unless the Treasury can produce em- dence that part of the payment was not salary but was in reality profits. The arbitrary disallowance by revenue agents is not evi- dence, nor does it "raise a valid inference" that part of the payment is not salary. The burden is on the Treasury, not on the taxpayer, to prove its contention. In spite of the clear and definite language used by the court, the following ruling a])])eared in Bulletin 39-21 : Ruling. In the ordinary case where an assessment is involved, if the Commissioner finds that a portion of an amount paid as salary or compensation is not properly compensation for services, and a tax- payer attempts to upset such finding, the burden of proof in court would be upon him (the taxpayer), to show that the action of the Commis- sioner was wrong and that such salary was nothing more than a reasonable allow^ance for compensation. It therefore clearly appears that the Commissioner is fully au- thorized to disallow a deduction as ordinary and necessary expenses of the full amount of an alleged salary paid to an officer by a cor- poration where the facts of the particular case show that the amount represents something other than compensation for services, and in order to determine this fact he (the Commissioner) may take into consideration salaries paid to similar officers of other corporations. .... (B. 39-21-1841; A. R. M. 138.) The burden of proof is not on the taxpayer, but on the Treasury. If it can be shown that part of the payment repre- sents something other than salary, the Treasury can disallow such amount, but only if evidence is forthcoming to that effect. 874 DEDUCTIONS The Treasury is not authorized to use a stereotyped table of salaries to determine "reasonableness." \\'hat similar officers receive from other corporations is not relevant. The criterion is, "Is the payment a true salary?" The Treasury contends that the decision applies only to 1917 and prior law^s, and that the phrase, "including a reason- able allowance for salaries," which first appeared in the 1918 law, granted new powers to the Commissioner. This is not the case. The Commissioner claimed full powers prior to 19 18. In view of the statement of the court that Congress may limit the deduction for salaries, the question to be answered under the 19 18 act is : Did Congress intend to delegate such a power to the Commissioner? Assuming that Congress did intend to delegate such a power to the Commissioner (which is seriously doubted in the opinion of the author — the intention was to extend the deduc- tion, not to extend the power of the Commissioner), it is doubted if Congress may delegate this power to the Commis- sioner. If this discretion may be delegated to him, why can not Congress go a little further and say that corpora- tions and individuals shall pay a tax on a net income which shall be determined by the Commissioner of Internal Rev- enue? It would be extremely difficult for Congress to place a limit upon officers' salaries other than the present limitation on deductions of "necessary expenses." In other words, a law would have to be framed so that all taxpayers would be treated alike and the fixing of a specific amount would be ridiculous. It would, moreover, be economically unsound to enact such a limitation. The limitation to "necessary" is sufficient to prevent fraud. Any other limitation would impair the efficiency of honest concerns, and it would work many inequities. The opera- tion of a corporation should be left in the hands of the direc- tors. The author is of the opinion that there is no necessity for such a provision, because if salaries are arranged so as I FOR EXPENSES 875 to distribute profits, the Commissioner has ample power to require an adjustment.""'^ Amounts ostensibly paid as compensation — Test of deduc- tibility. — Regulation. Among the ordinary and necessary expenses paid or incurred in carrying on any trade or business may be included a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services. This test and its practical application may be further stated and illustrated as follows : (i) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible, (a) An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few stockholders, practically all of whom draw salaries. If in such a case the salaries are based upon or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries, if in excess of those ordinarily paid for similar services, are not paid wholly for services rendered, but in part as a distribu- tion of earnings upon the stock, (b) An ostensible salary may be in part payment for property. This may occur, for example, where a partnership sells out to a corporation, the former partners agreeing to continue in the service of the corporation. In such a case it may be found that the salaries of the former partners are not merely for services, but in part constitute payment for the transfer of their business. (2) The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to com- pensation at a flat rate. Generally speaking, if contingent com- pensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influ- enced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid. (3) In any event the allowance for the compensation paid may not exceed what is reasonable in all the circumstances. It is in general " U. S. V. Philadelphia Knitting Mills Co., 273 Fed. 657. 876 DEDUCTIONS just to assume tliat reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enter- prises in like circumstances. But if the salaries paid bear a close relationship to stock ownership, see paragraph ( i ) of this article. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.^® .... (Art. 105.) In dealing with necessary expenses no possible fault can be found with the test laid down in the foregoing regulations regarding such payments, viz., whether they are reasonable or not. The test of deductibility of compensation payments is whether or not they are legal and are in fact payments purely for services. When a salary is a necessary business ex- pense it may be ten times as much as the Commissioner thinks a "reasonable" salary would be, yet the entire amount is an allowable deduction. It must always be borne in mind that if the payments are allowed as expenses the recipients must report the amounts received as income. This is of .special importance in dealing with employees whose compensation depends on profits. ^^ The Treasury is now considering the propriety of salaries claimed in returns for prior years, and many adjustments are being made. Too much weight is being given to com- parisons with prior years. The 1917 and 1918 laws en- deavored to reduce the inevitable burdens of the excess profits tax by permitting as deductions reasonable salaries, even though no salaries or very small salaries had been claimed in prior tax returns. Based on the higher cost of living and the higher salaries paid by business concerns whose officers are not large stockholders, it would seem that in some cases the al- lowances now being made by the Treasury are too low. The matter is one which must be settled on the merits of each case. See Art. 32. ' See Chapter XIV. FOR EXPENSES 877 Compensation fixed by contracts. — Ruling. The committee has reached the conclusion that where salaries have been fixed long before any Excess Profits Tax Law was contemplated the Income Tax Unit is not authorized by the law or regulations to arbitrarily fix the salaries of the officers of any company at an amount less than that authorized. In general, the committee does not think that the Unit is authorized by law or regu- lation to look back of any corporate action fixing the salaries of officers when such action was taken by the directors long before any Excess Profits Tax Law was even contemplated, and where the salaries were not fixed on the basis of stock ownership or do not bear a close relationship thereto. Neither, in the judgment of the committee, is the Unit authorized to look back of any corporate resolution fixing salaries after the passage of the Excess Profits Tax Law, provided there is no evidence of intent to reduce the tax of the corporation, and provided that after deducting the amount actually fixed and paid the corporation has a normal return on its invested capital left, or where such deduction does not reduce the net earn- ings subject to tax below that of competing concerns which secure the services of officers and employees by open bargaining. (C. B. 2, page no; A. R. R. 53.) After the issuance of this ruling, the Treasury officials, in certain cases, reduced salaries, and in consequence a protest was filed by the taxpayers concerned, claiming that A. R. R. 53 (above) prohibits such action. The matter was again referred to the Committee on Appeals and Review, with the result that a memorandum of a more definite character answering specific questions was issued. This memorandum is digested as fol- lows : Ruling. Held, that compensation on whatever basis fixed repre- senting only the price paid for services pursuant to a free bargain be- tween a stockholder and the business enterprise is deductible in de- termining the taxable net income of such enterprise ; that the Income Tax Unit has authority under the law and regulations to analyze the payments made as compensation for services rendered in order to de- termine whether there are included therein amounts ostensibly paid as compensation but which in fact represent a distribution of profits; and that A. R. R. 53 (C. B. 2, p. no), is not applicable in cases where the element of free bargaining does not enter into the action taken by the board of directors of the corporation in fixing the amount of salaries to be paid to tlic officers who are controlling stockholders or sole stockholders, and particularly does not apply where the corporation 878 DEDUCTIONS is uwned, conti'olled, officered, and directed by the same persons. (B. Digest 39-21-1841 ; A. R. M. 138.) The following quotation, which appears as an opinion of the Solicitor, is of interest here : Ruling It may be admitted that the expenses claimed as a deduction in any case were necessary in the sense of being legally binding and were incurred under a contract entered into in the best of faith and with no possibile reference to taxation, and yet if they were not "ordinary and necessary," if they were unusual and not essential to the maintenance and operation of the business and the properties of the corporation they would still be not deductible. Although they would admittedly be expenses they would not be the expenses for the deduction of which the statute provides (C. B. 3, page 133; L. O. 1045.) The author reiterates his opinion that the Treasury cannot substitute its judgment for that of directors and stockholders. Ruling. The salesmen employed by a corporation have contracts with it guaranteeing them weekly or monthly drawing accounts. Under these contracts the corporation is obligated to make weekly or monthly allowances so long as the salesmen remain in the employ of the cor- poration, regardless of the amount of business secured by them. It does not appear that any of the advances are repaid by the salesmen unless they earn commissions in a subsequent year in excess of such advances. Held, that advances so made by the corporation in 1917, constituted an allowable deduction as a business expense in computing the cor- poration's net income for that year. (C. B. 4, page 117; A. R. R. 374.) The case has arisen wherein a salary contract having a few years to run is terminated by the payment of a lump sum in lieu of stipulated annual amounts. Does such lump sum con- stitute a deduction in the year paid, or should it be prorated over the remaining years of the contract? When the recipient reports the entire amount in the year received, it appears that such amount should be taken as a deduction in one year by the payer. While the inclusion of the total amount tends to make the salary accounts compara- tively large, the termination of the contract may be to the best interests of the payer and therefore be considered necessary and reasonable in carrying on business in that year. FOR EXPENSES 879 Factors which enter into the determination of the reason- ableness of compensation. — Ruling. The problem of determining reasonable compensation for personal services is one of difficulty, in that there are few general rules which can be laid down as guides to a decision. Many factors are involved, among them being the character and amount of respon- sibility, ease or difficulty of the work itself, time required, working conditions, future prospects, living conditions of the locality, indi- vidual ability, technical training, profitableness to the employer of the services rendered, and the number of available persons capable of performing the duties of the position. These and other factors have a bearing, and the amount of weight to be attached to each one can be determined only in the light of the circumstances in each particular case. (C. B. i, page 220; T. B. M. 44.) Method of determining reasonableness of compensation. — Ruling The department is not warranted in fixing any amount as a maximum limit for deductions for officers' salaries and compensation for personal services, but that each case must be decided in the light of all its circumstances. (C. B. i, page 105; T. B. R. 46.) The Committee on Appeals and Review has evidently deviated from this principle. For instance, in a later case the following appears: Ruling The apphcation of the formulae provided by the compilation of salary statistics shows that the allowance for com- pensation made by the Unit is fully equal to the average of that paid for similar services by similar enterprises under similar circum- stances, and though the computation of the amount appears to have been somewhat meticulous, the Committee finds no reason for any substantial modification. (C. B. 3, page 140; A. R. R. 223.) Cases wherein compensation paid was held reasonable. — Rulings. All the stock of a corporation was owned by its four officers, who devoted all their time and attention to the business of the corporation, acting not only as officers but also as buyers, book- keepers, etc. These officers drew only nominal salaries of 1/36 x dol- lars each for a number of years after organization. The gross sales increased from 11 x dollars in the first year of business to 64 x dollars in 1916 and 90 x dollars in 1917. Early in 1917, before the passage of any excess-profits tax law, the board of directors fixed salaries of 2 :r dollars each for three of its officers and 88o DEDUCTIONS X dollars for the fourth. These salaries were paid in 1917 and de- ducted from gross income. Held that the amounts paid and deducted were reasonable and properly deductible from gross income. (C. B. 2, page 109; A. R. M. 30.) A company's gross sales in 1917 amounted to 1000 x dollars and its net income was 125 x dollars. Salaries and contingent compen- sation were paid to its officers and certain employees as follows: Basic salary. Total. President and treasurer g x dollars. 9 x dollars. Secretary and general manager 6 x dollars. 18 x dollars. Assistant treasurer 3 x dollars. 11 x dollars. Office manager x dollars. 9 x dollars. Office manager (Y office) 2 x dollars 10 x dollars. S7 X dollars. Contracts were made prior to igiy with these officers and em- ployees for services to be performed. The value of the services to be performed and the possibility of securing more remunerative em- ployment were taken into consideration in making the contracts. No payments were based on stock holdings. The contingent com- pensation or commission was paid for the purpose of retaining the services of men who had grown up with the business and were familiar with the various phases of the business, and was based on net profits after regular dividends had been paid. The committee recommends that the full amount of compensation paid be allowed as a deduction, since it represented the price paid for services pursuant to a free bargain made in advance between the individual and the business enterprise. (C. B. 2, page 109; A. R. R.31.) A started a business a number of years ago with a small amount of capital. At a later date, the business was incorporated, 90 per cent of the stock being issued to A. The business was developed by his efforts until in 1917 the gross sales amounted to 555 x dollars and the net income to 65 x dollars, whereas in 191 1 the gross sales amounted to only 167 x dollars and the net income to 8 .ir dollars. In prior years A, as president of the corporation, drew a nominal salary of x dollars, taking his earnings as dividends, but in 1917 his salary was increased to 10 x dollars. In view of the extraordinary circumstances of the case, including the fact that A is and has been the sole administrative officer of the corporation and devotes his entire time to its direction in all details, the salary of 10 x dollars does not appear to be excessive and is, therefore, an allowable deduction as a business expense. (C. B. 2, page 109; A. R. R. 32.) FOR EXPENSES 88 1 A, the president and treasurer of a close corporation, and B, its vice president, each held 45 per cent of the outstanding capital stock. C, its secretary, held 3 2/2^ per cent of the stock. Nominal salaries were paid to A and C. There was an agreement between A and B that A was to receive in addition to his share on his capital invested, direct compensation in proportion to the results he might achieve for the company. Accordingly A, and C also, received in 1915, 1916 and 1917 as additional compensation 10 per cent and i per cent, re- spectively, of the profits. These amounts, although large, were not in proportion to stock holdings and having been paid according to agreement made in advance and for services rendered are held to be deductible as ordinary and necessary business expenses of the company. (C. B. 2, page no; A. R. M. 39.) Cases wherein compensation was held unreasonable. — Rulings. The Committee is of opinion that where a division of the profits of a business, as a bonus to its officers and managers, absorbs all the profits derived, except an amount sufficient to pay dividends at a moderate rate upon its preferred and common capital stock, such a distribution can not be regarded as an "ordinary and necessary" expense of business, and that the excess over a reasonable amount for compensation should be disallowed. Such a distribution to managers and officers of a company which varied from year to year as to the percentage paid to each and where the same persons did not always participate in the distribution can not be said to have occurred as a result of open bargaining, or as the result of bona fide contracts and arrangements entered into and followed prior to the year 1917, even though such payments were, in fact, purely for services and in accordance with an estab- lished custom of the company. (C. B. 3, page 140; A. R. R. 223.) A close corporation operated for a number of years prior to 1917, sometimes making moderate losses and sometimes moderate profits, paying only nominal salaries to its officers. In 1917 it was highly successful and distributed to the five stockholders who are also officers approximately 12 per cent of its net income, in exact propor- tion to their stock holdings. Of the total amount distributed 18 per cent was paid currently during the year and 82 per cent was paid on or about the close of the year 1917. In view of the salaries paid by other companies in the same line, doing a corresponding volume of business, the aggregate salaries paid appears to be excessive; and as some of the officers receiving the largest salaries did not devote all of their time to the work, a substantial part of the so-called salaries would seem to be nothing more than a distribution of profits. Forty per cent of the deduction taken for above salaries was not allowed. (C. B. 1, page 105; T. B. M. 70.) 882 DEDUCTIONS Treatment of excessive compensation. — Regulation. x\s to the treatment of amounts ostensibly paid as compensation, but not allowed to be deducted as such, the following rules apply : (i) In the case of excessive payments by corporations, if such payments correspond or bear a close relationship to stock holdings, the amount of the excess should be treated as dividends and would thus be exempt from the normal tax in the hands of the recipients. If such payments constitute in part payment for property, the amount of the excess should be treated by the corporation as a capital ex- penditure and by the recipient as part of the purchase price. (2) In the case of excessive payments by individuals or partner- ships, the amounts disallowed should ordinarily be treated as shares of the profits of a partnership, except that a payment for property should be treated by the individual or partnership as a capital ex- penditure and by the recipient as part of the purchase price.*" (Art. 106.) The foregoing regulations are properly applicable when- ever distributions of profits ostensibly as compensation have been made. The 1922 regulations omit part of the same article in Regulations 45, which attempted, in effect, to treat excessive payments as salaries in order to deny to the recipients the right to credit the norinal tax. Ruling. The Unit reduced the amount of the deduction claimed by the M Company for salaries of its officers which had been voted by its board of directors. It is stated by one of the officers that such action would necessitate the return to the corporation of the amount disallowed as a deduction for salaries, and a request is made for permission to file an amended return for the years the excess salaries were paid to him and that the overpayment on his returns be credited to the payment of tax for 1920. Held, that where a corporation by proper action of its board of directors votes compensation to its officers, and the corporation has paid the amount to them, the individuals must report the full amount of such compensation in their individual returns. The amount dis- allowed as a deduction by this office on account of excessive salaries paid by a corporation has no effect on the legality of the corporation *'^ [Former Procedure] T. D. 2696, April 10, 1918, which covered most of the points contained in articles 105 (see page 876) and 106, above quoted, also provided : "If a compensation contract with the majority stockholder or stock- holders is approved by all the stockholders, as well as by the directors, it might, however, be dealt with like any other contract." FOR EXPENSES 883 act in actually paying the excessive compensation to its officers. An individual to whom an amount of salary has been paid by a corpora- tion in excess of the amount allowed the corporation as a deduction for compensation paid its officers is under no obligation to refund the excessive amount of salary to the corporation. The individual should report as income the entire amount of salary paid by the cor- poration for the year in which received or accrued. It is held further, that under article 106, Regulations 45, the excess of the amount allowed the corporation as a deduction in returns of annual net income and which bore a close relationship to the stock holdings of such officers are not subject to normal tax in the hands of the recipients. No claim for refund will lie if the payments made ostensibly as salaries represented an appropriation of assets of the corporation. (B. 35-21-1792; O. D. 1012.) The foregoing is in some respects contradictory and is based on article 106 before it was modified in the 1922 regu- lations. If the salaries were in fact excessive, they were illeg- ally voted by the directors. If, upon full investigation, it was found that profits were being distributed, it was proper to dis- allow the deductions for expenses; but if the payments were not in exact proportion to stockholdings, the directors acted illegally and the excess payments should be returned. Bonuses and other special compensation*^ — Although the question of bonuses is covered in a general fashion in arti- cles 105 and 106 of the regulations, quoted above, it is more specifically treated in the following paragraph : Regulation. Bonuses to employees will constitute allowable deductions from gross income when such payments are made in good faith and as additional compensation for the services actually rendered by the employees, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered (Art. 107.) This regulation accords with sound business practice. " [British Practice] "The principle established would extend to bonuses as follows: where the payments are made to the employees be- cause they are employees they are assessable. They are in every way re- garded as part of the salary earned. The employer may, of course, in- clude them among his expenses for purposes of his own assessment." Income Tax Practice, by W. E. Snelling (London), 2nd Ed., page 126. 884 DEDUCTIONS However, it has not been observed by all revenue agents. If a taxpayer believes that deductible items have been disallowed an appeal should be made to the Commissioner, who can be depended upon to confirm the regulation just quoted. The question of reasonableness is one which must be left, in most cases, to the directors of a corporation. A bonus may appear to be unreasonable, but if paid in good faith it becomes a necessary business expense. It would be a fine thing if the Treasury could disallow all overpayments to employees, and distribute the aggregate to underpaid employees. Unfortunately there are obstacles to such procedure. In the opinion of the author the courts will not disallow any compensation, no matter how unreasonable it appears to be on the surface, and no matter how large it seems to be when compared with the amounts paid by other concerns, unless the payment is proved to be merely a division of profits distributed proportionately to stockholdings. Contingent salaries are deductible in the year paid. — Ruling. When additional compensation is agreed to be paid by a corporation to its officers at a future date, upon the happening of certain contingencies expected to result from the rendition of ser- vices, the amount of such compensation being left for future deter- mination, the amount eventually so paid is not to be treated as back salary and allocated to the years during which the services v^^ere rendered, but constitutes a business expense to the corporation for the taxable year in which the same was paid. (C. B. 3, page 142; A. R. R. 232.) Salaries may be determined after close of fiscal year — when? — Ruling. The compensation of the officers of a corporation had been continued without change for several years. In 1919, two days before the close of its fiscal year, the salaries of the principal officers of the corporation were largely increased for the year then closing. Section 234 (a) of the Act of 1918 provides that in computing the net income of a corporation subject to tax there shall be allowed as deductions all ordinary and necessary expenses paid or incurred FOR EXPENSES 885 during the taxable year, including a reasonable allowance for salaries. The authorization to increase the salaries in question occurred before the books were closed for the fiscal year, and as such became a lia- bility of the corporation for that year. If the compensation thus authorized was reasonable the total amount is an allowable deduction. (C. B. 2, page in; O. D. 504.) The foregoing case should be distinguished from cases like the following: Ruling. The M Company, years ago, established an annual bonus system for paying its ofiicers and employees additional com- pensation for services rendered. In 1914, 191 5 and 1916 no bonuses were paid, and on January i, 1917, the system was abolished. The bonuses as to amount were always fixed by an officer who resided in Europe, and who usually visited this country once a year. War conditions in 1917 and 1918 prevented his visiting this country, and consequently the amount of the bonuses was not determined until his visit in 1919, at which time bonuses were paid for 1916. Held, that the bonuses in question were not paid on account of services rendered during the year 1919, and therefore can not be deducted as items of business expense for that year. Bonuses or additions to salaries voted subsequent to the close of any taxable year, and also subsequent to the closing of the books for such taxable year can not be considered as ordinary and necessary expenses of doing business during such year as are deductible under the Revenue Act of 1918. The aggregate of these bonuses constitutes income to the recipi- ents for the year 1919 because they were first credited to them and made available during that year. (C. B. 2, page in ; O. D. 497.) In other v^ords, the business could deduct the expense in 1916 (a low tax year) if at all, but the recipients were tax- able in 1919 (a high tax year) ! In view of the specific reason for the delay, which rendered an election by the employees impossible, the latter should have been permitted to file amended returns for 19 16. Ruling. The Committee reconnnends the disallowance of addi- tional compensation claimed by a corporation as a deduction for 1917 where such additional compensation was not as a matter of fact authorized or paid until 1919 and that such additional compensation be allowed as a deduction under the heading of ordinary and neces- sary expenses in the taxpayer's return for the year 1919 in which year the payment was actually made. (C. B. 4, page 134; A. R. R. 519.) 886 DEDUCTIONS In this case, the secretary-treasurer of a corporation per- formed all of the executive duties of the president during the latter's illness in 191 7, but due to a combination of circum- stances it was not possible to pass the appropriate additional compensation resolution until 19 19. Under proper accounting methods the profit of 191 7 should bear the expenses of the services performed in that year, even if payment was not made until two years later. For this reason, the deduction in 191 7 should have been permitted. The Committee quoted T. B. M. 86*" in its opinion as follows : Ruling Salaries voted subsequent to the close of any taxable year, and also subsequent to the close of the books for such taxable year, can not be considered an ordinary and necessary expense of doing business The ruling is sound or unsound depending on circum- stances. The date of voting a salary is not of major impor- tance. An officer or employee who renders service is entitled to reasonable compensation from day to day (even though none is voted), under the ordinary rule of law that the recipient of a benefit is bound to pay for it unless there is a prompt dis- avowal of an intention to pay. "Christmas gifts." — Regulations 62*^ do not specifically discuss the deductibility of the "Christmas gifts" which so many business houses are accustomed to distribute to em- ployees each year. The reasoning of article 105 would indi- cate that such payments to employees are deductible so long as the total compensation, including such payments, "is only such amount as would ordinarily be paid for like services by like enterprises in like circumstances." However, it may be that the Treasury expects to classify these payments in the category of "donations" as defined in the following para- graph. "C. B. I, page 106. *^See page 420. FOR EXPENSES 887 Regulation Donations made to employees and others, which do not have in them the element of compensation or are in excess of reasonable compensation for services, are considered gratu- ities and are not deductible from gross income. (Art. 107.) In the author's opinion the Treasury, in the matter of Christmas gifts and similar items, has not always interpreted the law properly in the past. Most Christmas gifts to employees are wages, pure and simple. Particularly where the gifts are large, an employee, on being asked the amount of his compensation for the year, will in his answer name a figure which includes the "gifts." This is not a theory. It is standard business practice to include items of this kind as one of the necessary business expenses intended by the framers of the law to be an allowable deduction. Educational and "welfare" outlays for employees. — It is now considered advantageous for an employer to educate and stimulate his employees in all matters relative to the business and to promote their development so that they may become more useful and valuable. Schools are founded, classes are formed, lecture courses are arranged, gymnasiums are opened, athletic games are encouraged, entertainments are provided, and many other ways are found of carrying out the purpose in view. Some of these plans appear to be altruistic and of a semi-charitable nature. When this idea is uppermost, the cost of the ventures should be entered on the books as gifts or donations. If, as is often the case, the controlling motive is the better- ment of the business, the cost is a business expense, pure and simple, even though the results are disappointing. In these days of labor and other administrative troubles, the cost of any practical and effective plan of improving the moral, mental and physical condition of employees is a practical business expenditure. It is not a charitable scheme. It is a money- making, not a money-spending, proposition. Tn the opinion 888 DEDUCTIONS of the author such expenses are allowable deductions and may be so claimed. Ruling. Inquiry is made whether the following are allowable deductions in the income tax returns of a taxpayer : (i) Amounts expended in outfitting a baseball team which repre- sents the taxpayer, and the uniforms of which bear the name of the taxpayer the players represent. (2) Expenses incurred in furnishing entertainment to the tax- payer's employees by means of picnics or dances. Inasmuch as it appears that the name of the taxpayer is given considerable publicity in the appearance of the taxpayer's baseball team in various parts of the district in which the taxpayer does busi- ness and by a report of the games in the newspapers of the vicinity, it is held that the expenses incurred relative to the outfitting and support of the ball team representing the taxpayer are similar to those expended in other methods of advertising and are deductible as business expenses in the income tax returns of the taxpayer. However, expenses incident to the furnishing of entertainment to the employees by means of picnics or dances are not such "ordinary and necessary" business expenses as are comprehended by the Revenue Act of 1918, and therefore are not allowable deductions from gross income for purposes of computing income tax. (B. 37-21-1815; O. D. 1030.) The author is of the opinion that the latter part of the fore- going ruling is unsound. Such entertainments contribute to a finer esprit de corps, which in turn is reflected in the productivity of the business. If the directors believe that the expenses are necessary, the bur- den of proof is on the Treasury to show that they are not. Ruling. Where a corporation encourages or requires its em- ployees to attend part-time schools it may deduct as a business ex- pense reasonable amounts paid as compensation to such employees during their absence from employment while attending such schools. (C. B. 4, page i3o;0. D. 850.) Pensions to ex-employees and their dependents. — Regulation. Amounts paid for pensions to retired employees or to their families or others dependent upon them, or on account of injuries received by employees, and lump-sum amounts paid or accrued as compensation for injuries, are proper deductions as ordinary and necessary expenses. Such deductions are limited to the amount not com- pensated for by insurance or otherwise. No deduction shall be made FOR EXPENSES 889 for contributions to a pension fund held by the corporation, the amount deductible in such case being the amount actually paid to the employee. When the amount of the salary of an officer or employee is paid for a limited i)eriod after Iiis death to his widow or heirs, in recognition of the services rendered by the individual, such payments may be deducted (Art. 108.) This regulation recognizes that the total payments to em- ployees themselves or to their dependents are allowable de- ductions.** It is open to criticism, however, because of its re- fusal to permit the deduction of amounts set aside during accounting periods as accruing expenses. The regulation is inconsistent with other regulations which permit deductions for liabilities incurred but not paid. Amounts appropriated to pension funds are supposed to approximate the liabilities which attach to all pension plans. Obviously in many cases actual payments are deferred, but if it can be shown that the contributions to a fund are not in excess of the reasonable requirements of the pension plan, applicable to the employees on the payrolls during the period in question, the entire con- tribution is clearly a necessary expense of the business. Contributions to pension funds which are deducti- ble. — Ruling. Donations by a corporation to a pension fund for the benefit of its officers and employees, the fund being organized entirely " [Former Procedure] The procedure in regard to the deducti- bility of pensions paid to dependents of employees has had a checkered history. T. D. 2090 provided that : Regulation. Amounts paid for pensions to retired empolyees, or to their families, or others dependent upon them, or on account of injuries received by employees, are proper deductions as ordinary and necessary expenses. i However, the 1918 edition of Regulations 33, articles 136 and 137, took the position that : Regulatiox. When the amount of the salary of an officer or em- ployee is paid for a limited period after his death to his widow or heirs, in recognition of the services rendered by the individual, no services being rendered by the widow or heirs, such payment is not "ordinary and neces- sary" expense of transacting business and does not constitute an allowable deduction. This was once more reversed by Reg. 45, Art. iu8. Art. 108 of Reg. 62 is the same as in Reg. 45. 890 DEDUCTIONS separcate and distinct from the corporation, having its own set of books, making its own investments, and paying its own expenses, legal title of which does not remain in the corporation, are deemed to be donations to a charitable institution conducted for the benefit of the corporation's employees or their dependents representing a con- sideration for a benefit flowing directly to the corporation as an incident of its business and are allowable deductions from gross in- come in determining net income subject to tax. (C. B. i, page 224- O. D. no.) Commissions of various types. — Commissions paid to salesmen and commissions on INSURANCE premiums DEDUCTIBLE. Regulation Commissions paid salesmen, .... commis- sions on insurance premiums, .... are income to the recipients; .... (Art. 32.) Consequently they are deductible as compensation for ser- vices.*^ Management compensation or commissions paid AGENTS deductible. — An old Treasury decision specifically states that: Ruling. A commission paid to' a real estate agent for col- lecting rents and for management of property, is a legitimafe busi- ness expense and constitutes an allowable deduction in computing net income. (T. D. 2090.) The same rule would apply to the charges of trust com- panies or other agents who collect income and manage per- sonal as well as real property. Usually the recipient of the income receives and enters a net amount and fails to record the items of gross income and deductions therefrom. Where part of the income is from dividends or tax-free covenant bond interest this method results in a loss of the credits for normal tax. When all the items of income are entered gross there should also be entered as de- ductions the expenses which are applicalile to the income. " See page 420. FOR EXPENSES 891 Commissions paid to stockbrokers not deductible as expenses. Regulation Commissions paid in purchasing securities are a part of the cost price of such securities. Commissions paid in selling securities are an offset against the selling price (Art. 293-) When securities are sold the profit is decreased or the loss is increased by the commissions charged. Therefore the amounts paid in such commissions are fully deductible even- tually. Compensation paid in stock deductible.*^ — Regulation Compensation paid an employee of a cor- poration in its stock is to be treated as if the corporation sold the stock for its market value and paid the employee in cash (Art. 33.) Stock issued to employees for services. — During recent years many concerns have sold stock to their employees so that they may participate in the profits of the business. Generally, these sales are made on an instalment plan, the company credit- ing a small amount each year to the employee, which is applied to the purchase of the stock. The employee also pays a small amount every week or month, which is likewise applied against the purchase price of the stock. The amounts which the company credits to the employee are for services rendered and are deductible as a necessary business expense. Rulings. A proportionate part of the par value of a company's stock delivered to a trustee to be held in escrow for the benefit of certain employees of the company which stock is to be delivered to them at the expiration of a number of years in recognition of faithful service, may be taken as a deduction in the income tax returns of the company for each of such years during the period the trustee holds the stock, providing the corporation keeps its books on an accrual basis. If the employee for whom the stock was deposited should forfeit " See page 430. 892 DEDUCTIONS his right to receive the stock, the corporation must report as income in the year in which the right to receive the stock is forfeited, the amounts taken as a deduction in previous years on account of the forfeited stock. (C. B. i, page 107; O. D. 124.) If a corporation distributes shares of its treasury stock to its em- ployees as additional compensation, the market value of the stock at the time of distribution is deductible by the corporation. Any differ- ence between such market value of the stock and its cost to the cor- poration is neither taxable gain nor a deductible loss to the corpora- tion. (C. B. 4, page 137; A. R. M. 114.) This ruling depends on the fact that no taxable profit or deductible loss can arise from transactions engaged in by a corporation in its own treasury stock. Had it distributed stock in some other corporation owned by it, the difference between cost and market price would be a taxable profit or deductible loss, as the case may be. Compensation to employee of a partnership under a par- ticipation of profits agreement deductible. — Regulation compensation for services on the basis of a percentage of profits .... [is] income to the recipients; .... (Art. 32.) It follows, of course, that the payment constitutes an item of business expense to the partnership. Partners' and sole proprietors' so-called salaries. — Except for the purposes of excess profits taxation the designation of salaries for partners or proprietors is essentially an artificial and pointless practice. Withdrawals made by individuals or partners from a business in which they own all or part of the capital are normally in anticipation of profits. As between partners, salary allowances may serve to adjust or define dis- tributions of profits or sharing of losses, but merely calling such drawings expenses does not make them so. In the language of the Treasury :^' "Wages or salary drawn by a taxpayer from his own business are more in the nature *' Income Tax Primer, 1918, question 62. FOR EXPENSES 893 of a charge out of profits than a charge against profits. If such could be deducted they would merely be added to his income, the effect of which would be to take money out of one pocket and put it in another." For the proper determina- tion of super-normal profits, however, it was necessary to take such deductions into account. Insurance Life insurance premiums paid by insured not deductible. — Regulation Premiums paid for life insurance by the in- sured are not deductible (Art. 291.) Ruling. Where a corporation insures the life of its president, the stockholders being beneficiaries in proportion to their stock hold- ings and the wife of the president (not herself a stockholder) being a beneficiary in proportion to her husband's stock holdings, no deduc- tion for the payment of premiums can be allowed under article 294 of Regulations 45, as amended by T. D. 3019, since the corporation itself is indirectly a beneficiary under the policy. The premiums paid on such a policy are a charge against surplus and represent dividends to the stockholders subject to surtax to the extent that such premiums are paid out of earnings or surplus accu- mulated since February 28, 1913. This applies as well to the officer upon whose life the insurance is carried. (C. B. 3, page 192; O. D. 659.) As no part of the proceeds of the policy would be paid to the taxpayer the Treasury ignores the corporate entity in the foregoing decision. The decision is sound, however, from an equitable if not from a legal point of view. When the equity is in favor of the taxpayer the Treasury finds it im- possible to look through the corporate entity. Whether or not the deduction of life insurance premiums of this type should be permitted resolves itself very largely into a question as to whether or not the degree of security of a source of income shall be taken into account in levying a tax on the income from that source. For example, shall income from personal effort, which may suddenly be terminated at the death of the producer, be given some concession compared with "funded" income? In England, where this qiiestion is 894 DEDUCTIONS of long standing/^ the earned incomes arc not only taxed at lower rates but premiums on insurance on one's own life or that of his wife are deductible up to one-sixth of the net in- come. ""^ At the time the 191 3 law was passed Judge Hull explained that no deduction was permitted for such expenditures because the exemption was large enough to cover them. The exemp- tion was materially lowered in the 19 17 law, but no deduction was provided for life insurance premiums. "Business" life insurance premiums not deductible/" — Law. Section 215. [Individuals and corporations — items not deductible] .... (4) Premiums paid on any life insurance policy covering the life of any officer or employee, or of any person financially interested in any trade or business carried on by the tax- payer, when the taxpayer is directly or indirectly a beneficiary under such policy. *' Seligman, The Income Tax, pages 79, 133, 154-155. After first per- mitting the deduction and then forbidding it, the permission was firmly established in the law in 1853. ■" Murray and Carter, A Guide to Income Tax Practice, 8th Ed., page 259. The allowance, however, is "not admissible as a deduction in arriving at the total income for the purpose of a claim for relief in respect of 'earned income.' " °" [Former Procedure] Under T. D. 2090 (December 14, 1914) pre- miums on such insurance were deductible, but when the policies matured or upon the death of the insured the amount received was reportable as income. This procedure was changed by T. D. 2519 (August 30, 1917) which forbade the deduction of the premiums annually but provided in- stead that they might be cumulated and deducted from the gross proceeds, when received, of any policies of which the business concern was the beneficiary. As applied to term policies for special purposes if there was no surrender value, the premiums represented a business expense and credit should have been claimed therefor. The test of deductibility prior to 1917 should rest on reasonable protection to a business as against investment or profit possibilities. If the premiums paid merely provided for reimbursement of possible business losses by fire or death of a valuable executive, or against any true business risk, the cost of insur- ance was correspondingly a true business expense. 1917 Law. Section 32. "That premiums paid on hfe insurance policies covering the lives of officers, employees or those financially interested in any trade or business conducted by an individual, partnership, corpora- tion, joint-stock company or association, or insurance company, shall not FOR EXPENSES 895 "Group" insurance premiums are deductible. — The law disallows deductions for premiums only when the taxpayer is a beneficiary. So-called "group" insurance premiums are deductible because the proceeds of the policies are paid to someone other than the taxpayer. Regulation If, however, the taxpayer is in no sense a beneficiary under such a policy, except as he may derive benefit from the increased efficiency of the officer or employee, premiums so paid are allowable deductions ^^ (Art. 294.) Accident insurance premiums. — The 192 1 law,"^" and regulations^^ hold that proceeds of accident insurance policies are not taxable income. Therefore premiums paid for acci- dent insurance are not allowable deductions. The controlling reason for taking out accident insurance is to secure special income in case one's regular income is shut off. It would therefore seem logical to tax the income and allow credit for premiums paid and for any unusual expenses arising from the contingency giving rise to the payment of the insurance. In the case of a business, however, such premiums are deductible. be deducted in computing the net income of such individual, corporation, joint-stock company or association, or insurance company, or in computing the profits of such partnership for the purposes of subdivision (e) of sec- tion eight (3)." A possible explanation of the insertion of Section 32 in the law in 1917 is the desire to prevent evasion. It is conceivable that in a year of high tax rates a concern might reduce its taxes by insuring heavily various persons associated with the business. Evasion would be par- ticularly easy if the various types of "investment" insurance were avail- able. The provision of the 1918 law was inserted in the 1921 act without change. " In an early edition of Regulations 45, this sentence read as follows : "But if the taxpayer is in no sense a beneficiary imder such a policy, except as he may derive advantage from the increased efficiency of the employee, and pays the premiums purely as reasonable additional compen- sation of such employee, they are allowable deductions." "Section 213 (b-6). "See page 351. 896 DEDUCTIONS Property insurance premiums — when deductible. — Regulations Other items that may be included as busi- ness expenses are .... insurance premiums against fire, storm, theft, accident or other similar losses in the case of a business (Art. loi.) Insurance paid on a dwelling owned and occupied by a taxpayer is a personal expense (Art. 291.) In conformity with these rulings, premiums on insurance covering a dwelling house occupied by the owner may not be deducted." On the other hand, if the insurance covers a barn on a farm it is deductible. Premium on fidelity bonds deductible. — Regulation. Where an employee is required to furnish bond and pay the premium on such bond as a necessary incident to his employment, the premium on the bond will constitute an allowable deduction in computing net income. (T. D. 2090.) Ruling. Premiums paid on indemnity bonds furnished by Gov- ernment employees for the faithful performance of their duties con- stitute allowable deductions in computing net income for the purpose of the income tax. (C. B. 4, page 124; O. D. 878.) If the premium is paid by the employer the payment is likewise deductible as a business expense. Premiums paid on insurance policies to secure loans. — Rulings. A taxpayer who borrowed money for business purposes and was required to take out life insurance in favor of the lender as security for the loan, is entitled to deduct the premiums paid for such insurance as a business expense under Section 214 (a) 1 of the Revenue Act of 1918; however, the premiums will cease to con- stitute a business expense upon maturity and payment of the loan. (C. B. 2, page 104; O. D. 396.) The premiums paid on a life insurance policy taken out by a tax- payer for the sole purpose of protecting a bank from which he pro- cured a loan, constitute an allowable deduction in determining net income, even though the insurance was not taken out until some time after the loan had been made. (B. Digest 35-21-1791 ; O. D. loii.) Likewise it would appear that if any policy were assigned Income Tax Primer, 1918, question 67. FOR EXPENSES 897 to secure a loan, the premiums would immediately become de- ductible, but the Treasury has held that : Ruling. Office Decision 396 (C. B. 2, page 104), holding that pre- miums paid on a life insurance policy required as collateral for a loan are deductible as a business expense, is to be strictly construed. The policy must have been taken out for the sole purpose of using it as security for the loan. A taxpayer is not permitted to deduct the premiums paid on a policy taken out prior to the negotiations for a loan and later assigned to the lender as security for such loan. The subsequent assignment of the policy to the lender is merely inci- dental to the purpose for which the policy was secured, and no addi- tional expense is incurred or loss sustained by virtue of its temporary use as collateral. The increase in the cash surrender value of a policy accruing during the period it is used as collateral is not to be con- sidered in computing the net income of the person who pays the premium. A corporation which takes out a policy on the life of one of its officers for the purpose of using the policy as collateral may not deduct the premiums paid thereon. (C. B. 3, page 139; O. D. 711.) It is difficult to reconcile the last paragraph of the fore- going ruling with O. D. 396. It is made plain, however, that in certain cases life insurance premiums are deductible even though the taxpayer is "indirectly" a beneficiary. It would also appear that if a creditor takes an assignment of life insurance as security, he will be entitled to deduct the premiums paid on the insurance, if the debtor fails to pay the premiums. W^hen changes such as renewals and reduction of loans occur, it may be necessary to divide the amount paid as premi- ums in order to arrive at deductible portion. Ruling. In case a loan is renewed for the full amount, and a policy of insurance taken out in favor of the lender for the express purpose of securing the loan is continued as security, the premium paid thereon by an individual taxpayer is deductible as a business ex- pense under the same conditions applicable in the case of the original loan. If partial payment is made upon the maturity of the loan, and the loan is renewed for the reduced amount, the premium paid is de- ductible only to the extent that it is paid on insurance required as security for the reduced amount of the loan. (C. B. 4, page 123; O. D. 843.) 898 DEDUCTIONS 'Self-insurance" reserves. Regulation. Funds set aside by a corporation for insuring its own property are not a proper deduction, but if such funds are set aside, or a reserve therefor is set up, any loss actually sustained and charged to such funds or reserves may be deducted. (Reg. 33, 1918, Art. 144.) If the amounts set aside are simply equal to the premiums charged by an insurance company it is quite possible that the courts would decide that such reserves or provisions against losses would be allowable deductions as business expenses. Certainly sound accounting practice requires that such items should be charged to an expense account. Insurance under v/orkmen's compensation laws.— Premi- ums- paid to insurance companies or state insurance commis- sions by employers under workmen's compensation laws are deductible. If these laws permit an employer to establish re- serves for the purpose of carrying the risk, such reserves can- not be deducted, but payments to employees from such reserves are deductible. Rulings. Under the Workmen's Compensation Law of a State, employers are required either to make periodical payments to the State Insurance Fund created to compensate employees for injuries received in the course of their employment, or to maintain a benefit fund providing for the payment of such compensation, giving a bond as additional security for the payment of such compensation. Where the employer makes the periodical payments to the insur- ance fund of a State such payments are allowable deductions for the year in which paid or accrued. If, however, the employer maintains a fund actually depositing periodically in a trust company an amount to be held in reserve as a special fund for the payment of compensation as injuries occur, the amount thus deposited is not an allowable deduction from gross income, since there is no means of determining how much of this fund will be used for the purpose for which it is held. In such case the actual amount paid during a year to the employees as compensation where injuries occur is a proper deduction for that year whether the amount so paid is greater or less than the deposits made during the period to the fund which is maintained. (B. 27-21-1712; O .D. 964.) A corporation carried its own compensation insurance in ac- cordance with the Workmen's Compensation Law of the State of l i:he amount which appHes to the taxable period may be taken as a deduction. Ruling. The commission paid by the lessor to a broker for ne- gotiating a long-term lease should not be prorated over the term of the lease but constitutes a proper deduction in computing net in- come for the year in which paid or accrued. (I-4-40; I. T. 1171.) It is difficult to distinguish the foregoing ruling from office decision 1013, qtioted above. Deferred payments to lessor deductible when accrued. — Ruling. Under the terms of a lease of real estate it is provided that the lessee may withhold for the first three years of the life of the lease a certain part of the annual rental in order that it may conserve its liquid assets. The amounts so withheld are to be paid to the lessor in monthly installments during the remaining life of the lease. In the event of the cancellation of the lease the amounts so withheld are agreed to be an absolute liability of the lessee. The books of the lessee are kept on the accrual basis. Held, that the amount of the rental withheld by the lessee during each of the first three years of the lease may be accrued as an ex- pense for that year and deducted from gross income in its return. (C. B. 4, page 141; O. D. 794.) Rentals paid by professional men and others. — Under the title, "Business expenses of the professional man" (page 862). will be found a full discussion of this topic. Business Expenses Distinguished from Capital Outlay Organization and similar expenses. — The Treasury rulings forbid the deduction of attorneys' fees, accountants' fees, fees paid to state authorities and other expenditures usually grouped under the phrase "organization expenses." On this point the rulings are in direct conflict with good accounting practice. (jo8 DEDUCTIONS Regulation. Expenses of the organization of a corporation, such as incorporation fees, attorneys' and accountants' charges, are ordinarily capital expenditures, but where such expenditures are limited to purely incidental expenses, a taxpayer may charge such items against income in the year in which they are incurred. (Art. 582.) The foregoing regulation, unlike the same article in Regu- lations 45," accords at least in part, with the following, which may be taken as a fair reflection of present accounting prac- tice : Formerly if the expenses incurred in the organization of the company (such as incorporation fees, legal, engineering and other expenses, engraving bonds and stock certificates, transfer fees and stamps, etc.) were more than could fairly be charged into current expenses, it was considered permissible to spread such charges over a term of years, preferably three, but not more than five. Sentiment is changing as to the wisdom of spreading these expenses over more than three years. The best practice is to charge off immediately every- thing which has no tangible or residual value. The benefit from such items cannot be compared to advertising and exploitation expenses. It is a fallacy to assume that stock certificates, incorporation expenses, etc., have any of the attributes of an asset; and so the sooner the cost appears in the expense account, the better. The old theory of deferring part of the charge to income was sound enough, but the rule has been abused; and so we now find ap- portionments over five years or longer. In some cases all organiza- tion expenses, using the term in its broadest sense, are permanently capitalized. The author advocates charging off all such expenses as they are incurred. *^- If the expenses are actual and are incurred in good faith, they constitute deductions which should be allowable for the period during which they appear on the books as charges to expenses. If a corporation actually capitalizes the items, of course it must not claim credit for the deduction; but if it fol- lows proper and now almost settled corporate practice, this class of expenditures should appear in its books as ordinary expenses. If state laws are complied with and the usual fees are charged and paid, certainly such expenses are necessary " [Former Procedure] For text and criticism of past practice, see Income Tax Procedure, 1921, pages 719-720. "'Auditing, Theory and Practice (3rd edition), R. H. Montgomery, page 576. FOR EXPENSES 909 to the operation of the corporation. The fact that the items are not recurring ones seems to have had something to do with the former procedure of the Treasury. Anyone famihar with corporate affairs knows that thousands of items occur once only, but nevertheless are ordinary and necessary. Expenses incurred in selling capital stock. — Regulations If the stock is sold at a discount, the amount of the discount is not a loss deductible from gross income. . . ... (Art. 543; Reg. 45, Art. 542.) Any and all expenses incidental to or connected with the selling of the capital stock (common or preferred) of a corporation for the purpose of raising capital to be by it invested in property or em- ployed in the business for which the corporation is organized are not an "expense of operation and maintenance" within the meaning of this title, and such expense is not an allowable deduction from the gross income, for the reason that such an expense is incurred in a capital transaction; that is, the raising of capital to be invested or employed in the business (Reg. 33, 1918, Art. 145.) The comments on organization expenses"^ apply to the foregoing regulation. Of course discounts on capital stock are not business expenses; but ordinary expenses of securing capital should not be capitalized. If it is not proper to capital- ize an expense item it should be an allowable deduction as a business expense. Regulation A holding company which guarantees divi- dends at a specified rate on the stock of a subsidiary corporation for the purpose of securing new capital for the subsidiary and increas- ing the value of its stock holdings in the subsidiary may not deduct amounts paid in carrying out this guaranty in computing its net in- come, but such payments may be added to the cost of its stock in the subsidiary (Art. 582.) Assessments on stock. — The following ruling holds that voluntary assessments paid by security holders are not deducti- ble by them as business expense : Regulation Amounts to be assessed and paid under an agreement between bondholders or stockholders of a corporation, to "■' See page 907. 9IO DEDUCTIONS be used in a reorganization of the corporation, are investments of capital and not deductible for any purpose in returns of income. .... An assessment paid by a stockholder of a national bank on account of his statutory liability is ordinarily not deductible (Art. 293.) Ruling. The payment of a statutory assessment under State law against a taxpayer as a stockholder of a bank is not a deductible loss in the year paid but is an additional capital expenditure which must be added to the original cost of his stock. Gain or loss can not be de- termined until the stock is sold or otherwise disposed of in a closed transaction. (B. Digest 30-21-1744; A. R. R. 588.) An answer to a question in the Primer makes the general statement that "assessments made by a corporation on its capital stock are regarded as further investments of capital and do not constitute an allowable deduction in the return of the individual."*"' If the assessments result in losses, credit may be claimed for the payments. If sustained prior to 19 18 the deductions w^ill be subject to certain limitations.®^ In another answer, the Primer states that in the case of a mutual irrigation company, "assessments in proportion to stockholdings merely to raise funds to keep the irrigation system in usable condition and not to make extensions or betterments" may be deducted.*^* Expenses incurred in purchase of treasury stock — part of cost. — Ruling. The expenses, exclusive of the purchase price, incurred by a company in purchasing its own stock for the purpose of retire- ment or holding as treasury stock, are not such expenses as can be classified as ordinary and necessary expenses- incurred in carrying on the business, and hence are not deductible from gross income. These expenses are to be considered part of the purchase price of the stock retired. (C. B. 4, page 286; O. D. 852.) Legal payments by corporations fall into three classes : ( i ) capital expenditures which have a continuing benefit, (2) pay- ments to stockholders, (3) necessary expenses. 'Income Tax Primer, 1918, question 70. ' See Chapter XXIX, "Deductions for Losses." 'Income Tax Primer, igiS, question 71. FOR EXPENSES 911 If the payments on account of stock returned to the treas- ury are made to stockholders, the above ruHng is sound. If the expenses are ordinary and necessary, are not distributions to stockholders, nor expenses having a continuing benefit, they should be claimed as allowable deductions. Deferred charges — advertising, etc. — Ruling. A corporation conducted in its taxable year a national campaign of advertising its manufactured product. Inquiry is made as to whether this expense of advertising must be charged off as an op- erating expense during the year in which it was incurred, or whether it can be carried as a deferred asset and charged off over a period of years. It is held that the expenses of such advertising campaign are deductible as a business expense only in the return for the year in which such expenses were paid or in the year in which liability there- for accrued, if the books of the company are kept on an accrual basis. (B. 38-21-1829; O. D. 1039.) It has been the custom of some concerns to spread extra- ordinary expenditures over a period of years. If the future will assuredly receive some benefit therefrom, the policy is sound enough. (See "Organization and similar •expenses, etc.," page 907.) But any doubt should always be settled in favor of an immediate absorption. If these expenditures are deductible at all, the proportion actually charged to profit and loss is the only part which should be deducted in the income tax return. In other words, it would be improper to deduct all expenditures in one year if in the books of account a propor- tion thereof was deferred to later periods. Repairs and depreciation. — Regulation. The cost of incidental repairs which neither mate- rially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as expense, provided the plant or property account is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, should be charged against the depreciation reserve if such account is kept (Art. i03-) (J 12 DEDUCTIONS The tendency of some inspectors is to question deductions for repairs on the theory that the usual depreciation allowances include ordinary maintenance."^ The law permits deductions for maintenance and operation in addition to depreciation. The necessity for allowing both claims is very well expressed in a recent decision. "^^ The court said : Decision. It will thus be seen that the deductions allowed are to include, not only ordinary and necessary amounts actually paid out in the operation of the property, but also the amounts paid out in the maintenance thereof, and in addition a reasonable sum for depreciation, if any. Now, the operation of a business or property includes payment for labor and materials which go into the actual operation thereof, while maintenance means the upkeep or preserving the condition of the property to be operated, and therefore, in my judgment, includes the cost of ordinary repairs necessary and proper from time to time for that purpose. "Depreciation," as used in the statute is not to be confused with ordinary repairs. It is intended to cover the estimated lessening in value of the original property, if any, due to wear and tear, decay, or gradual decline from natural causes, inadequacy, obsolescence, etc., which at some time in the future will require the abandonment or replacement of the property, in spite of ordinary current repairs. Equipment purchased on so-called rental plan. — In many cases equipment is purchased and title is reserved in the vendors until final payment is made. In the meantime the pay- ments on account are treated as rental. Technically, the payments may be looked upon as expenses because failure to pay the final instalment might result in the repossession of the equipment by the vendor, but in the case of solvent taxpayers the whole transaction is merely a purchase on the instalment plan. The entire purchase price should be set up as an asset on one side and as a deferred liability on the other. Depreciation should be written off as if the equipment were owned. If the rentals are charged as expenses it would be neces- ®' See Chapter XXXI, "Deductions for Depreciation." '^'* The San Francisco & Portland Steamship Co. v. Scott, 253 Fed. 854. (T. D. 2773, November 8, 1918.) FOR EXPENSES 913 sary to include the entire purchase price (less depreciation) as taxable income for the year when title passes. Cost connected with title to property not deductible. — Regulation The cost of defending or perfecting title to property constitutes a part of the cost of the property and is not a deductible expense (Art. 293.) The cost of perfecting title is a proper capital charge, but the cost of defending title may not add anything to the value of the property. If not, the item is a business expense. Expenses of obtaining return of property from Alien Property Custodian not deductible. — Ruling. Attorneys' fees paid for services rendered in securing for a non-resident alien, the return of property and income from the Alien Property Custodian, are not allowable deductions from gross income. If the Alien Property Custodian returned property, as dis- tinguished from money, the attorneys' fees should be treated as a part of the cost price of the property. If the Alien Property Cus- todian took over property, converted it into cash, and delivered money to the taxpayer, the attorneys' fees constitute an offset against the selling price. (B. Digest 39-21-1842; O. D. 1048.) It is unlikely that expenses incurred in connection with the recovery of seized property add to its value. If not, such expenses should be treated as business expenses. Architect's fee not a business expense. — Regulation The amount expended for architect's serv- ices is part of the cost of the building (Art. 293.) Cost of copyright and plates not deductible. — Regulation Amounts expended for securing a copyright and plates, which remain the property of the person making the pay- ments, are investments of capital (Art. 293.) In the two foregoing cases the payments are properly designated as capital, but it should be noted that the items become allowable deductions as depreciation when spread over a term of years. ^^ See Chapter XXXI. 914 DEDUCTIONS Title abstract companies — maintenance of records. — Rulings. Title abstract companies incur relatively large and continuous expenditures in keeping their plants up to date, such as the expense of adding and incorporating in the plant records that are being made daily in the various courts and in the Recorder's office. These records which are added to and incorporated in the plant for the purpose of keeping it in up to date running order and prevent- ing depreciation are in the nature of ordinary and necessary repairs. The expenses, therefore, incurred in making such records are current expenses, and as such are deductible for the year in which incurred and paid or accrued. Since a title plant is not an asset of a nature which gradually approaches a point where its usefulness is exhausted, but is an asset of a more or less permanent character, it is not a proper subject of a depreciation allowance. (B. 36-21-1799; O. D. 1018.) The cost of land title abstract books purchased is a capital expenditure. The expenditure for them may not be deducted as a loss by reason of the purchaser's claim that they are of no service to it because it already owns another set of the same records. (B. 39-21-1843; O. D. 1049.) Carrying charges on real estate. — A distinction must be drawn between operating expenses, which can be charged as necessary expenses of doing business, and expenses which arise when there is no going business which can be charged. Unproductive real estate is a case in point. There may be taxes, interest and other items of expense to be taken care of and no income out of which the payments can be made. Capital must be used to make the payments, and in the circumstances the items will be regarded as capital expendi- tures. As soon as a property is being operated or used the capitalization of charges must cease, even though the property is being operated at a loss. If a property is only partly op- erated the charges may be partly capitalized. When several properties are under one ownership, it is the custom to absorb the charges on the unproductive prop- erties in the surplus * income from productive property. There is no objection to this from a conservative accounting point of view. As long as capital gains were subject to high surtaxes, it was in many cases to the taxpayer's advantage to I FOR EXPENSES 915 capitalize expenses on unproductive property, rather than to charge them off immediately, so as to minimize the amount to be reported as taxable profit in the year of sale. With the low rate of tax on capital gains, however, it will now be to the advantage of the taxpayer to have the profit on realization as large as possible and to get credit from year to year against income subject to high surtax rates for the carrying charges. Payments for goodwill not an expense. — In some cases payments are made which are of the nature of goodwill rather than expenses. Such payments should not be claimed as de- ductions even though it is decided that they should not be capitalized. Payments to a retiring partner, when in excess of reasonable compensation for services rendered, should be charged to goodwill and not to expenses. Payments under leases or to officers of corporations in excess of reasonable compensation for the use of property, or for services, are not ordinary or necessary expenses of a business. Payments which properly are chargeable either to expenses or to capital, such as development and establishment expendi- tures, should not be charged on the books as expenses unless it is proposed to claim credit therefor as allowable deductions. Miscellaneous Lobbying expenses and campaign contributions not de- ductible. — Regulation Sums of money expended for lobbying pur- poses, the promotion or defeat of legislation, the exploitation of prop- aganda, inchxding advertising other than trade advertising, and con- tributions for campaign expenses, are not deductible from gross in- come. (Art. 562.) Lobbying expenses will probably appear under legal ex- penses and will no doubt be allowed. In the case of corpora- tions, campaign contributions are illegal and should not ap- pear in the books. The words "advertising other than trade 9l6 DEDUCTIONS advertising" were not used in Regulations 33 which were in force until 1919. Advertising Liberty bonds certainly is not trade advertising, but has been allowed. It would be held that any advertising for the good of a business would be an allow^able deduction. Trading stamps expenditure a business expense. — The Treasury in the Regulations 45 and 62 has provided in a very definite manner for the deduction of trading stamp expense, in effect reversing the earlier ruling that a reserve set up as a liability equal to the redemption value of the stamps is not deductible. '° Regulation. Where a taxpayer, for the purpose of promoting his business, issues with sales trading stamps or premium coupons redeemable in merchandise or cash, he should in computing the in- come from such sales subtract only the amount received or receiv- able which will be required for the redemption of such part of the total issue of trading stamps or premium coupons issued during the taxable year as will eventually be presented for redemption. This amount will be determined in the light of the experience of the tax- payer in his particular business and of other users engaged in similar businesses. The taxpayer shall file for each of the five preceding years, or such number of these years as stamps or coupons have been issued by him, a statement showing (o) the total issue of stamps during each year, (6) the total stamps redeemed in each year, and (c) the percentage for each year of the stamps redeemed to the stamps issued in such year. A similar statement shall also be pre- sented showing the experience of other users of stamps or coupons whose experience is relied upon by the taxpayer to determine the amount to be subtracted from the proceeds of sales. The Commis- sioner will examine the basis used in each return, and in any case in which the amount subtracted in respect of such stamps or coupons is found to be excessive an amended return or amended returns will be required. (Art. 91; Reg. 45, Art. 88.) In effect the foregoing regulation permits the deducting of reserves set up for trading stamps. Likewise, similar re- serves should be allowed for cash discounts because the same principle is involved. (See page 451.) '" [Former Procedure] A reserve set up was not deductible under an earlier regulation. (Reg. 33, 1918, Art. 141.) FOR EXPENSES 917 Maintenance funds required by law should be deductible. — Ruling. Payments to trustees by a cemetery corporation during the taxable year of a certain percentage of the proceeds of sales of cemetery lots set aside for a maintenance fund to be controlled solely by the trustees thereof are not deductible from the gross income of the corporation even though such payments are required by state law. (C. B. 2, page 216; O. D. 529.) The author is of the opinion that the foregoing ruling is erroneous, and that it should be changed to accord with the principle laid down in article 567/^ whereby banking corpora- tions are allowed to deduct "depositors' guaranty funds" when such funds are required by law. Dues paid to chambers of commerce and associations de- ductible. — Ruling. Membership fees or dues paid by individuals and cor- porations to a chamber of commerce or board of trade are deductible from gross income as a business expense provided the membership is employed as a means of advancing the business interests of the individual or corporation. (C. B. 2, page 105; O. D. 421.) Likewise, fees paid to trade associations to promote the g'eneral business interests are also deductible." & Payments for baseball players. — Ruling. An amount paid by a baseball club to another baseball club as the purchase price of a contract between such club and a player covering the services of the player for a period of more than one year is deductible from gross income during the life of the contract, a proportionate part of the price paid being deductible each year. (C B. 4, page 142; O. D. 836.) Dues paid to labor unions. — Ruling. Dues paid by an individual to an organized labor union are deductible as a business expense in computing his net income for income-tax purposes. (C. B. 2, page 105; O. D. 450.) " See page 902. "C. B. 2, page I OS; O. D. 496. 9l8 DEDUCTIONS Fees paid to secure employment. — Ruling. Fees paid to secure employment are considered allow- able deductions for the purpose of computing net Income subject to tax. (C. B. 3, page 130; O. D. 579.) Bonus paid for an early delivery of steamship. — Ruling. A bonus was paid for the delivery of a steamship at a date earlier than that stipulated in the contract for its construction and the question is presented whether the amount is properly charge- able as a business expense or as a capital expenditure. Held, that as the bonus paid for delivery at a date earlier than that contracted for added nothing to the value of the vessel after the contract date of delivery the amount so paid is properly charge- able as a business expense and is deductible from income received between the date of delivery of the vessel and the date it would have been delivered had no bonus been paid. (C. B. 3, page 131 ; O. D. 664.) Earnings paid city, etc., by public utility an expense. — Regulation In the case of a public utility acquired, con- structed, operated, or maintained by a taxpayer under contract with any State, Territory, or political subdivision thereof, or with the Dis- trict of Columbia, containing an agreement that a portion of the net earnings of such public utility shall be paid to the State, Territory, or political subdivision thereof, or the District of Columbia, the amount so paid may be deducted by the taxpayer as a necessary ex- pense in transacting business (Art. 87; Reg. 45, Art. 84.) Payments by railroads to Interstate Commerce Commis- sion. — Ruling. Under the provisions of section 15 — A of the Interstate Commerce Act, as amended by the Transportation Act approved Feb- ruary 29, 1920, railroad corporations are required to pay to the Inter- state Commerce Commission one-half of their net raihvay operating income in excess of 6 per cent on their invested capital. It is under- stood that such payments are absolute, the railroad company having no present or future rights therein. Held, that any sum so paid may be deducted in the taxable year in which paid or accrued, dependent upon whether the books of the corporation are kept upon a cash receipts and disbursements or ac- crual basis. (B. 32-21-1762; O, D. 989.) 1 FOR EXPENSES 919 Amounts paid on judgments or other binding adjudica- tions. — Regulation Judgments or other binding adjudication, such as decisions of referees and boards of review under workmen's compensation laws, on account of damages for patent infringement, personal injuries, or other cause, are deductible from gross income when the claim is so adjudicated'^ or paid, unless taken under other methods of accounting which clearly reflect the correct deductions, less any amount of such damages as may have been compensated for by insurance or otherwise (Art. ill.) The present regulations are very definite in holding that losses which occur in one year and which are not discovered until a later year cannot be deducted in the later year, but are only deductible as of the time when they actually occurred. The principle applies to all kinds of expenses. Exception is made only for overlapping items which do not materially dis- turb the income for any one year. The regulation has some merit and should be followed in most cases, but greater lati- tude should be given to taxpayers. If, in the opinion of the lat- ter, true net income for the taxable year can be stated by charg- ing items as an expense during the taxable year, taxpayers should not be forced to make amended returns for prior years. " [Former Procedure] Ruling. A corporation was sued for infringing a trade-name cov- ering a period ending in 1912. Judgment was obtained in 1916, The Treasury Department holds that the amount of this judgment should be prorated over the period ending in 1912, according to the income of each year. Such part of it as by this method is found applicable to the income of the corporation for the period 1909 to 1912, would be referable to those years but no part of this sum would be deductible in the return of income for 1916. The same corporation also paid in 1916 an additional sum as con- sideration for dismissal of a pending suit for interest on the above judgment from the date of the decision of the Circuit Court of Ap- peals to the date of payment and for the unrestrained use of the trade- name in question. The Treasury Department holds that if this amount "can be segregated between interest and use, it would be treated the same as in the other case, for the period subsequent to 1912, and such part thereof as shall be thus found applicable to the 1916 income would be deductible in the return of income for that year under the respective heads of "business expense" and "interest," and if segregation has not been or cannot be made, the entire amount may be treated as "business expense" to be prorated as above indicated." (Substance of letter to The Cor- poration Trust Company, signed by Commissioner W. H. Osborn and dated February 9, 1917.) 920 DEDUCTIONS The inevitable result would be that for years to come taxpayers will be finding that expenses, which ordinarily would and should be charged to current operating accounts, occurred dur- ing the years 1918 and 19 19 when the tax rates were very high and, acting under the letter of the regulations, amended re- turns will be made with a resulting saving in tax. The 1922 regulations appear to modify the rule in cases when taxpayers have actually provided in prior periods for losses finally determined in later years. It is provided that judgments, etc., are deductible in the years when paid "unless otherwise provided for by the taxpayer's method of account- ing." It is to be hoped that this refers to reserves which have been set up for accruing and estimated losses and liabilities set up in good faith in order to reflect true net income. Deductions for probable but uncertain expenses. — Ruling. A report of a master in chancery, appointed by an interlocutory decree in a suit for damages for alleged infringement of a patent, assessing damages against the taxpayer, which report was filed during the taxable year, but was not confirmed until the following year when judgment was entered on the report, can not be regarded as a determination of the amount of the claim, and no deduction for the taxable year is permissible in regard to the judg- ment referred to. (C. B. i, page 207; S. 923.) The question involved in the foregoing is a difficult one to discuss. If it appears that an expense has been incurred but its amount is doubtful, good accounting practice and con- servative business methods demand that an estimate be made and entered in the books. It would be a dangerous practice to omit a liability from the books merely because the exact amount thereof was unknown. The law permits the deduction of necessary business expenses and expressly approves the accrual system of accounting. It is therefore safe to assume that when during a taxable year an expense has been incurred or when it is so probable that an expense has been incurred that good practice requires the setting up of the transaction as a liability, the amount of the expense (even though it is an FOR EXPENSES 921 estimate) when entered in the books in good faith will be held by the courts to be deductible in the same period. The controlling idea is that the income of a future period should never have to bear expenses w'hich belong to a past period. The law need not be amended to effect this. The author has no serious criticism to make of the practice of requir- ing amended returns so long as the Treasury is consist- ent, but in no case should substantial expenses and losses applicable to a past period be carried forward to a subsequent period when the taxpayer has made provision for such ex- penses in the period to which the expenses are chargeable. Ruling. A reserve to cover a contingent liability, representing an estimated amount of claims actually outstanding at the close of the year, which will be paid on account of loss and damage to freight and injuries to persons, is not dcductiljle. Such amounts are de- ductible only for the year when the claims are put in judgment or paid. (C. B. 4, page 142; O. D. 879.) Payments to trustee for the ultimate benefit of the tax- payer not deductible. — Ruling. Pursuant to the requirements of its by-laws a corpora- tion entered into a trust agreement under the terms of which a sum amounting to not less than a certain per cent of the corporation's paid-in capital stock must be turned over to the trustee annually until a fund has accumulated amounting to x dollars, inclusive of the in- terest which is required to be added to the principal, when the income therefrom is to be turned over annually to an executive committee of the corporation for a purpose related to the business of the cor- poration. Held, that the amounts paid to the trustee by the corporation are not deductible from its gross income. The interest accruing to the fund is income of the corporation which should be reported by it in its return. (B. Digest 39-21-1840; O. D. 1047.) Attorney's fees paid by maker of illegal sales, not deduc- tible. — Attorney's fees paid by a proprietor of a retail busi- ness, who was fined and imprisoned for making illegal sales, have been held to be personal." C. B. 4, page 209; O. D. 952. 922 DEDUCTIONS The foregoing ruling holds in effect that gross income earned illegally is taxable. The theory may be commendable but it is doubtful if the ruling is sound. If it is, many other de- ductions arising from illegal transactions would not be de- ductible. It has also been held that a fine paid by a corporation for violation of the Anti-Trust Act is not deductible as an ordinary and necessary expense." '=1-4-45; I. T. 1174. CHAPTER XXVII DEDUCTIONS FOR INTEREST The passage of the 191 8 law greatly simplified the pro- cedure for deducting interest paid. Previous laws had im- posed restrictions upon corporation deductions for this purpose, making it necessary to distinguish interest payments very sharply from other payments.^ The only change in the 1921 law is that the restriction on interest paid to carry tax-exempt securities is extended to Victor}^ 3^ per cent notes not owned by original subscribers. Deductions allowed to individuals. — Law. Section 214. (a) . . . . (2) All interest paid or accrued within the taxable year on indebtedness, except on indebtedness in- curred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title;- .... Deductions allowed to corporations.^ — Law. Section 234. (a) .... (2) All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness in- ' The arbitrary restriction imposed by the 1913 and subsequent laws, its effect and the proper method of arranging the accounts in order to prevent unnecessary burdens are fully discussed in Income Tax Procedure, 1919, pages 454-463- " [Former Procedure] 1917 Law. Section 5. "(a) .... Second. All interest paid within the year on his indebtedness except on indebtedness incurred for the pur- chase of obligations or securities the interest upon which is exempt from taxation as income under this title ;...." This restriction was introduced by the 1917 law. Before that time an interest deduction was not disallowed because incurred for the pur- chase of tax-exempt securities. The 1918 law introduced the words "or carry" in speaking of tax-exempt securities. ^For a discussion of the limitation which formerly applied in the case of corporations, see Excess Profits Tax Procedure, 1921. 924 DEDUCTIONS curred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title; .... Regulation. Interest paid or accrued within the year on in- debtedness may be deducted from gross income, except that interest on indebtedness incurred or continued to purchase or carry securi- ties, such as municipal bonds and first Liberty loan 3^^ per cent bonds, the interest upon which is wholly exempt from tax, is not deductible. This exception, however, does not apply in the case of 3% per cent Victory notes originally subscribed for by the taxpayer, and interest on indebtedness incurred to purchase or carry such notes is deduct- ible. Since other obligations of the United States issued after Sep- tember 24, 19 17, are not wholly exempt from taxation under this title, interest paid on indebtness incurred or continued to purchase such obligations (whether or not originally subscribed for by the tax- payer) is deductible in accordance with the general rule. (Art. 121.) This article has been changed so as to provide for the change in the deductibiHty of interest paid to carry 3%% Victory notes. Interest which is deductible. — Ah interest paid on indebted- ness by an individual or a corporation is deductible, except interest paid' on money borrowed to purchase or carry certain securities the interest upon which is wholly exempt from taxa- tion. United States obligations issued prior to September 24, 19 1 7, including first or 3^ per cent Liberty bonds, are ex- empt from taxation and interest on money borrowed to pur- chase or carry such obligations is not deductible. This date, September 24, 19 17, marked a change in policy by the United States government. The understanding was that after that date securities entirely exempt from taxation were not to be issued, and, consequently, the restriction on the deduction for interest w^as not applied to interest paid on money borrowed to carry obligations of the United States issued thereafter.* The * [Former Procedure] The 1917 law did not allow as a deduction interest paid on indebtedness incurred for the purchase of obligations of the United States issued after September 24, 1917, to the extent to FOR INTEREST 925 3^^ per cent Victory notes issued in 19 19 are entirely free from taxation. Sections 214 and 234 of the 192 1 law provide that interest on money borrowed to purchase or carry the 3^ per cent notes is deductible in income tax returns only when the notes are in hands of original purchasers. When the cam- paign for their sale was being made, one of the most potent arguments used was that a taxpayer who had a large income from other sources might borrow money to buy the tax-exempt Victory notes and secure a net return on a margin of 10 per cent invested in the bonds of as much as 26 per cent per annum. In some cases banks advanced 100 per cent of the amount re- quired to buy the bonds and represented to taxpayers that they* would realize a large profit (through the reduction in taxes) without any investment. The size of the savings, of course, depended on several factors: (i) the market price of the notes; (2) the margin required; (3) the rate of interest charged by banks on the loans; and (4) the size of the tax rate. In disallowing the deduction of interest paid to carry Vic- tory notes other than original subscriptions, the Treasury can- not be accused of a breach of faith because the representations made were only in connection with the original subscriptions to the various issues after the first. The mere fact that other which an}-^ part of the interest from such obligationis was tax-exempt. The 1917 law entirely omitted the reference to obligations of the United States, and it was therefore held that any interest paid on indebtedness in respect of the $5,000 of second Liberty bonds (the interest on which principal amount of bonds was exempt) was not deductible. This restriction was made effective by the following directions in section E, page 2 of income tax form 1040 (revised Jan- uary, 1 91 8) : Interest on bonds and other obligations of the United States ISSUED SINCE September i, 1917. — Interest paid. "If indebtedness has been incurred for the purchase of such obligations, find what percentage the amount of such obligations held in excess of $5,000 is of the total amount of such obligations held, and enter in column 5 the same percentage of the interest paid on the indebtedness." Under the 1918 law interest paid on money borrowed to purchase or carry Victory 3^ per cent notes was fully deductible. 926 DEDUCTIONS than original subscribers were given the same advantage under the 19 18 law was really a gift by Congress, which it was quite at liberty to withdraw at any time on reasonable notice. It is urged that Congress commits a distinct breach of faith in retroactively taking away the deduction, that it should have been continued at least until the act containing its repeal was introduced in Congress. Interest on scrip dividends deductible. — Regulation. Interest paid by a corporation on scrip dividends is an allowable deduction. ..... . Interest on certificates of deposit deductible. — .... In the case of banks and loan or trust companies, interest paid within the year on deposits or on moneys received for investment and secured by interest-bearing certificates of indebtedness issued by sucli bank or loan or trust company may be deducted from gross income. (Art. 564.) Interest on real estate mortgage deductible. — Regulation Interest paid by the taxpayer on a mortgage upon real estate of wliich he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note se- cured by such mortgage, may be deducted as interest on his indebted- ness (Art. 121.) Should discount on bonds be treated as payment of interest ? — Bonds usually sell at a discount because the inter- est is fixed at a lower rate than the purchasers of the bonds think the debtor corporation should pay. Under proper ac- counting methods the discount is distributed ratably over the life of the bonds. The annual interest paid plus the annual proportion of discount together form the true cost. Regulation If it [a corporation] sells its bonds at a discount, the amount of such discount is treated in the same way as interest paid, .... (Art. 563:) The Treasury in the past treated the discount as a loss;* therefore the discussion of bond discounts as a deduction will be found in Chapter XXIX, "Losses." 'Article 135, Regulations No. 33. FOR INTEREST 927 Bank of deposit may deduct interest paid on de- posits EVEN THOUGH MOST OF THE ASSETS CONSIST OF TAX- EXEMPT BONDS. — An interesting question arises in the case of a bank which pays interest on deposits and invests most of its assets in tax-exempt bonds. A bank had capital and sur- plus of $1,000,000 and deposits of $10,000,000. Its funds were so invested that the income was as follows : From tax-exempt sources (chiefly municipals) . . $300,000 From other sources 350,000 Total income $650,000 Expenses : Interest paid to depositors $250,000 Expenses 100,000 350,000 Net income $300,000 The interest from tax-exempt bonds not being returnable the bank was not subject to the federal income tax. Ruling. It is the ruling of this office that a bank doing a com- mercial business and receiving deposits upon which it pays interest is entitled to deduct from its gross income shown upon its annual tax return the full amount of interest paid to its depositors. The pay- ment of such interest is one of the ordinary and necessary expenses in the carrying on of its banking business. Although the deposits constitute indebtedness of the bank, such indebtedness was not in- curred and is not continued for the purpose of purchasing or carrying obligations, even though the deposits are invested in bonds or other obligations the interest upon which is wholly exempt from income and excess profits tax. (Letter to Lybrand, Ross; Bros. & Montgomery, signed by Commissioner Roper, June 24, 1919.) Interest on overdue federal taxes is deductible. — Interest accrues very rapidly on assessments of additional taxes for 191 7 and prior years which are the subject of claims in abatement. Many taxpayers, when additional taxes are paid, treat the entire payments as tax payments. Since federal taxes are not allowable deductions but interest is fully deductible, it is important to separate the payments. Ruling. Interest paid or accrued under the provisions of section 928 DEDUCTIONS 250 (a), (b) and (c), Revenue Act of 1918 is deductible under the provisions of section 214 (a) 2 or section 234 (a) 2 in computing- net income. (C. B. 2, page 227; O. 922.) State taxes deductible as interest — when? — Not- withstanding the phrase '*or any other tax paid pursuant to the contract"*' a regulation has been issued stating that a cor- poration paying a state tax or any other than a federal tax for someone else pursuant to its agreement may deduct such payment as interest paid on indebtedness. This regulation is as follows: Regulation. Corporations may deduct taxes from gross income to the same extent as individuals, except that in the case of corporate bonds or obhgations containing a tax-free covenant clause, the cor- poration paying a Federal tax," or any part of it, for some one else pursuant to its agreeemnt is not entitled to deduct such payment from gross income on any ground. In the case, however, of cor- porate bonds or obligations containing an appropriate tax-free cove- nant clause, the corporation paying a State tax or any other than a Federal tax for some one else pursuant to its agreement may deduct such payment as interest paid on indebtedness.^ (Art. 565.) The foregoing is an unusually liberal interpretation of the law. Bank charges on tax-exempt obligations may be de- ducted. — Ruling. Interest paid by a contractor on funds advanced by a bank and discount charged by the bank for cashing municipal certi- ficates of indebtedness are deductible from gross income. (B. 34-21- 1778; O.D. 999.) Interest on dividends paid by court order deduc- tible. — Ruling. Where a court of original jurisdiction entered a decree in 1917 requiring a corporation to distribute dividends, and upon an ' Section 234 (a-3). ' [Former Procedure] In the earlier edition of Regulations 45 in place of the phrase "paying a federal tax" there appears this expression "paying a tax .... whether federal, state or otherwise." The regulation was inaccurate as state taxes are and always have been deductible. * Tax paid under a tax-free covenant clause is not to be included in the gross income of the obligee. See page 678. FOR INTEREST 929 appeal the decree was affirmed by a court of last resort, which in ad- dition to confirming the decree of the lower court awarded interest on the amount of the dividends from the date of the decree of the lower court to the date of payment, such interest is deductible from the gross income of the corporation for the year in which paid, .... (C. B. 4, page 141; O. D. 778.) Interest on construction is deductible if not capi- talized. — Ruling. Interest and taxes paid by a corporation in connection with the construction of its original plant are deductible from its gross income under the Revenue Act of 1913, even though such pay- ments are properly chargeable to capital account and are so charged by the corporation on its books, provided the corporation amends its returns so as to exclude the interest and taxes so deducted from capital account. (C. B. i, page 109; S. 935.) Interest which is not deductible. — Generally speaking, the only interest on borrowed money which is not deductible is that paid on indebtedness created or continued to purchase or carry state and municipal bf)nds, United States bonds issued prior to September 24, 191 7 (including Liberty 3/4's), Farm Loan bonds, and United States Victory 3^4's not originally subscribed for. Interest limitation is sound. — The restriction on the deduction is sound. It was made imperative by the establish- ment of very high income tax rates. So long as the rates of the tax were low, there was no appreciable inducement to a tax- payer to borrow money with which to buy tax-exempt se- curities. Under very high surtax rates the situation changed. For instance, a taxpayer subject to income taxes aver- aging 40 per cent of his income would find it profitable to buy tax-exempt securities on a large scale. He might purchase $1,200,000 of tax-free 3^ per cent bonds, and borrow against them $1,000,000'. If he paid 4 per cent interest on the loan, he would be in the position of receiving $42,000 per annum not subject to any tax, and an allowance of $40,- 000. which would be a clear deduction from all taxable in- 930 DEDUCTIONS come. If $40,000' of his income was subject to 40 per cent surtax he would avoid his just taxes to the amount of $16,- 000 for the year. As heretofore stated, such saving in taxes is possible in the case of the 3^^ per cent Victory bonds, if originally subscribed for. Segregation of interest paid when both exempt and NON-EXEMPT SECURITIES ARE USED AS COLLATERAL. It is as- sumed that a borrower would use tax-exempt securities (ex- cepting 3^ per cent Victory bonds originally subscribed for) as collateral only when no other collateral is available. When the collateral consists entirely of tax-exempt securities, no part of the interest paid on the borrowed money is deductible. When the collateral consists entirely of securities not tax- exempt or of any United States bonds issued after September 24, 1 91 7, and originally subscribed for by the taxpayer, the entire interest paid is deductible. When the collateral consists of both classes, part of the interest paid is deductible and part is not deductible. There are at least two methods in use for determining the amount of deductible interest which are not entirely accurate : 1. By claiming as deductible the same proportion of the total interest paid as the taxable interest received on bonds pledged is of the whole amount of interest received on such bonds. 2. By averaging by the month the relative amounts of principal of taxable and non-taxable bonds pledged and apply- ing the result for the year to the interest paid. Banking houses and other taxpayers should, whenever possible, keep their securities separated so that those not tax- exempt and the 3^ per cent Victory bonds (if originally sub- scribed for by the taxpayer) will be used before any others. When feasible, loans should be wholly secured by one of these two classes. This will insure the greatest saving in taxes and the least annoyance in bookkeeping. When both exempt and non-exempt securities must be used FOR INTEREST 931 as collateral for the same loan, the only accurate method of segregating the interest paid is the following : 3. Since collateral loans are made by lenders on the mar- ket value of the securities pledged, and not on their par value or income-producing basis, interest paid on loans should be apportioned between exempt and non-exempt securities in the ratio that the market value of one class of securities bears to the other. Federal taxes assumed by corporation issuing tax- free BONDS NOT deductible AS INTEREST. — When collcction at the source was provided for in the 19 13 law it was found that many corporations had made contracts with their bondholders under the terms of which the corporations agreed to pay for the bondholders any taxes they might be required to retain out of interest due the bondholder. These contracts were supposed to influence favorably the terms upon which bonds could be sold. Under such a theory the subsequent imposition of a tax which falls within the contractual obligation means to the corpora- tions additional cost of money borrowed — hence the equivalent of an increased interest rate. As a necessary expense of doing business, taxes paid on this account should be an allow- able deduction, but on the ground that the payments constitute the voluntary assumption of taxes assessed against bondhold- ers and not the corporations the latter are not permitted to claim credit for the payments in their tax returns either as interest or taxes. ^ Law. Section 234. (a) .... (3) .... (c) .... In the case of obligors specified in subdivision (b) of section 221 no deduction for the payment of the tax imposed by this title or any other tax paid pursuant to the contract .... shall be allowed; Certain ground rents not deductible as interest. — Regulation Payments made for Maryland or Pennsyl- vania ground rents arc not deductible as interest but may, under proper circumstances, be deducted as rent. (Art. 121.) 'Under the 1921 law the obligees do not have to include such taxes in their gross income. Prior laws did not contain such a requirement but the Treasury cstabHshed it by regulation. 932 DEDUCTIONS Ground rent is defined to be a rent reserved to himself and his heirs by the grantor of land out of the land itself. It is not granted like an annuity or a rent charge, but is re- served out of the conveyance of the land in fee. It is an estate separate from the ownership of the ground, and is held to be real estate, with the usual characteristics of an estate in fee simple — descendible, devisable and alienable." A rental for other than business purposes is not an allow- able deduction under the income tax, while no such restriction applies in the case of interest payments. The refusal to per- mit ground rents such as those described to be deducted as interest is to prevent rents of non-business character from being deducted under the guise of interest payments. Dividends on preferred stock not deductible as in- terest. — Regulation So-called interest on preferred stock, which is in reahty a dividend thereon, can not be deducted in arriving at net income." (Art. 564.) Interest paid on instalment subscriptions to capi- tal STOCK NOT deductible. — When interest was paid on the instalments due under a contract to subscribe for stock, such interest is considered as a distribution of profits and as such is not deductible.^^ If interest is paid ratably to all stockholders it might be deemed to be a distribution of profits; but if paid to some on the theory of borrowed money and not to others, the interest payments should be treated as fully allowable. Interest on taxpayer's own capital^" not deduc- tible. — Regulation. Interest calculated for cost-keeping or other pur- poses on account of capital or surplus invested in the business but "■" Wilson V. Isemiuijcr, 185 U. S. 55, 46 L. Ed. 804, 22 S. Ct. 573. " See page 705. "B. 32-21-1765; O. D. 991. "The economic term for so-called interest charged against oneself as a cost or carrying charge is "imputed" interest. FOR INTEREST 933 which does not represent a charge arising under an interest-bearing obHgation, is not an allowable deduction from gross income. (Art. 122.) The atithor considers this position to be entirely sound/* Some concerns regard interest as an element of manufacturing cost, and, basing inventory valuations on such so-called costs, thereby overstate the inventory valuations. It is like pulling oneself up by one's own boot-straps. If the concern deducts such interest, it should logically account for it immediately as interest received. The point is covered more fully in an earlier Treasury decision, quoted in part below. Ruling. A corporation would not be permitted to include in its deductions the rental value of the property which it owns and occupies nor would it be permitted to deduct from gross income the interest which the capital invested or employed would earn were it otherwise invested. It therefore follows that a corporation cannot take into account as a part of the cost of manufacture any possible earnings; that is, earnings which might accrue on its capital or investment had such capital been so placed as to earn a given rate. of interest. (T. D. 2137, January 30, 1915.) Accounting procedure. — Accrual basis is permitted. — The law clearly states the right of a taxpayer to return on either a paid or an accrual basis. Sections 214 and 234 specifically state that "all interest paid or accrued zvithin the taxal^le year on indebtedness" shall be allowed as a deduction. From the point of view of the gov- ernment and the taxpayer alike it is desirable that the in- terest deduction should be based upon the books of the tax- payer, provided always, of course, that the books are kept properly and honestly. Every well-kept set of books reflects the interest accrued during the year. Interest payments may and do fluctuate. Large loans may fall due on January i and have interest paid on December 31 in one year and on January 2 in another year. Although there may be some gain or loss in ^* Auditing, Theory and Practice (3rd edition), by R. H. Montgomery, page 155 et seq. 934 DEDUCTIONS taxes in the year when a change is made from one basis to the other, the net difference between the accrual and the paid basis is nothing at all over a period of years, unless the tax rate changes," When accrued interest is not deductible. — Ruling. A lumber company entered into a contract for the pur- chase of a timber tract, agreeing to pay for the quantity of timber which it is estimated will be cut each year, payment to be made at the time each block is cut at a certain rate per thousand feet, plus interest at 6 per cent per annum from the date of contract. Held, that inasmuch as the interest charge did not accrue and become payable until the timber was cut, it was not a proper deduction until that time. The agreement is an executory contract to purchase the timber and no interest is deductible except as the contract is '" [Former Procedure] The 1913 law permitted individuals to deduct "interest paid within the year" (section II, B) and allowed corporations to deduct interest "accrued and paid within the year" [section II, G (b) (third)]. In its interpretation the Treasury held, in the case of corporations, that to be allowable as a deduction, interest must be both accrued and paid within the same year (T. D. 1916). The 1916 law used the phrase "paid within, the year" in describing the interest deductions of both individuals and corporations [section 5 (a) (second); section 12 (a) (third)]. The same law permitted the use of the accrual basis by corporations [section 13 (d)]. The ruling issued to cover this point was T. D. 2433 (January 8, 1917). Prior to January 8, 1917, the government insisted that the inter- est allowance be reported on the paid basis. This worked against the government and in favor of the taxpayers, although the latter did not seek the advantage. On the contrary, most of them found the "paid" basis very objectionable and tried to change it and in many cases made up their returns in accordance with their books rather than in strict adherence to the law. A loss to the government occurred be- cause the tax rates increased. After that date in the case of individuals the regulations contented themselves with a general permission to make a return on a basis other than that of actual receipts and disbursements if the basis clearly reflected the income. (Reg. 33, 1918, Art. 24.) In the case of corporations, on the other hand, the utilization of the accrual basis for interest deductions was specifically authorized in the following: Regulation. " .... If the accounts of the company are kept on a basis other than actual receipts and disbursements, the amount of inter- est actually accrued at the contract rate .... may be deducted, provided it is so entered on the books as to constitute a liability against the assets. • • . . " (Reg. 33, 1918, Art. 180.) FOR INTEREST 935 executed. The interest payment does not constitute an operating expense of the company, but enters into the cost of the lumber pro- duced that year. (C. B. 3, page 149; O. D. 595.) Interest paid to partners. — From an accounting point of view interest paid to partners upon contributed capital or so- called partnership loans is an expense of the business only so far as the partners themselves are concerned. Contributions by general partners are at the risk of the business so far as creditors are concerned, and it is customary in preparing bal- ance sheets to combine all the partners' accounts as the aggre- gate capital of the partnership, irrespective of how the balances appear upon the firm's books. Under income tax pro- cedure it is of no importance to the government whether in- terest is allowed or paid to partners*. If charged on one side of the returns as an expense, the same amounts appear on the other side as income and the tax to be paid is not affected. ^^ " [Former Procedure] Under the excess profits tax law of 1917 which required a statement of invested capital and a determination of partnership profits as distinguished from the individual's net income, it made a decided difference whether or not interest on partners' loans or capital accounts were entered as a business expense. T. D. 2613 (December 20, 1917), published as bearing on the excess profits tax only, was as follows: Regulation. "In computing net income for purposes of the excess profits tax a partnership will be allowed to deduct amounts paid during the year to an individual partner as interest upon any bona fide loan, but no deduction for so-called interest upon capital will be recognized." Excess profits tax returns were based on income tax returns. Since the provision for the payment of interest was not mandatory, partnerships should not have availed themselves of the privilege unless the interest paid to partners was at a rate substantially greater than the rate of ex- emption (7 to 9 per cent) allowed on capital invested ; otherwise the net tax paid to the government would have been greater than if interest paid to partners had not been treated as an expense of the business, because the deduction of interest as an expense made the sum lent unavailable as part of invested capital. The case was not the same as that of partners' salaries. The allow- ance of salaries as an expense of the business did not diminish the ag- gregate capital invested; whereas if interest on partners' loans were treated as an expense, the principal amount of such loans must have been 936 DEDUCTIONS Individual interest deduction too broad. — While Congress may be criticized because of its former policy of restricting corporation interest 'deductions too narrowly," it may be criticized on the other hand because the interest deduction per- mitted to individuals is too generous. The law is supposed to proceed on the theory that the specific exemptions are suffi- cient to cover minimum personal living expenses — to provide the creature comforts. That was the reason given for not allowing life insurance premiums to be deducted. ^^ Living expenses above this minimum are not supposed to be deduc- tible. But if a man borrows money to buy an automobile, or places a mortgage on his house because he is living be- yond his means, he is permitted under the law to deduct all such interest paid. It is clearly a living expense and theoreti- cally should not be deductible. It would seem equitable that the law should permit the deduction of interest payments only where the interest-bearing debt was incurred in the pur- chase of property or investments for income-producing pur- poses. Such a provision raises some practical difficulties such as that of designating the particular purposes for which the proceeds of a loan are used, but these are not as a whole in- surmountable. deducted from the total of the invested capital of the partnership and tlie benefit of the deduction of 7 to 9 per cent thereon was lost. It was not suggested that the books of account should be changed to conform with the excess profits tax returns. It was not expected that the latter would agree with the books. " See page 923. "See Chapter XXVI, "Deductions for Expenses.' CHAPTER XXVIII DEDUCTIONS FOR TAXES The 19 1 8 revenue law was generous in its treatment of tax- payers, so far as allowances for taxes paid were concerned. The changes which have been made in the 192 1 law, while op- erating in the main to reduce the benefit that may be claimed by taxpayers, are still of so reasonable a nature that no great objections can be raised against them, with the exception of excess profits tax credits which will be mentioned later. All taxes paid in this country, except federal income tax and certain types of special assessments, are still allowable in determining the amount of income tax payable, either as de- ductions from the amount upon which the income tax is to be calculated, or else as a credit towards the amount of taxes payable. There is one important change in the law which affects both corporation and individuals receiving income from abroad, and that is the provision, inserted for the first time, that the foreign tax allowed as a credit shall not exceed the same average rate on the foreign income which the United States income and profits taxes are on the total income from both foreign and domestic sources; or, as the law puts it, that the credit taken shall not exceed the same proportion of tax against which credit is taken, which the foreign income of the taxpayer bears to his entire net income. The provision in the lav/ specifically allowing inheritance taxes as deductions from net income as accrued on the dUe date thereof, is a direct result of the Woodward case quoted on page 961. Until this year, aliens resident in the United States who were subjects of a foreign country could deduct the amount of 937 938 DEDUCTIONS "any such taxes paid during the taxable year to such country" if certain reciprocal advantages were granted to American citi- zens residing in that country. The 192 1 law changes this to "the amount of any such taxes paid during the taxable year to any foreign country if the foreign country of which such alien resident is a citizen or subject .... allows a similar credit to citizens of the United States . . . ." [sec. 222 (a-3)]. The result of this change is that the citizen of Canada, for example, who formerly could only obtain credit for Canadian taxes, may now obtain credit for taxes paid to countries such as Great Britain or France, which have no reciprocal clauses in their tax laws. This means that the credit depends entirely upon the attitude of the government of which the resident alien is a national. A new subsection^ provides that in the case of a return made for a 1920-192 1 fiscal year the credit for the entire fiscal year is to be determined under section 222, a deduction to be made therefrom, however, for any credit which the taxpayer has already taken. Taxes Deductible Individuals. — Law. Section 214. (a) That in computing net income there shall be allowed as deductions: .... (3) Taxes paid or accrued within the taxable year except (a) income, war-profits, and excess-profits taxes imposed by the authority of the United States, (b) so much of the income, war-profits and excess-profits taxes, imposed by the authority of any foreign country or possession of the United States, as is allowed as a credit under section 222, (c) taxes assessed against local benefits of a kind tending to increase the value of the property assessed, and (d) taxes imposed upon the taxpayer upon his interest as shareholder or member of a corporation, which are paid by the corporation without reimburse- ment from the taxpayer. For the purpose of this paragraph estate, inheritance, legacy, and succession taxes accrue on the due date thereof except as otherwise provided by the law of the jurisdiction imposing such taxes; .... ' Section 222 (d). FOR TAXES 939 Corporations. — Law. Section 234. (a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions: .... (3) Taxes paid or accrued within the taxable year except (a) income, war-profits, and excess-profits taxes imposed by the authority of the United States, (b) so much of the income, war-profits and excess-profits taxes imposed by the authority of any foreign country or possession of the United States as is allowed as a credit under section 238, and (c) taxes assessed against local benefits of a kind tending to increase the value of the property assessed. In the case of obligors specified in subdivision (b) of section 221 no deduction for the payment of the tax imposed by this title, or any other tax paid pursuant to the contract or provision referred to in that subdivision, shall be allowed nor shall such tax be included in the gross income of the obligee. The deduction allowed by this paragraph shall be allowed in the case of taxes imposed upon a shareholder or member of a corporation upon his interest as shareholder or member, which are paid by the corporation without reimbursement from the share- holder or member, but in such cases no deduction shall be allowed the shareholder or member for the amount of such taxes. For the purpose of this paragraph, estate, inheritance, legacy, and succession taxes accrue on the due date thereof except as otherwise provided by the law of the jurisdiction imposing such taxes;- .... '^ [Former Procedure] The provisions of the 1913 law relating to individuals read simply "all national, state, county, school and munici- pal taxes paid within the year, not including those assessed against local benefits." (Section II, B, third.) The corporation section of the 1913 law was as follows : "All sums paid by it (viz., the corporation) within the year for taxes imposed under the authority of the United States or of any State or Territory thereof, or imposed by the govern- ment of any foreign country." [Section II, G (b), fourth.] Under the law of 1913 taxes paid to a foreign country by citizens or alien residents of the United States were not allowable deductions. The provisions of the law for the deduction of taxes applied only to taxes paid to the United States, or to some state or political subdivision thereof in the United States. It was evidently an oversight on the part of the framers of the law. In his report of December 6, 1915, the Commissioner of Internal Revenue recommended that foreign taxes be made allowable deductions, and the permission was granted in the 1916 law. In consider- ing returns prior to 1916, this change in the law must be kept in mind. 1916 Law (as amended in 1917). Section 5. "That in computing net income in the case of a citizen or resident of the United States — "(a) For the purpose of the tax there shall be allowed as deduc- tions — .... 940 DEDUCTIONS The foregoing section provides a blanket deduction for all taxes except : 1. United States income, war profits and excess profits taxes. 2. A proportionate part of income, war profits and excess profits taxes imposed by a foreign countr}^ or pos- session of the United States. [See section 222 (a-5)-] 3. Local improvement taxes. 4. Taxes paid pursuant to a tax-free covenant in cor- porate obligations. (But such tax may be credited against the total tax payable by the obligee.) 5. Taxes on stockholdings, paid by the corporation with- out reimbursement from the owners of such stock. Excess profits taxes may be "credited." — Law. Section 236. That for the purpose only of the tax imposed by section 230 [income tax rates] there shall be allowed the following credits: .... (c) The amount of any war-profits and excess-profits taxes im- posed by Act of Congress for the same taxable year. The credit al- lowed by this subdivision shall be determined as follows: (i) In the case of a corporation which makes return for a fiscal year beginning in 1920 and ending in 1921, in com.puting the income tax as provided in subdivision (a) of section 205, the portion of the war-profits and excess-profits tax computed for the entire period under clause (i) of subdivision (a) of section 335 shall be credited against the net income computed for the entire period as provided in clause (i) of "Third. Taxes paid within the year imposed by the authority of the United States (except income and excess profits taxes) or of its Terri- tories, or possessions, or any foreign country, or by the authority of any State, county, school district, or municipality, or other taxing subdivision of any State, not including those assessed against local benefits." The phrase "except income and excess profits taxes" was inserted in the 1917 law. The provisions of the 1917 law relating to deductions for taxes paid were exactly the same for individuals and for corporations. 1917 Law (excess profits tax credit). Section 29. "That in assess- ing income tax the net income embraced in the return shall also be credited with the amount of any excess profits tax imposed b3' Act of Congress and assessed for the same calendar or fiscal year upon the taxpayer and, in the case of a member of a partnership, with his proportionate share of such excess profits tax imposed upon the partnership." FOR TAXES 941 subdivision (a) of section 205, and the portion of the war-profits and excess-profits tax computed for the entire period under clause (2) of subdivision (a) of section 335 shall be credited against the net income computed for the entire period as provided in clause (2) of subdivision (a) of section 205. (2) In the case of a corporation which makes return for a fiscal year beginning in 192 1 and ending in 1922, in computing the income tax as provided in subdivision (b) of section 205, the war-profits and excess-profits tax computed under subdvision (b) of section 335 shall be credited against the net income computed for the entire period as provided in clause (i) of subdivsion (b) of section 205. The method of calculation of excess profits taxes payable is fully described in Excess Profits Tax Procedure, 1921, and the Appendix A of this volume. After a return is prepared showing the taxpayer's net income, the next step is the deter- mination of the amount due as excess profits tax. For the sole purpose of caclulating the amount due as federal income tax, the amount of the excess profits tax (accrued but not paid) may be entered as an allowable deduction. On the remaining balance of net income, the federal income tax is to be assessed (see Chapter VII). "Net income'" is specifically defined in the law. After net income has been ascertained the excess profits tax is "credited" against net income (in fact deducted from "net income") and on the balance the income tax is imposed. It is clear, there- fore, that in determining whether or not a corporation is en- titled to the specific exemption of $2,000, it is only necessary to consider whether the "net income" is $25,000 or less. The excess profits tax is not considered because it has nothing to do with determining the "net income" of the corporation, which is the limiting factor. It has been suggested that the credit for excess profits taxes applies against the net income, and, if such net income is reduced to less than $25,000, the specific credit can be taken. No justification exists for such an inter- pretation. A corporation has a net income in 192 1 of $27,000. Its excess profits tax is v$4,ooo. Income tax is computed as fol- lows : 542 DEDUCTIONS Net Income $27,000.00 Less: Credits: Excess profits tax $4,000.00 Specific credit (not applicable) 4,000.00 Income subject to tax $23,000.00 Income tax at 10% $ 2,300.00 The fact that the credit of $4,000 reduces the taxable income to $23,000 does not make such income subject to the specific credit of $2,000. The latter is deductible only when the original net income as defined in the law^ is $25,000 or less. Foreign taxes paid may be deducted from taxes assessed in United States. — Subject to certain restrictions contained in section 222, quoted below, income or excess profits taxes paid during the taxable year to a foreign country or to any pos- session of the United States may be deducted from the amount determined to be due to the United States. This does not mean that such taxes are a deduction from or credit against net income, but that the items are a deduction from the amount of taxes otherwise payable. The amount to be credited is not to exceed the same proportion of the tax against which credit is taken, which the foreign income is of the total net income [see section 222 (a-5) below]. Individuals. — Law. Section 222. (a) That the tax computed under Part II of this title shall be credited with: (i) In the case of a citizen of the United States the amount of any income, war-profits and excess-profits taxes paid during the tax- able year to any foreign country or to any possession of the United States; and (2) In the case of a resident of the United States, the amount of any such taxes paid during the taxable year to any possession of the United States; and (3) In the case of an alien resident of the United States, the amount of any such taxes paid during the taxable year to any foreign ^ Section 232. FOR TAXES 943 country, if the foreign country of which such alien resident is a citi- zen or subject, in imposing such taxes, allows a similar credit to citizens of the United States residing in such country; and (4) In the case of any such individual who is a member of a part- nership or a beneficiary of an estate or trust, his proportionate share of such taxes of the partnership or the estate or trust paid during the taxable year to a foreign country or to any possession of the United States, as the case may be (b) If accrued taxes when paid differ from the amounts claimed as credits by the taxpayer, or if any tax paid is refunded in whole or in part, the taxpayer shall notify the Commissioner, who shall redeter- mine the amount of the tax due under Part II of this title for the year or years affected, and the amount of tax due upon such redetermination, if any, shall be paid by the taxpayer upon notice and demand by the collector, or the amount of tax overpaid, if any, shall be credited or refunded to the taxpayer in accordance with the provisions of section 252. In the case of such a tax accrued but not paid, the Commissioner as a condition precedent to the allowance of this credit may require the taxpayer to give a bond with sureties satisfactory to and to be ap- proved by the Commissioner in such penal sum as the Commissioner may require, conditioned for the payment by the taxpayer of any amount of tax found due upon any such redetermination; and the bond herein prescribed shall contain such further conditions as the Com- missioner may require. (c) These credits shall be allowed only if the taxpayer furnishes evidence satisfactory to the Commissioner showing the amount of income derived from sources without the United States, and all other information necessary for the verification and computation of such credits. (d) If the taxpayer makes a return for a fiscal year beginning in 1920 and ending in 1921, the credit for the entire fiscal year shall, not- withstanding any provision of this Act, be determined under the pro- visions of this section; and the Commissioner is authorized to disallow, in whole or part, any such credit which he finds has already been taken by the taxpayer. Limitation of credit for taxes paid to foreign gov- ernments AND possessions OF THE UnITED StATES. Law. Section 222. (a) . . . . (5) The above credits shall not be allowed in the case of a citizen entitled to the benefits of section 262; and in no other case shall the amount of credit taken under this subdivision exceed the same proportion of the tax, against which such credit is taken, which the taxpayer's net income (computed without de- duction for any income, war-profits and excess-profits taxes imposed by any foreign country or possession of the United States) from sources 944 DEDUCTIONS without the United States bears to his entire net income (computed v/ithout such deduction) for the same taxable year Section 262 refers to those receiving most of their income from sources within United States possessions. (See Chapter XXXVI.) A citizen of .Canada residing in the United States receives a net income of $40,000, of which $20,000 is net income in Canada and $20,000 is net income in the United States. The Canadian income tax is $1,300. The net income from sources without the United States, not deducting the Canadian income tax, is $20,000. The entire net income from all sources is v$40,ooo. The proportion of the foreign income to the total income is ><. The United States tax is $1,800. The limit for the credit for foreign credit against this tax is, therefore, 1/2 of $1,800, or $900. Hence, the taxpayer cannot take credit for the full $1,300 paid to the Canadian government, but only for $900 thereof. In other words, the maximum credit deduc- tible is that proportion of the United States tax which the foreign net income bears to the total net income. The maximum, of course, cannot exceed the actual amount of the foreign tax. The $400 of foreign tax not allowed as a credit against United States tax is, however, allowed as a deduction in computing total net income [section 214 (a-3-b) ; see page 938]. Taxes on foreign dividends. — Ruling. Where under a foreign income tax law corporations are required to withhold a fixed percentage of the total amount of dividends paid to the stockholders in this country, such tax being withheld in a lump sum, although imposed upon the individual stock- holders, the amounts withheld not being itemized by the foreign gov- ernment, in lieu of the individual tax receipts required to be attached to Form 11 16, the taxpayer may attach to the return on Form 11 16 his affidavit showing the number of shares held during the year, whether or not any of the shares held by him were acquired or sold during the year, giving dates and number of shares so acquired or sold; the total number of shares outstanding on which the dividend was declared regardless of whether the dividend was paid to citizens of the United States or other governments; and the total dividends paid or accrued on such shares during the year, and attach to and FOR TAXES 945 make a part of such affidavit a certified copy of the tax receipts from the foreign tax collector showing the payment of the tax en bloc, with copies of any other documents which he may have that will serve to corroborate the facts set forth in such affidavit. The amount of the credit claimed should be computed by dividing the total tax withheld by the total number of shares of the corpora- tion outstanding and multiplying this result by the number of shares held during the entire year. In the event that any of the shares were acquired or disposed of during the year, an adjustment should be made showing the amount of taxes properly allocated to the dividends received after acquisition or before disposition of the stock. (C. B. I, page i88; O. D. 232.) Countries which do and do not allow United States CITIZENS who are RESIDENTS A CREDIT FOR THE AMOUNT OF INCOME AND PROFITS TAXES PAID TO THE UNITED StATES. Regulation, (a) The following is an incomplete list of the countries which satisfy the similar credit requirement of section 222 (a) (3) of the Revenue Act of 1921, either by allowing to citizens of the United States residing in such countries a credit for the amount of income, war profits, or excess profits taxes paid to the United States, or in imposing such taxes, by exempting from taxation the incomes received from sources within the United States by citizens of the United States residing in such countries : Bulgaria, Canada, Italy, Newfoundland, Salvador. (&) The following is an incomplete list of the countries which do not satisfy the similar credit require- ment of section 222 (a) (3) of the Revenue Act of 1921, either by allowing no credit to citizens of the United States residing in such countries, for the amount of income, war profits, or excess profits taxes paid to the United States, or because such countries do not im- pose any income, war profits, or excess profits taxes : Argentina, Bahama, Belgium, Bermuda, Bolivia, Bosnia, Brazil, Chile, China, Costa Rica, Dutch Guiana, Ecuador, Egypt, Finland, France,"* Great ■' [Former Procedure] The following special decision has been pub- lished affecting taxes paid to France : Ruling. In accordance with section 222 (a) i of the Revenue Act of 1918, an American citizen may credit the amount of Federal tax with the amount of any income, war profits, and excess-profits taxes paid during the taxable year to France, provided such tax paid to France is on income from sources therein. If, however, the tax paid to the Government of France is imposed on an amount fixed at seven times the rent of his resi- dence in France (whether because he actually receives no income or in- sufficient income from France), such tax would be considered not to have been imposed on income from sources therein, and, therefore, not a proper credit under section 222(a) of the Act. The tax would, however, be a proper deduction under section 214 (a) 3. (B. 45-21-1911; O. D. 1093.) This footnote is coiUinucd on next page. 946 DEDUCTIONS Britain and Ireland, Guatemala, Herzegovina, India, Jamaica, Japan Montenegro, Morocco, New Zealand, Nicaragua, Panama, Paraguay, Persia, Peru, Portugal, Rumania, Santo Domingo, Serbia, Siam, Straits Settlements, Sweden, Switzerland, Venezuela. The former names of certain of these territories are here used for convenience in spite of the actual or possible change in the name or sovereignty. A resident of the United States who is a citizen or subject of any country in the first list is entitled, for the purpose of the total tax due the United States for 1921 (as to fiscal years beginning in 1920, see art. 386) and subsequent years, to a credit for the amount of any income, war profits, and excess profits taxes paid or accrued during the tax- able year to any foreign country. If he is a citizen or subject of any country in the second list, he is not entitled to such credit. If he is a citizen or subject of a country which is in neither list, then to secure the desired credit he must prove to the satisfaction of the Commis- sioner that his country satisfies the similar credit requirement of the statute. (Art. 385.) Portion of income tax paid to foreign government LtY citizen or resident OF United States not allowed as A credit is an ALLOWABLE DEDUCTioN.-^The limitation on the deduction of income tax by a citizen-resident of the United States imder section 214 (a-3-a) is modified under section 214 (a-3-b) in cases wherein a citizen or resident of the United States is taxed by the authority of a foreign country on income derived from sources entirely within the United States. A citizen of the United States residing abroad in many cases will be taxed by a foreign government on income derived from sources within the United States. The limitation in sec- tion 214 (a-3-a) applies only to income and profits taxes paid to the United States. Therefore income taxes paid to foreign governments Ijy a citizen or resident of the United States are Ruling. Any income, war profits, or excess-profits taxes paid by a citizen of the United States in igi8 to a foreign country, with respect to income received from sources therein, are an allowable credit under section 222 (a) of the Revenue Act of 1918 against the amount of the tax due to the United States for that year, provided the taxpayer's books of account are kept on a cash-receipt and payment basis and a return is rendered on that basis; if the taxpayer's books are kept on an accrual basis, and his returns are so rendered, the credit for taxes paid to a foreign country on income received from sources therein will lie limited to taxes accrued in the taxable year for which the return is rendered. (C. B. 2, page 196; O. 987.) FOR TAXES 947 allowable deductions from gross income under section 214 (a-3-b), to the extent that such taxes are not allowed as credits under section 222^ and, not being imposed by the authority of the United States, do not fall within the inhibition in section 214 (a-3-a). Corporations. — Law. Section 238. (a) That in the case of a domestic corporation the tax imposed by this title, plus the war-profits and excess-profits taxes, if any, shall be credited with the amount of any income, war- profits, and excess-profits taxes paid during the same taxable year to any foreign country, or to any possession of the United States : Provided, That the amount of credit taken under this subdivision shall in no case exceed the same proportion of the taxes, against which such credit is taken, which the taxpayer's net income (computed without deduction for any income, war-profits, and excess-profits taxes imposed by any foreign country or possession of the United States) from sources with- out the United States bears to its entire net income (computed without such deduction) for the same taxable year. In the case of domestic insurance companies subject to the tax imposed by section 243 or 246, the term "net income," as used in this subdivision means net income as defined in sections 245 and 246, respectively. The limitation on the credit mentioned above is the same as in the case of citizens or residents. For detailed compu- tation see page 944. The provisions of the law regarding accrued taxes differing from those paid, information to be furnished, and fiscal years are the same for corporation as for individuals. (See page 953-) " [Former Procedure] Taxes imposed by a foreign country on income from sources within the United States were not credits against the tax due to the United States under the 1918 law. Section 222 (a) (i) of that law specified that to be credits such taxes must have been assessed on "income derived from sources therein." Ruling. Income and war-profits taxes paid to a foreign country by a citizen of the United States residing in such foreign country on income from sources within the United States can not be treated as a credit for taxes under section 222. Such taxes are deductilile under section 214 (a) (3) in computing net income in his return to the United States. (C. P.. I, page 188; O. D. 317.) 948 DEDUCTIONS Credit for taxes when domestic corporation owns control in foreign subsidiary. Law. Section 238 (e)" For the purposes of this section a domestic corporation which owns a majority of the voting stock of a foreign corporation from which it receives dividends (not deductible under section 234) in any taxable year shall be deemed to have paid the same proportion of any income, war-profits, or excess-profits taxes paid by such foreign corporation to any foreign country or to any possession of the United States, upon or v/ith respect to the accumu- lated profits of such foreign corporation from which such dividends were paid, which the amount of such dividends bears to the amount of such accumulated profits: Provided, That the credit allowed to any domestic corporation under this subdivision shall in no case exceed the same proportion of the taxes against which it is credited, which the amount of such dividends bears to the am.ount of the entire net income of the domestic corporation in which such dividends are included. The term "accumulated profits" when used in this subdivision in reference to a foreign corporation, means the amount of its gains, profits, or income in excess of the income, war-profits, and excess-profits taxes imposed upon or with respect to such profits or in- come; and the Commissioner with the approval of the Secretary shall have full power to determine from the accumulated profits of what year or years such dividends were paid; treating dividends paid in the first sixty days of any year as having been paid from the accumulated profits of the preceding year or years (unless to his satisfaction shown other- wise), and in other respects treating dividends as having been paid from the most recently accumulated gains, profits, or earnings. In the case of a foreign corporation, the income, war-profits, and excess- profits taxes of which are determined on the basis of an accounting period of less than one year, the word "year" as used in this subdivision shall be construed to mean such accounting period. (f) For the purposes of this section a corporation entitled to the benefits of section 262 shall be treated as a foreign corporation. In order to prevent a domestic corporation securing credit against its United States tax for foreign income and profits taxes paid by a foreign subsidiary in a disproportionate degree, a limitation similar to that imposed upon taxpayers paying ° [Former Procedure] Under the 1918 law [section 240 (c)] the for- eign income tax to be allowed as a credit was such tax "paid," not "accrued," within the taxable year. The portion of such tax deductible was based on the ratio of the dividends received from such foreign corporation to its total net income. The limitation imposed was that such credit should not exceed the amount of dividends received from such foreign corporations. For detailed discussion see Income Tax Procedure, 1921, pages 752-755. FOR TAXES 949 foreign income taxes directly was included in the 192 1 law. This limitation is based on the theory that the foreign tax credited against the United States tax should be at the same rate with respect to foreign income as the United States tax is to United States income. In other words, it was felt that it would not be equitable to allow credit for foreign tax against United States tax if the foreign taxes were imposed at a higher rate than the United States tax. To accomplish this object the foregoing provision of the 192 1 law contains a statement of a maximum limit to the credit for foreign tax, viz. : the proportion of United States tax equal to the ratio of dividends received from the foreign corporation to total net income (including such dividends) of the domestic cor- poration. To illustrate assume the following: A domestic corpora- tion (A) owns the entire capital stock of a foreign corpora- tion (B) : Net income of A $100,000 (a) United States income and profits taxes payable by A $ 10.500 Net income of B $ 20,000 Foreign income and profits tax payable by B 4,000 Balance of accumulated profits available for dividends $ 16,000 (b) Dividend paid by B to A $ 10,000 (c) Ratio of (c) to (b)=5/8 (d) Ratio of (c) to (a) = i/io (e) The foregoing ratios are used in determining whether the limitation of tax indicated by (e) will preclude the full al- lowance indicated by (d). Foreign taxes paid "with respect to the accumulated profits" of $16,000, i. e., $4,000. 5^ (see above) thereof = foreign taxes allocated to dividend paid to United States parent corporation $2,500 But credit must not exceed i/io of United States tax ($10,500) .... 1,050 Amount of foreign tax disallowed as a credit i,450 It would seem, therefore, that the United States tax pay- able by the domestic corporation would be $9,450 ($10,500 — $1,050). In other words, the limitation applies. 95" DEDUCTIONS Section 238 (e) states that the ratio for the hmitation is the "proportion .... which the amount of such dividends bears to the amount of the entire net income of the domestic cor- poration." The theory is that the United States corporation will be allowed as a credit against the United States tax the foreign tax paid with respect to the dividend from the foreign corporation included in the United States corporation's in- come, which has been subjected to United States tax. By limiting the credit, however, to a proportionate part of the "taxes, against which such credit is taken," the foreign tax is, in effect, reduced to the same rate as the United States tax on the foreign dividend. If the rate of tax imposed by the for- eign country is higher than the United States rate, the effect of the computation is to allow the credit at the lower United States rate. If, on the other hand, the rate of foreign tax is lower than the United States rate, the full amount of foreign tax would be allowed with respect to such foreign dividend. It has been suggested that the phrase in section 238 (e) "upon or with respect to the accumulated profits of such for- eign corporation from which such dividends were paid," might limit the credit for taxes as shown in the above illustration to an amount allocated to the $16,000 of profits remaining after deduction of the foreign tax of $4,000. Such an interpreta- tion of the law, however, is not warranted because the entire amount of foreign tax was paid by the foreign subsidiary in respect of the profits remaining available as dividends. It is important also to note the difference in treatment of the deduction from United States income of any part of the foreign tax disallowed as a credit. A United States corpora- tion with a foreign branch (unincorporated) is permitted to deduct such an amount as section 234 (a-3) provides for the deduction of "Taxes paid or accrued within the taxable year except . . . . (b) so much of the income, war profits and excess profits taxes imposed by the authority of any foreign country or possession of the United States as is allowed as a credit under section 238, . . . ." But a United States cor- FOR TAXES 951 poration conducting" its foreign business through a foreign sub- sidiary is not allowed as a deduction from its United States income any foreign tax paid by the foreign subsidiary which is disallowed as a credit against the United States tax of the domestic corporation. The reason for this is that the deduction for taxes paid, under section 234 (a) quoted above, is allowed only to the taxpayer paying such taxes. In the case of a foreign sub- sidiary the foreign tax is paid by such foreign corporation and not by the United States corporation. Regulation A domestic corporation seeking such credit must comply with those provisions of subdivision (a) of article 383 which are applicable to credits for taxes already paid, except that in accordance with article' 611 the form to be used is Form 11 18 in- stead of Form 1116.'^ For the purposes of section 238 a corporation entitled to the bene- fits of section 262 is treated as a foreign corporation. (Art. 612.) Meaning of terms. — Regulation. "Amount of ... . taxes paid during the taxable year" means taxes proper (no credit being given for amounts repre- senting interest or penalties) paid or accrued during the taxable year on behalf of the individual claiming credit. "Foreign country" in- cludes within its meaning any foreign sovereign state or self-govern- ing colony (for example, the Dominion of Canada), but does not in- clude a foreign municipality (for example, Montreal) unless itself a sovereign State (for example, Hamburg). "Any possession of the ' [Former Procedure] For procedure as to foreign taxes prior to 1916, see footnote, page 939. Ruling. A domestic corporation owning a majority of the voting stock of a foreign corporation is not entitled to credit for taxes paid by such foreign corporation to any foreign country or possession of the United States which are not actually paid within the taxable year of the domestic corporation. (C. B. i, page 237; T. B. R. 36.) Space does not permit comment on the foregoing ruling. It may be entirely sound; but the author is not convinced by the arguments in the detailed ruling that Congress intended to allow credits for such taxes ("many foreign taxes which accrued prior to 1918 remain un- paid") paid in 1918 and in subsequent years, although they accrued prior to 1918. 952 DEDUCTIONS United States" includes, among others, Porto Rico, the Phihppines and the Virgin Islands (Art. 382.) The definition in the foregoing regulation of the phrase "to any foreign country," is no doubt technically correct, but it probably does not carry out the intention of Congress. In the first edition of Regulations 45 the term used was, "any governmental authority,"^ which more nearly accords with the accepted meaning of "any foreign country." The Treas- ury has not been consistent in its definitions of "foreign gov- ernment" and "foreign country." The section of the law set- ting forth the items not included in gross income reads: Law. Section 213. That for the purposes of this title .... the term "gross income" — (b) Does not include .... (5) The income of foreign governments received from invest- ments in the United States Article 86 reads as follows : Regulation. The exemption of income of foreign governments applies also to their political subdivisions (Art. 86.) There is no sound reason why "foreign government" in section 213 should be construed to include political subdivi- sions, whereas the term "foreign country" used in sections 222 and 238 is construed to exclude such subdivisions. It is customary to refer to "state" income taxes and it is quite conceivable that in a federal statute state income taxes might be specifically mentioned as being deductible. But if subsequently the city of New York were to impose an income tax and a taxpayer who had been paying $1,000 to the state thereafter paid $500 to the state and $500 to the city the courts would probably hold that since a city is an instrumental- ity of a state, income taxes paid to a city would be deductible. If a citizen of the United States who now pays a $1,000 * [Former Procedure] Regvlatiox. " . . . . Foreign country" means any governmental au- thority, not that of the United States or any part or possession thereof, having power to impose such taxes, and it therefore includes a self-govern- ing colony, such as the Dominion of Canada (Reg. 45, April, 1919, Art. 382.) FOR TAXES 953 income tax in England hereafter should pay $500 direct to the British government and $500 to the city of London the regulation would prohibit the deduction of the amount paid to London, even though the change merely represented an adjustment of a policy of apportionment. In the opinion of the author the words "to any foreign country" mean "to any foreign country or any subdivision of a foreign country which has or may receive authority to impose an income tax." The intention of the law was to reduce the burden on a citizen of the United States who might be taxed very heavily on income arising in a foreign country. It would seem to make little or no difference whether such foreign tax were im- posed by a municipality or by a recognized sovereign govern- ment. In one country the state might impose income taxes. In another country with a different tax system, income taxes equally onerous might be laid by local authorities but none by the state. Congress did not intend to discriminate against one system in favor of the other. The following decision has recently been issued : Ruling. The term "foreign country" as used in sections 238 (a) and 234 (a) (3) of the Revenue Act of 1918 is held to mean the composite whole made up of all the subdivisions of a foreign State subject to the same central control. Each of the subdivisions, in this sense, is not a "country" but a part of a "country." The Province of British Columbia, therefore, does not come within the meaning of the term "foreign country"' as contemplated by the statute. Amounts of mineral tax and income tax paid or accrued to the Province of British Columbia by a domestic corporation are deductible as business expenses from the taxable income of the corporation. (B. 39-21-1844; O. D. 1050.) Procedure for securing credit for foreign taxes. — Regulation, (a) When credit is sought for income, war profits or excess profits taxes paid other than to the United States, the in- come tax return of the individual must be accompanied by Form 1 116, carefully filled in with all the information there called for and with the calculations of credits there indicated, and duly signed 954 DEDUCTIONS and sworn to or affirmed. When credit is sought for taxes already paid the form must have attached to it the receipt for each such tax payment. When credit is sought for taxes accrued the form must have attached to it the return on which each such accrued tax was based. This receipt or return so attached must be either the original, a dupHcate original, a duly certified or authenticated copy, or a sworn copy. In case only a sworn copy of a receipt or return is attached, there must be kept readily available for comparison on request the original, a duplicate original or a duly certified or authenticated copy, (b) In the case of a credit sought for a tax accrued but not paid, the Commissioner may require as a condition precedent to the allowance of credit a bond from the taxpayer in addition to Form 1116. If such a bond is required, Form 11 17 shall be used for it. It shall be in such penal sum as the Commissioner may prescribe, and shall be conditioned for the payment by the taxpayer of any amount of tax found due upon any redetermination of the tax made necessary by such credit proving incorrect, with such further conditions as the Commissioner may require. This bond shall be executed by the tax- payer, his agent or representative, as principal, and by sureties sat- isfactory to and approved by the Commissioner (Art. 383.) Form 1 1 16 provides for the calculation of such tax in terms of foreign money and its conversion into United States money, but does not state what rate of exchange is to be used. The form does specify, however, that claimant must "attach a statement describing in reasonable detail why and how he determined upon this particular rate." The Treasury has ruled" in the case of income credited that the rate of exchange prevailing at the time the amount^ were credited should be used. This is of importance in these days of highly variable exchange rates. It therefore seems proper to use the prevailing exchange rate on the date or dates when taxes were actually paid to the foreign countries. Credit for foreign taxes under fiscal year basis.^° — In case of fiscal years 1920 to 1921, the credit is computed ° Letter to Herbert M. Teets, New York, N. Y., signed by Deputy Commissioner L. F. Speer, dated January 11, 1916; also C. B. 3, page 234; O. D. 809. '" [Former Procedure] Ruling. A domestic corporation which derives its entire income from operations in Cuba and keeps its books on an accrual basis, may file on Form II 18 a "claim for credit" of the amount of any Cuban income, war FOR TAXES 955 for the full year under the 192 1 law, and the portion thereof not already claimed is allowed [section 238 (d)]. When amounts subsequently paid differ from ac- cruals. — Regulations. In case credit has been given for taxes accrued, or a proportionate share thereof, and the amount that is actually paid on account of such taxes, or a proportionate share thereof, is not the same as the amount of such credit, or in case any tax payment cred- ited is refunded in whole or in part, the taxpayer shall immediately notify the Commissioner. The Commissioner will thereupon redeter- mine the amount of the income tax of such taxpayer for the year or years for which such incorrect credit was granted. The amount of tax, if any, due upon such redetermination shall be paid by the taxpayer upon notice and demand by the collector. The amount of tax, if any, shown by such redetermination to have been overpaid shall be credited against any income, war profits or excess profits taxes, or instalment thereof, then due from such taxpayer under any other return, and any balance of such amount shall be immediately refunded to him (Art. 384.) .... To secure such a credit a domestic corporation must pursue the same course as that prescribed for an individual by article 383, except that form 1118 is to be used for claiming credit and form 1119^^ for the bond, if a bond be required. For the redetermination of the tax, when a credit for such taxes has been rendered incorrect by later developments, see article 384, all of the provisions of which apply with equal force to a corporation taxpayer. For credit where taxes are paid by a foreign corporation controlled by a domestic cor- poration, see article 612. A claim for credit in such a case is also to be made on form 11 18. (Art. 611.) profits or excess profits tax accrued for the fiscal year ended June 30, 1918, and apply such credit against its Federal income and profits tax for the same fiscal period. This credit should be prorated with reference to that part of the fiscal year falling within the calendar year 1918. If the 1918 Federal tax has been paid without claiming this credit and the company wishes to credit the overpayment against the 1919 taxes, Form 11 18 should be accompanied by a claim for refund on Form 46 and possibly a claim for credit on Form 47-A. A claim for credit on Form 11 18 for the amount of Cuban income, war profits or excess profits tax accrued for the fiscal year ended June 30, 1919, may be filed and applied against the company's Federal tax liability for the same fiscal period. (C. B. 2, page 221; O. D. 406.) See also section 238 (c), 1918 law. "See Appendix of Excess Profits Tax Procedure, 1921, for reproduc- tion of form. 956 DEDUCTIONS Forms to be used by individuals and partnerships when credit for foreign taxes is claimed. Ruling. A domestic partnership has leased certain of its patents to a British licensee for a fixed royalty, and the British government requires the licensee to withhold and pay to it the British income tax on the royalty payments. The partners, in order to obtain credit for such tax paid to the British Government, should attach to the return of the firm on Form 1065 a claim for credit, Form 11 18, modified throughout by substi- tuting the word "partnership" for the word "corporation." In lieu of the required receipt or return, a copy of the receipt issued to the British licensee showing the payment of tax made to the British Government, duly attested by the president of the British licensee, will be accepted. The individual members of the partnership are required to attach Form 11 16 to their individual returns, accompanied by a copy of the receipt issued to the British licensee and a copy of the affidavit made by the president of the British licensee. (C. B. 3, page 220; O. D. ■583.) When a partnership pays income or excess profits taxes to a foreign country the tax so paid is not to be included as an expense in form 1065,^^ but is to be allocated to the individ- ual partners on the same basis as the profits. The amounts may, subject to the limitations already mentioned, be deducted by the partners from the fax computed on their individual returns. Only the difference, if any, between the foreign tax so credited and the total amount of such foreign tax, is to be entered in form 1065 and thus be deducted from gross income in computing net income subject to United States income tax. Massachusetts trust operating property in a for- eign COUNTRY. — Where, under the laws of a foreign country, taxpayers are taxed as individuals, although in this country they would be and are regarded as an association, the individ- uals who were actually assessed by the foreign government must claim credits against their individual income taxes, and the association not having paid the tax cannot claim the credit. ^" For copy of form, see Appendix B. FOR TAXES 957 Ruling. A Massachusetts trust, taxable as an association, owns and operates property in a foreign country, which does not recognize the separate entity of the association but regards it as a partnership, the shareholders paying income tax individually to the foreign country upon their respective shares of the net profits of the association. Held, that the association is not entitled to claim under the Revenue Act of 1918, as a credit on Form 11 16, the amount of the taxes so paid by the shareholder, but that the shareholders who paid such taxes are entitled to the credit within the limitation of article 381, Regulations 45. (B. 42-21-1872; A. R. R. 643.) Tax on bank stock, etc., no longer deductible by share- holders. — Taxes on bank stock (or similar taxes on the stock of other corporations) paid by the bank are, under the 192 1 law, deductible by the bank, but they are not deductible by the shareholders.^^ Regulations. Under the revenue act of 1921 banks or other corporations paying taxes assessed against their stockholders on ac- count of their ownership of the shares of stock issued by such cor- porations, without reimbursement from any such shareholder or mem- ber, may deduct the amount of taxes so paid. The statute specifically provides, however, that in such cases the stockholders may not deduct the amount of the taxes. ^* (Art. 566.) In computing the net income of an individual no deduction is al- lowed for the taxes imposed upon his interest as shareholder or mem- ber of a bank or other corporation, which are paid by the corporation without reimbursement from the taxpayer (Art. 135.) Taxes paid under secured debt laws deductible. — Regulation Amounts paid to States under secured debts laws in order to render securities tax exempt are deductible. (Art. 131-) Automobile license fees deductible. — Regulation. Automobile license fees arc ordinarily taxes. (Art. Ruling. A taxpayer whose books are kept on the receipts and disbursements basis may deduct from gross income on his 1919 return " See page 734 for procedure under the 1913 law. See Income Tax Procedure, 1921. Under the 1918 law, stockholders for whom a corpora- tion paid taxes assessed on their holdings, were required to report such taxes as additional dividend, subject to surtax, at the same time deducting the item under "taxes" in computing net income. But see Income Tax Troccdiirc. 1921, page 760 ct scq., rulings under iyi8 law. " Section 214 (a-3). 958 DEDUCTIONS automobile taxes levied against him by the State of Iowa for 1919 and 1920, provided he actually paid such taxes during 1919. If the books of the taxpayer are kept on the accrual basis, then only the amount of such tax applicable to the year 1919 may be taken as a deduction in preparing his 1919 income tax return, and the amount which represents the 1920 tax may be deducted on such taxpayer's 1920 return, notwithstanding the fact that he actually paid the tax for both years in 1919. (C. B. 2, page 116; O. D. 388.) Business, excise and license taxes deductible. — Regulation business, license, privilege, excise .... taxes paid to internal revenue collectors, are deductible as taxes imposed by the authority of the United States, provided they are not added to and made a part of the expenses of the business or the cost of articles of merchandise with respect to which they are paid, in which case they can not be separately deducted. (xA.rt. 132.) The foregoing regulation does not operate as a limitation upon the deduction, but merely points out that a dealer who pays these federal taxes must not deduct them twice. The stipulation that the taxes be paid to an internal revenue collector must be regarded as explanatory. It must not be interpreted to mean that taxes to be deductible must be paid to an internal revenue collector. It simply means that taxes so paid are among the allowable deductions. All taxes other than federal income and profits taxes and local assessments, are deductible by the taxpayer who is as- sessed for them and responsible for their payment. The actual payments may be made by withholding agents as in the case of theater tickets, etc. When the tax is paid to the collector by someone other than the taxpayer, the latter is the onl)-' one who can claim the payment as a deduction. Rulings. The Republic of Cuba imposes on all corporations operating sugar plantations in Cuba, a tax of a certain amount on each bag of sugar produced. Apparently this tax is based on pro- duction, not on income, and is in the nature of an excise tax. There- fore a domestic corporation may deduct from gross income in its return to the United States Government the amount of such tax paid to the Cuban Government but may not claim the amount as a credit FOR TAXES 959 against the total tax due to the United States. (C. B. 2, page 115; O. D. zi^-) Wholesale liquor dealers who exercised their option of including excise taxes in cost of merchandise in calculating inventory may not now amend such inventory and treat the taxes as business expenses. (C. B. I, page 112; O. D. 137.) Excise and stamp taxes are deductible only by the one against whom such taxes are levied. — Ruling. Receipt is acknowledged of your letter of February 28, 1920, in which you inquire as to the taxpayer who is entitled to the benefit of a deduction from gross income in respect of excise and stamp taxes levied by the federal government. In reply you are advised that the general rule which applies in respect of a deduction for all taxes is that the deduction may be taken only by the person against whom such taxes are levied. The fact that one person ultimately pays a tax levied upon another does not give such person a right to the benefit of the deduction. As to the person against whom excise and stamp taxes are levied, your attention is directed to sections 900 to 907, and 1006, iioo to 1 107, inclusive, of the Revenue Act of 1918. (Letter to Leslie, Banks & Company, New York, N. Y., signed by G. V. Newton, Acting Assistant to the Commissioner, and dated March 6, 1920.) Customs duties deductible. — Regulation, import or tariff duties paid to the proper customs officers .... are deductible as taxes imposed by the authority of the United States, provided they are not added to and made a part of the expenses of the business or the cost of articles of merchandise with respect to which they are paid, in which case they can not be separately deducted. (Art. 132.) The deduction may be claimed on articles intended for per- sonal or family use as well as by dealers who btiy to resell. Stamp and similar taxes deductible. — Regulation stamp taxes paid to internal revenue col- lectors are deductible (Art 132.) In view of the heavy stamp and other taxes being collected by federal and state authorities, it may be worth while for tax- payers to preserve a record of the stamps used on stock trans- actions and for many other purposes. The payment of taxes 960 DEDUCTIONS as represented by stamp purchases is plainly an allowable de- duction. Stamp taxes on certificates of stock which have been sold should be treated as taxes and not as a deduction from the proceeds of sale/^ Taxes payable by the manufacturer are not deductible by the ultimate consumer. Luxury and excise taxes. — The 1921 law has repealed many of the luxury and excise taxes^® and those that remain are almost all payable by the manufacturer. In view of this it has been decided to omit from this edition of Income Tax Procedure any lengthy discussion on this subject such as ap- peared in the editions of prior years. Although the number of taxes is still large, the test for their deductibility or otherwise is the same in all cases, viz. : Is the tax levied against the per- son desiring to make the deduction? If, as in the case of club dues or admissions, the tax is levied against the taxpayer, the latter can deduct it. If it is levied against the manufacturer, he includes it in his cost of production and the consumer is not entitled to any deduction; even if the manufacturer passes the tax on to the consumer as a specific item, the consumer cannot deduct it. Claims where accurate records of tax payments not kept. — Each taxpayer is expected to return every dollar of taxable ^^ [Former Procedure] Under the 1918 law taxable income was the same whether tax stamps were treated as expenses or as taxes, but under the 1913 law and in most cases under the 1917 law stock losses were not deductible. Hence when stamp taxes on transfers of stock were treated as deductions from proceeds of sales (and the transaction resulted in a loss), credit was not secured for the item of stamp taxes, because the cost of the stamps was merged in the stock loss. '" [Former Procedure] Under the 1917 law taxes were imposed on a large variety of things including the following: facilities (passenger fares, freight, express, berths, seats, telegraph and telephone messages), promis- sory notes (except when Lilicrty bonds were used as collateral) conveyances of real estate, powers of attorney, proxies, admissions to theaters and other places of amusement, and dues charged by social and similar clubs. The 1918 law modified these taxes to some degree and added the lux- ury tax, the tax on the retail price of jewelry, perfumes, cosmetics, etc. In addition, there were levies against a greatly extended list of articles payable by the producer on the basis of the wholesale price rather than by the consumer on the basis of the retail price. FOR TAXES 961 income even though no permanent record of it was made. Similarly a taxpayer ma}^ claim credit for all taxes paid if the claim is made in good faith and can reasonably be sup- ported. Since receipts were not usually given by those who collected the taxes, vouchers cannot be furnished. If one's memory is trustworthy no objection can be made to a claim based on the taxpayer's statement. Ruling. An individual may claim as a deduction the amount of war tax paid on facilities furnished by public utilities, which include tax on railroad and steamship fares, and the war tax paid on admis- sions and dues. The war excise taxes imposed by section 904 and paid by the purchaser are deductible, but the war excise taxes imposed by section 900, which are levied against and paid by the manufac- turer, producer, or importer, are not deductible by the individual purchaser. (C. B. i, page 112; O. D. 287.) Inheritance taxes deductible. — On June 6, 192 1, the United .States Supreme Court held" that when Congress included all taxes^^ among allowable deductions it used language which is to be taken in its ordinary meaning, and that inheritance or estate taxes paid by an estate may be deducted from taxable income. Decision. The act of 1916 calls the estate tax a "tax" and par- ticularly denominates it an "estate tax." This court recently has recognized that it is a duty or excise and is imposed in the exertion of the taxing power of the United States. New York Trust Co. v. Eisner, — U. S. — . It is made a charge on the estate and is to be paid out of it by the administrator or executor substantially as other taxes and charges are paid. It becomes due not at the time of the decedent's death, as suggested by counsel for the Government, but one year thereafter, as the statute plainly provides. It does not segregate any part of the estate from the rest and keep it from pass- ing to the administrator or executor for purposes of administration, as counsel contend, but is made a general charge on the gross estate and is to be paid in money out of any available funds or, if there be none, by converting other property into money for the purpose. " U. S. V. Alan H. ll'oodzvani, ct ai. (T. D. 3x95; C. B. 4, page 153). "The suit was brought under the 1916 law under which federal income as well as all other taxes (except those lor local benefits) were allowable deductions. Under later laws tlie only exclusions are federal income and profits taxes. 962 DEDUCTIONS The author consistently held in all former editions of this book that, unless and until the law restricts the deductions of ' inheritance or estate taxes, the amount paid by, or for, an es- tate is an allowable deduction. Regulation. Federal estate taxes, paid or accrued during the taxable year, are an allowable deduction from the gross income of the estate in computing the net income thereof subject to tax. Such taxes are deemed to have accrued on the due date thereof, namely, one year after the decedent's death, except in any case where the Commissioner has granted an extension or extensions of time for payment, such taxes are then deemed to have accrued on the due date or dates of such extension or extensions. Estate, succession, legacy, or inheritance taxes, imposed by any State, Territory or possession of the United States, or foreign coun- try, are deductible by the estate, subject to the provisions of section 214, where, by the laws of the jurisdiction exacting them, they are imposed upon the right or privilege to transmit rather than upon the right or privilege of the heir, devisee, legatee, or distributee, to receive or to succeed to the property of the decedent passing to him. Where such taxes are imposed upon the right or privilege of the heir, devisee, legatee, or distributee, so to receive or to succeed to the property, they constitute, subject to the provisions of section 214, an allowable deduction from his gross income. Where, in accordance with a direction contained in the testator's will, the taxes upon the right to receive any particular devise or devises, legacy or legafcies are so payable as to relieve the particular devisee or devisees, legatee or legatees from the burden thereof, then the person or persons entitled to the fund or other property out of which payment is made may not take deduction of the taxes so paid, but deduction thereof is available only by such devisee or devisees, legatee or legatees ; each, if there be more than one, being authorized to deduct such part of the taxes so paid as he would otherwise have been entitled to do had there been no such testamentary direction. Where there is a life estate and a remainder, and, by the laws of the jurisdiction imposing them, the taxes in respect to both interests are payable out of the remainder interest, with no legal obligation imposed whereby the remainderman is entitled to reimbursement, then deduction of the taxes so paid may be taken only by the re- mainderman. Where, in the case of an annuity, the taxes in respect thereto are, by the laws of the jurisdiction imposing them, payable in the first instance out of the fund set aside for creating the an- nuity, but are to be repaid or restored to such fund from the annuity, then deduction thereof may be taken only by the annuitant. The accrual dates of such taxes shall be the due date thereof ex- FOR TAXES 963 cept as otherwise provided by the law of the jurisdiction imposing them. Where deduction is claimed of any such taxes, the amount thereof and the name of the State, Territory, or possession of the United States, or foreign country, by which they liave been imposed shall be stated in the return. (Art. 134.) The foregoing regulations recognize that taxes accrued as well as paid may be deducted. The deduction for accrued taxes is not limited to estates which keep their accounts on an accrual basis, because the law [section 214 (a-3)] provides that the allowable deduction is for taxes paid or accrued, and specifies that estate taxes accrue ''on the due date thereof." The regulation points out the conditions under which the right to deduct inures to the estate and when to the distributees. For instance, when legacies are made payable free of tax, and the estate pays the tax for the legatee, it is held that the latter and not the estate is entitled to the deduction. The same prin- ciple is applied to remaindermen and annuitants. The deduc- tion is complicated by the procedure in the local jurisdiction in which the estate is administered. It may be expected, there- fore, that the foregoing regulations will be amended from time to time. Taxes paid for another person — who deducts? — Credit should be taken for taxes by the owner of the property taxed; but if a husband pays the taxes on a residence the title to which is in the name of his wife there appears to be no pro- hibition in the law against the deduction by the husband in his return. Strictly speaking, the payment represents a gift to the wife and should be deducted by her. Tax deductions too broad. — In the opinion of the author not all taxes deductible under the law are proper deductions. For example, a tax paid upon an individual's own residence, the rental value of which is not taxable, is an allowable de- duction, although such a tax clearly is a living or personal ex- pense. This may be said to be true also of luxury taxes and of import duties paid by individuals on goods destined for 964 DEDUCTIONS their personal consumption. It would be more equitable if taxes were deductible only when paid on income-producing property or on property acquired for income-producing pur- poses. Taxes Not Deductible The law permits the deduction from gross income of all taxes levied by the authorities enumerated, with four specific exceptions, viz., the federal income tax, the excess profits tax/" a proportionate part of foreign income and excess profits taxes (which are a credit against United States taxes), and certain types of special assessments. Consecjuently the procedure at this point resolves itself largely into the problem of determin- ing whether or not particular expenditures are taxes. Federal income tax cannot be deducted. — In 191 7 the prac- tice of permitting the deduction of federal income taxes was abandoned.^" They are no longer deductible. In the period of low rates the question of deducting the " The excess profits tax is credited against net income in computing the income tax. "™ [Former Procedure] Deductibility of 1916 income taxes accrued on portion of fiscal year ending in 1917. — Federal income taxes were deductible before 1917. The law forbidding the deduction was passed October 3, 1917. It was the intention of Congress to apply the restriction to the new in- come and excess profits taxes, and the restriction was a perfectly sound one. but there was no intention to forbid a taxpayer to take credit for accrued 1916 federal income taxes. For comments and sug- gestion, see Income Tax Procedure, 1920, pages 614-615. Ruling. Additional excise taxes assessed against a corporation under the Revenue Act of 1909 and paid during subsequent years are allowable deductions from the gross income reported on the corporation's return for the year in which paid ; but income taxes assessed under the Revenue Acts of 1913 or 1916 are deductililo only if paid prior to January i, 1917. (C. B. I, page III ; O. D. 240.) The foregoing ruling is erroneous. T. D. 2433 (January 8, 1917) per- mitted the deductions of 1916 taxes accrued December 31, 1916, but not paid. The regulation has not been rescinded, Init in specific cases individuals as well as corporations have been permitted to make the deduction. FOR TAXES 965 income tax was of slight practical importance, but when rates rose to a level where, in some cases, they took the bulk of the taxpayer's income, the situation was entirely changed. It may appear at first glance that the allowance or prohibition of the deduction would make no net financial difference to the government, because it could raise the rates to compensate for the decrease in the aggregate tax base. But as a mattef of fact the allowance of this deduction would cut in half the total possible financial productivity of the income tax. Ap- proaching the question from the point of view, not of the aggregate yield, but of the distribution of the burden among the taxpayers — the individual point of View — it will readily be seen that, under highly progressive rates, the allowance of the deduction would have the effect of providing relief to those in the upper surtax classes to a much greater extent both absolutely and relatively than to those in the low^er classes. It would operate "to flatten out" the progressive rates. Again, during a period when incomes are fluctuating violently in amount from year to year and when the tax rates themselves change with the seasons, the permission to deduct income tax payments would yield very uneven results."^ Finally the argument that to refuse the deductions is to levy a tax on a tax is specious. The government is seeking a standard by which to apportion a burden and it decides that this apportionment shall be according to net incomes as they stand before the burden is imposed — not according to the amounts remaining after provision has been made for the l3ur- den which it is seeking to impose. There should be no objec- tion on the part of the taxpayers to this provision in the law. " Assume two men with equal incomes in 1919, one of whom in 1918 had the same income as in 1919, while the other that year had no income at all. In 1919, the first man would he taxed much less than the second because of the deduction for income taxes on his previous year's income. On the other hand in 1920, if we assume the incomes of both to remain as they were in 1919, the second man would pay less than the first man because of his heavier 1919 taxes. No matter how long the two might continue to receive the same income, they would never pay the same tax. With rates varying from year to year, the possibilities of inequality would be great. 966 DEDUCTIONS . Adjustment of taxes of prior years. — When there is an adjustment of returns for years prior to 191 7 and the in- come tax is redetermined, the additional tax paid or the refund received may require a further adjustment of taxes for the succeeding year or years. Penalty additions to taxes may or may not be de- ductible. — Ruling, (a) The addition to tax authorized to be assessed by section 3176, Revised Statutes, as amended, on delinquent or false and fraudulent returns is to be considered a penalty and not a tax except for purposes of collection. (b) Such an addition to tax made on excess profits tax returns is not an allowable credit in arriving at the net income subject to normal income tax. (c) The payment of such an addition to tax is not to be dis- allowed as a deduction from gross income in obtaining net income on the ground that it is a part of the income or profits tax within the provisions of law forbidding the deduction from gross income of those taxes. (d) The payment of an addition to tax for delinquency in filing a return may be deducted from gross income as a business expense when such an addition to tax is an incident to carrying on a business or trade. The payment of an addition to tax upon a false or fraudu- lent return may not ordinarily be deducted from gross income as a business expense and may never be deducted in the case of an indi- vidual who himself was guilty of making a fraudulent return. (C. B. I, page 241 ; O. 926.) Special assessments may or may not be deductible. — Taxes which may not be deducted include "those assessed against local benefits of a kind tending to increase the value of the property assessed."^" The provision which broadens the deduction so as to include assessments which do not increase the value of the property appeared for the first time in the 19 18 law and is an improvement over former procedure.^^ '"Section 214 (a-3-c). '^ [Former Procedure] The 1918 law was the same in this respect as the present law. The laws of 1917 and of prior years excluded as deductions ail taxes assessed against local benefits. [See 1917 law, section 5 (a), third.] Regulation. So-called "taxes," more properly assessments, paid for local benefits, such as street, sidewalk, and other like assessments, imposed FOR TAXES 967 Regulation. So-called taxes, more properly assessments, paid for local benefits, such as street, sidewalk and other like improve- ments, imposed because of and measured by some benefit inuring directly to the property against which the assessment is levied, do not constitute an allowable deduction from gross income. A tax is considered assessed against local benefits when the property subject to the tax is limited to the property benefited. Special assessments are not deductible, even though an incidental benefit may inure to the public welfare. The taxes deductible are those levied for the general public welfare by the proper taxing authorities at a like rate against all property in the territory over which such authorities have jurisdiction. Assessments under the statutes of California relating to irrigation and of Iowa relating to drainage, and under certain stat- utes of Tennessee relating to levees, are limited to property benefited, and when it is clear that the assessments are so limited, the amounts paid thereunder are not deductible as taxes. When assessments are made for the purpose of maintenance or repair of local benefits, the taxpayer may deduct the assessments paid as an expense incurred in business, if the payment of such assessments is necessary to the con- duct of his business. When the assessments are made for the purpose of constructing local benefits, the payments by the taxpayer are in the nature of capital expenditures and are not deductible. Where assessments are made for the purpose of both construction and main- tenance or repairs, the burden is on the taxpayer to show the allo- cation of the amounts assessed to the different purposes. If the allocation can not be made, none of the amounts so paid is deductible. (Art. 133.) 24 The regulation recognizes the distinction between capital expenditures and expense as constituting the dividing line between the deductible and the non-deductible types of special because of and measured by some benefit inuring directly to the property against which the assessment is levied, do not constitute an allowable deduction from gross income. Taxes deductible are those levied for the public welfare by the proper taxing authorities at a like rate against all property in the territory over which such authorities have jurisdiction. Special assessments, such as are hereinbefore contemplated and which are measured upon the basis of the benefit flowing directly to the prop- erty, are not deductible, even though an incidental benefit may inure ♦^o the public welfare. (Reg. ^3. 1918, Art. 194.) '* [Former Procedure] The editions of Regulations 45 published early in 1919 included the following sentence: "Assessments under Illinois laws relating to drainage districts are not limited to the prop- erty benefited and assessments so paid are deductible." The expres- sion, in the sentence which discusses the statutes of several states, "and when it is clear that the assessments are so limited," was intro- duced by T. D. 2937. Sec C. B. i, page 112; O. D. 928. 968 DEDUCTIONS assessments. But it also goes further and attempts to apply another test of deductibility, that is, whether an assessment which is not of the nature of a capital expenditure "is neces- sary to the conduct of his business." The regulation does not directly state that such assessments when imposed against non-business property are not allowable deductions, but it plainly infers this. Whatever can be said for its equity, such a position is obviously illegal. The law itself when it says '*Taxes paid .... not including those assessed against local benefits . . . ." [section 214 (a-3)] practically defines a spe- cial assessment as a tax. and when such assessments are not "of a kind tending to increase the value of the property assessed" they are deductible, irrespective of whether they can be shown to be business expenses or not. The tax on a tax- payer's residence has always been an allowable deduction. Under the 19 18 law taxes assessed against local benefits which do not increase the value of the property were also made al- lowable deductions, and the 192 1 law is like that of 1918 in this respect. Assessments which do not increase value of prop- erty ARE deductible. — There is a legal and economic distinc- tion of long standing between taxes and special assessments. This distinction is based upon the fact that the special assess- ments ordinarily represent the purchase price of equipping the land with facilities, commonly called '"improvements" — such as street paving, side-walks, sewers, etc. This equipment nor- mally results in a "benefit inuring directly to the property against which the assessment is levied." The economic basis for the non-allowance of such assessments consists of the fact that they are in effect expenditures of a capital nature. But it must be recognized that this foundation disappears when the special assessments are levied for purposes transitory in character. Moreover, the use of special assessments for tran- sitory "service" activities — such as lighting and cleaning streets, snow removal, etc. — is becoming more and more wide- FOR TAXES 969 spread. These are essentially expenses and they become al- lowable deductions under the 19 18 law. Types of special assessments which can be deducted will be found in Massachusetts, where special assessments may be levied to provide funds for street sprinkling, for protection of trees by moth extermination and for current expenses. Of course, the element of depreciation appears in most public works, but the distinction to be made is whether or not the improvement is one which is properly of a capital nature. If not, the taxes paid on assessments are deductible. If the improvement is of a capital nature which in time requires renewals, depreciation may ])ossibly be claimed. Special assessments which may not be deducted. — In the case of the permanent types of equipment, such as sewers, streets, etc., the justice of placing special assessments on a different basis from taxes depends upon whether their nature as capital expenditures is recognized. Theoretically, the buyer of a tract of land makes his purchase "on notice" that he will be called upon to pay for its equipment with sewers, roads, etc., by the special assessment method, and consequently he makes an allowance in the price he pays for the land for this additional expenditure which must ultimately be made up from the prices he will receive when he sells the lots. It is clear that he should be permitted to include all such ex- penditures for special assessments as capital in calculating his taxable gain for income tax purposes when he has sold his lots. Unless he fully calculated his future special assessment bur- den when he purchased the tract he vv'ill suffer a loss. The same principle applies to special assessments on improved property. If there is no element "tending to increase the value of the property" the payment does not constitute a proper capital item, because the property owner would not expect to be able to add the assessment to the price of the property in case of sale. 970 DEDUCTIONS If the assessment does tend to increase the value of the property it is not a deduction for income tax purposes, but it adds to the capital value of the property and should be so re- garded in computing the gain or loss in case of sale. Ruling. Amounts expended by an estate on account of special assessments for the maintenance or repair of streets or for sidewalk improvements levied upon property used in a trade or business, if the same is necessary in the conduct of such trade or business, con- stitute allowable deductions. In case any of the property of the estate is used for residential purposes by anyone beneficially interested in the estate, the amounts expended in payment of assessments levied upon such property for maintenance and repairs can not be deducted by the estate unless the rental value of the property is included in the gross income of the estate (C. B. 3, page 149; O. D. 613.) As stated on page 968, the author is of the opinion that taxes assessed for local benefits which do not increase the value of the property assessed are deductible. Ruling. Assessments for local benefits paid by a tenant for his landlord according to agreement are held to be additional rent paid by the tenant, and therefore deductible from his gross income. The amount so received by the landlord is taxable income to him but because of its nature is not an allowable deduction from his gross income. (C. B. 2, page 123; O. D. 373.) Certain so-called taxes deductible only as business EXPENSE. — In some places charges for water furnished by a municipality are known as taxes, chiefly because they are assessed by the city and become a lien on real estate if not paid. Likewise, in certain communities"^ "assessments" are laid upon residents to raise funds for fire protection, road improvement, etc. These do not bear the stamp of government action; they do not become a lien on real estate when not paid; and they are in fact voluntary purchases of certain services and equip- ment through a common fund. No such expenditures are de- ductible as taxes or as expenses except when paid as an inci- ^For definition of "political subdivision," see page 95i- . The definition is of importance when considering items of doubtful deductibility. FOR TAXES 971 dent to the possession of income-producing property or to a business carried on for profit. Tax on undistributed surplus not deductible. — Ruling. Replying to your comunication of March 14, 19 19, you are informed that the 10 per cent tax which was imposed on corporation's undistributed net income by section 10 (b) of the Revenue Act of September 8, 1916, as amended by the Revenue Act of October 3, 191 7, is not an allowable deduction from the gross income of a corporation shown on an income tax return. (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated April i, 1919.) The 10 per cent tax was a tax upon income and for that reason was not deductible. Postage not deductible as a tax. — Regulation Postage is not a tax .... (Art. 131.) Postage, of course, is deductible as a necessary business expense. Federal tax paid by corporations under tax-free covenants not deductible. — The 2 per cent federal tax on "tax-free" bonds, which corporations theoretically withhold at the source, is held to be paid for account of the recipient of the interest, "^ and since it is an allowable credit to the recipient, taxes so paid are not deductible by the corporation. In Azotes on the Rci'- enite Act of 1918, the Secretary of the Treasury suggested (page 22) that the law be amended to provide that "such tax may be deducted by the obligor as interest." Regulation. Corporations may deduct taxes from gross in- come to the same extent as individuals, except that in the case of corporate bonds or obligations containing a tax-free covenant clause, the corporation paying a Federal tax, or any part of it, for someone else pursuant to its agreement is not entitled to deduct such pay- ment from gross income on any ground. In the case, however, of corporate bonds or obligations containing an appropriate tax-free covenant clause, the corporation paying a State tax or any other ^'For method of securing advantage of the deduction, see Chapter XIX, "Income from Interest," page 678. 972 DEDUCTIONS than a Federal tax for someone else pursuant to its agreement may deduct such payment as interest paid on indebtedness.-' Under the revenue act of 1921 any tax paid by a corporation pursuant to a tax- free, covenant clause need not be included in the gross income of the obligee. (Art. 565.) The last sentence of this article is new. Suggestion to corporations. — Corporations having "tax-free" covenant bonds are under no necessity to pay a tax on the interest of such bonds as are held by persons whose income is less than the personal exemption. They can make a saving by giving close attention to the form of certificates filed with them by such persons. Many bondholders with very small incomes are not careful to file the form of certificate which claims the exemption. Wherever feasible the certificates claiming exemption should be substituted for those not claim- ing exemption. Ruling. If an individual who received during 1917 interest on bonds containing a tax free covenant clause was not liable to the pay- ment of normal income tax for that year, the amount of tax paid at the source in his behalf by the debtor corporation is refundable to the debtor corporation, if such tax was not actually withheld from the individual bondholder. The amount of any income or excess profits taxes, or any installment thereof, shown to be due on the debtor corporation's income and profits tax return may be credited with the amount of the excess tax in question paid at the source. (B. 46-21- 1924; O. D. 1103.) Accrual Method Permitted Since January 8, 1917,^^ when T. D. 2433,^^ (which held that under the 1916 law, effective as of January i, 1916, ^ [Former Procedure] Article 193 of Regulations 3^, 1918, did not state specificallj- that "a State tax or any other than a federal tax" was deductible as interest. " [Former Procedure] Regulations. Deductions for taxes, however, should be the aggre- gate of the amounts actually paid, as shown on the cash book of the corporation. (Reg. 33, 1914, Art. 158.) Reserves for taxes cannot be allowed, as the law specifically provides that only such sums as are paid within the year for taxes shall be de- ducted. (Reg. 33, 1914, Art. 156.) ■-■° See page 379. FOR TAXES 973 accrued liabilities, such as taxes, would be allowable deduc- tions) was issued, the regulations have permitted the deduction of accruals for all taxes which in themselves are eligible sub- jects for deduction. Furthermore, the 192 1 law plainly states that the term "paid" means "paid or accrued.""" Conse- quently, all tax reserves, except those for federal income and excess profits taxes and for special assessments, are deduc- tible. In these years of highly fluctuating profits, proper re- serves for taxes are, of course, of great importance. Accrual of New York State tax. — Ruling. The New York State personal income-tax law, passed May 14, 1919, provides for the imposition of an annual tax upon income, and concludes with the statement that "such tax shall first be levied, collected, and paid in the year 1920, upon and with respect to the taxable income for the calendar year 1919, or for any taxable year ending during the year 19 19." A taxpayer of the state of New York who keeps his accounts upon the accrual basis, may ii% rendering his federal income tax return for 1919, deduct the accrued tax for his fiscal year ended in 1919, imposed by the New York state personal income tax law, pro- vided such fiscal year ended subsequent to May 14, 1919, the date of passage of the State taxing act. In case his fiscal year ended prior to May 14, the accrued tax would not be deductible in his Federal income tax return for 1919 since it was not a known liability at the time of closing his accounts for such fiscal year. In the event of judicial interpretation of the New York state per- sonal income tax law which would have the effect of changing the individual's tax liability thereunder it would be necessary for him to file an amended return for Federal income tax purposes. (C. B. 2, page 121; O. D. 505.) New York State franchise tax to be prorated when report- ing on a calendar year basis. — Ruling. The New York State franchise tax, imposed for the privilege of doing business in that State for the fiscal year of the State ending October 31, 1920, is based on 1918 income, but is not due and payable until a later date. A taxpayer mailing a calendar- year return on an accrual basis may deduct two-twelfths of such tax in his return for 1919 and ten-twelfths in his return for 1920. (C. B. 2, page 112; O. D. 371.) Section 200 (4). 974 DEDUCTIONS State of Wisconsin — surtax for 1920. — Rui.iNC. Chapter 459 of the Session Laws of 1921, for the State of Wisconsin imposes an additional surtax on net income in excess of $3,000, retroactive for the year 1920. Inquiry is made whether tax- payers who are called upon to pay this additional tax for 1920 are en- titled to recompute their Federal income tax for that year, taking into consideration the additional surtax imposed by said act of the Wisconsin Legislature. Held, that since the surtax was not such a known liability at the time of closing their books for 1920 as to justify them in setting up an accrual for such surtax, it is not an allowable deduction from gross income for 1920, but is deductible by the taxpayers in the year in which paid, or in which liability therefore accrued, if the books of the taxpayers are kept on an accrual basis. (B. 48-21-1949; O .D. 1118.) [Former Procedure] Munition manufacturer's tax — Title III, section 302 (c) (d). Act of September 8, 1916. — Ruling, i. Only taxes and interest actually paid within the taxable year may be deducted from gross inccmie in munition manufacturer's tax returns for the years 1916 and 1917. 2. Income taxes paid for 191 5 in 1916 may not be deducted from gross income. 3. Only that interest is deductible which was actually paid within the taxable year on debts or loans which filled both of two requirements : (i) That they were contracted to meet the needs of the munition business and (2) that the proceeds thereof were actually used to meet such needs. Interest paid within the taxable year on that part of the principal used in the munition business in 1915, if an^^, from which the profit is not returned for the purpose of the munitions tax, is not deductible. (C. B. 4, page 145; L. O. 1057.) Method of computing and accounting for munition manufac- turer's TAX when taxpayer's ACCOUNTS ARE KEPT ON THE ACCRUAL BASIS. — Ruling. Where a corporation in 1916 kept its accounts on the accrual basis, and either accrued munitions taxes or credited amounts to a reserve set up to meet such taxes, thus taking advantage of section 13 (d) of the Revenue Act of 1916, it became bound by the provisions of that section and Treasury Decision 2433, and the amounts so accrued or credited must, in computing income subject to tax for 1916, be deducted from gross in- come for that year, and not for 1917, during which year such munitions taxes were paid. Section 13 (»d) of the Revenue Act of 1916 is a qualifying section, and when accounts of a corporation are kept on a basis other than that of receipts and disbursements it qualifies the manner of making deductions authorized in section 12 (a) of the Act, and the word "paid"' in the latter section is to be read "paid or accrued" depending on how the accounts of the corporation are kept. (C. B. 4, page 147; L. O. 1059.) CHAPTER XXIX DEDUCTIONS FOR LOSSES Preceding chapters discuss the deductions for expenses, in- terest and taxes. The new concept of capital gains and losses introduced in the 192 1 law is treated in Chapter XVII. It re- mains to discuss the deductions embraced within the compre- hensive term "losses." It is desirable to subdivide this sub- ject and to devote separate chapters to the special items, namely, losses due to bad debts, depreciation, obsolescence, depletion and gifts. (Chapter XXX to XXXIV.) Consequently the subject matter of this chapter is a residuum consisting of the losses due to general and miscellaneous causes, including fluctuation in market values, to disasters and accidents of vari- ous kinds, to dishonesty, to faulty judgment, etc'., etc. Until the 19 18 act became effective, individuals were sub- ject to a very definite restriction in that losses incurred by them in transactions entered into for profit outside their regu- lar trade or business were deductible only to an amount not exceeding profits arising from similar transactions.^ ' [Former Procedure] The provision of the 1913 law relating to the deduction of losses by individuals was as follows: 1913 Law. "Section II (b) .... fourth, .... losses actually sus- tained during the year, incurred in trade or arising from fires, storms or shipwreck, and not compensated for by insurance or otherwise " The 1916 law introduced the March i, 1913, basis of valuation and the provision permitting "ontside" losses, equal to profits arising from similar transactions, to be deducted. The 1916 and 1917 laws contained the following: 1916 Law. "Section 5. [Individuals] .... (a) .... Fourth. Losses actually sustained during the year, incurred in his business or trade, or arising from fires, storms, shipwreck, or other casualty, and from theft, when such losses are not compensated for by insurance or other- wise : . . . . "Fifth. In transactions entered into for profit but not connected with his business or trade, the losses actually sustained therein during the year to an amount not exceeding the profits arising therefrom." 975 9/6 DEDUCTIONS Until recently the Treasury has restricted the word "pro- fits" to mean only those gains derived from the sale or other disposition of the investment itself. The Solicitor in a recent ruling has broadened this defini- tion :^ Ruling. It is therefore held that all returns — e.g., dividends, rents, interest, surplus from sales, etc. — actually realized within the taxable year from subordinate endeavors enteretl into for profit are "profits" within the meaning of the fifth deduction, sec. 5 (a), Reve- nue Act of 1916; and thai; losses actually sustained within the same taxable year by reason of similar transactions, closed and completed, may be offset to the extent of such realized profits. (C. B. 4, page 163; L. O. 1061.) The foregoing ruling is retroactive. Taxpayers who had losses in 19 17 which were not deducted because of the regula- tions then in force, may now file claims for refund. The 1918 law included certain "relief" provisions^ designed to prevent hardship during the period following the war from possible violent changes in inventory values. The administration by the Treasury of the section relating to declines in value of 1918 inventories has restricted the relief to far less than Congress intended when it enacted the 19 18 law. The 1921 law contains no provision similar to the in- ventory loss provision contained in sections 214 (a- 12) and 234 (a-14) of the 1918 law. Section 204 of the 1918 law- was so narrowly construed by the Treasury as to deprive some taxpayers of relief who are entitled to it. The 1921 law con- The following ruling is of importance of those whose principal occu- pation prior to 1918 was trading on margin : Ruling. "An individual was daily in touch with his broker during 1917, purchasing and selling stocks exclusively on margin, sustaining losses on some transactions and realizing gains on others, the net result being a loss. "Since he devoted sufficient time and attention to the purchase and sale of stocks to constitute a vocation, and since all purchases and sales were made on margin, thereby indicating that the shares of stock were purchased for resale and not as an investment, it is held that the amount of the loss represents an allowable deduction in computing net income for 1917." (C. B. 4, page 157; A. R. R. 404.) "See also Bulletin 32-21-1760; A. R. R. 604. ^ Section 214 (a-12) for individuals, and section 234 (a-14) for cor- porations. FOR LOSSES 977 tains a "net loss" provision* similar in principle to section 204 in the 1918 law, which permits the application of the loss of one year against the net income of a later year. In its appli- cation, however, the 192 1 "net loss" provision differs mate- rially from the corresponding section of the 1918 law. It is discussed at the end of this chapter, page 102 1 et seq. The chief problems to be discussed in this chapter are, therefore, the determination of procedure under these special "relief" provisions and the establishment of the standard by which to measure losses due to diminution in values. This second problem is similar to that discussed in Chapter XVI, "Income from Exchanges and Sales of Property." Losses Which Are Deductible In a broad sense there are no limitations, under the 1921 law, upon the right of individuals and corporations to deduct all losses sustained during the taxable year. 1 921, w^hether or not incurred in business or trade. There are certain require- ments such as those regarding transactions entered into for profit, "wash sales," etc., but in general all losses may be de- ducted. The restrictions are fully discussed in the following pages. Individuals. — Law. Section 214. (a) That in computing net income there shall be allowed as deductions: .... (4) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in trade or business; (5) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in any transaction entered into for profit, though not connected with the trade or business; but in the case of a nonresident alien individual only if and to the extent that the profit, if such transaction had resulted in a profit, would be taxable un- der this title. No deduction shall be allowed under this paragraph for any loss claimed to have been sustained in any sale or other dis- position of shares of stock or securities m.ade after the passage of this Act where it appears that within thirty days before or after the date * Section 204. 978 DEDUCTIONS of such sale or other disposition the taxpayer has acquired (otherwise than by bequest or inheritance) substantially identical property, and the property so acquired is held by the taxpayer for any period after such sale or other disposition. If such acquisition is to the extent of part only of substantially identical property, then only a proportionate part of the loss shall be disallowed; (6) Losses sustained during the taxable year of property not con- nected with the trade or business (but in the case of a nonresident alien individual only property within the United States) if arising from fires, storms, shipwreck, or other casualty, or from theft, and if not com- pensated for by insurance or otherwise. Losses allowed under para- graphs (4), (5), and (6) of this subdivision shall be deducted as of the taxable year in which sustained unless, in order to clearly reflect the income, the loss should, in the opinion of the Commissioner, be ac- counted for as of a different period. In case of losses arising from de- struction of or damage to property, where the property so destroyed or damaged was acquired before March i, 1913, the deduction shall be computed upon the basis of its fair market price or value as of March I, 1913; .... Corporations. — Law. Section 234. (a) . . . . (4) Losses sustained during the taxable year and not compensated for by insurance or otherwise;"' un- less, in order to clearly reflect the income, the loss should in the opinion of the Commissioner be accounted for as of a different period. No de- duction shall be allowed for any loss claimed to have been sustained in any sale or other disposition of shares of stock or securities made after the passage of this Act where it appears that within 30 days before or after the date of such sale or other disposition the taxpayer has ac- quired (otherwise than by bequest or inheritance) substantially iden- tical property, and the property so acquired is held by the taxpayer for " [Former Procedure] The corresponding clause in the 1913 law read: Law. Section II, G (b) .... "all losses actually sustained within the year and not compensated by insurance or otherwise." 1916 Law. "Section 12. (a) .... Second. All losses actually sus- tained and charged oflf within the year and not compensated by insurance or otherwise " It should be noted that the 1916 law reads "actually sustained and charged off." The words "and charged off" did not appear in the sec- tion relating to individuals and were inserted in the corporation sec- tion only in 1916. The 1918 law omitted tlie words "and charged off" which formerly appeared, but it is to be assumed that losses will not be allowed unless charged off by items or through reserves. FOR LOSSES 979 any period after such sale or other disposition, unless such claim is made by a dealer in stock or securities and with respect to a trans- action made in the ordinary course of its business. If such acquisition is to the extent of part only of substantially identical property, then only a proportionate part of the loss shall be disallowed. In case of losses arising from destruction of or damage to property, where the property so destroyed or damaged was acquired before March i, 1913, the deduction shall be computed upon the basis of its fair market price or value as of March i, 1913; .... Regulation If (i) a corporation sells its capital as- sets for less than their cost, and such assets were acquired before March i, 1913, then if the fair market value on March i, 1913, less depreciation subsequently sustained and allowable as a deduction is less than the amount realized, no loss is deductible; if (2) such fair market value less depreciation subsequently sustained and allowable as a deduction is greater than the amount realized, but the amount realized exceeds original cost, no loss is deductible; if (3) the amount realized is less than both original cost and the value of March i, 1913, less depreciation subsequently sustained and allowable as a deduction, the deductible loss is the difference between such amount realized and such cost or March i, 1913. value, whichever is lower (Art. 563.) Losses, to be allowed as deductions, must meet the pro- visions of the law that they have been actually ''sustained." This is a reasonable requirement. Most concerns charge off or provide reserves for losses as and when losses occur and the items to be deducted can be taken directly from the books. In the case of individuals who keep no books, more difficulty is experienced. In discussing the phrase "losses sustained'' the regula- tions state that this condition "must usually be evidenced by closed and completed transactions."" This, however, does not preclude the use of inventories for the purpose of ascertaining gains or losses. The privilege of using inventories, long per- mitted to business men generally in the case of merchandise, was not extended to dealers in securities until late in 191 7; but at that time was supported by an opinion of the Attorney General who advised that the Supreme Court in a case under the 1909 law sanctioned the practice. For a •Reg. 62, Art. 141. 98o DEDUCTIONS full discussion of inventories the reader is referred to Chapter XV, page 452 et seq.'' If an individual is engaged in business on his own account or as a partner and the year's operations result in a net loss, the amount of such loss is an allowable deduction from income from other sources in a tax return. The Treasur}^ has ruled that a partnership which holds all of the stock of a corporation and provides funds to liquidate losses incurred by that corporation, may not deduct such pay- ments as losses of the partnership. In the case of a partnership which incorporates and com- mences its operations as a corporation during a taxable year, the loss sustained by the partnership during the portion of the taxable year it was operating cannot be deducted from the income of either the preceding or succeeding taxable year unless the circumstances are such that it can, and does, take advantage of section 330® of the 19 18 law and elects to be taxed as a corporation for the full taxable year.® Losses may be deducted in year sustained. — The 1921 law^° permits losses to be deducted in a year other than the one in which the loss was sustained. ^^ ' See also page 985. * Section 229 of the 1921 law is analagous to the third paragraph of section 330 of the 1918 law. »C. B. 4, page 54; O. D. 855. See also B. 29-21-1736; A. R. R. 571. '"Sections 214 (a-6) and 234 (a-4). " [Former Procedure] The 1918 and prior laws did not contain this specific provision. Losses, however, were supposed to be deducted in the year when sustained, and the Commissioner had full power to permit amended returns in cases where the discovery was in a later year. The following ruling illustrates the narrow interpretation of the 1918 law. Ruling. "The M Company in 1918 delivered under a bona fide sale goods guaranteed as to quality until July i, 1919. On inspection of a por- tion of the goods in May, 1919, they were found unsuitable, and to save loss resulting from a complete inspection a compromise resale to the M Company was effected at the original purchase price less certain con- cessions. "Held, that the M Company may not take into its inventory as of December 31, 1918, the goods delivered in that year and that the resale established a basis, in the taxable year 1919, for determining loss." (C. B. 4, page 47; A. R. M. 129.) FOR LOSSES 981 Regulation. As a general rule losses allowed under paragraphs (4)> (5)» ^i^d (6) of this subdivision shall be deducted as of the tax- able year in which sustained. In exceptional circumstances^ however, in order to avoid injustice to the taxpayer and to more clearly reflect his income, the Commissioner may permit a loss to be accounted for as of a year other than the one in which sustained. For example, an embezzlement or a shipwreck may occur in 1921 but not become known until 1922 and in such a case income may be more clearly reflected by accounting for the loss as of 1922 rather than of 1921. If a tax- payer desires to account for a loss as of a period other than the one in which actually sustained, he shall attach to his return a statement setting forth his request for consideration of the case by the Com- missioner, together with a complete statement of the facts upon which he relies. However, in his income tax return he shall deduct the loss only for the taxable year in which actually sustained. Upon the audit of the return the Commissioner will decide whether the case is within the exception provided by the statute ; if not within the exception the loss will be allowed only as of the taxable year in which sustained. The allowance of a deduction for a loss in a year other than the one in which sustained is entirely within the discretion of the Commissioner and he will consider exercising this discretion only in exceptional cases. A shrinkage in the value of the taxpayer's stock in trade, as reflected in his inventory, is not such a loss as is contemplated by the provision of the statute authorizing the Commissioner to allow the deduction of a loss for a taxable year other than the one in which sustained. (Art. 146.) The vvord "sustained" as used in the law is of doubtful meaning. If used in its ordinary meaning taxpayers should not be permitted to shift losses to periods not affected. If the word is synonymous with "discovered" it is quite proper that losses discovered in one year should not be related back to the period when sustained. The illustrations used in Art. 146 indicate that the word "sustained" is synonymous with "be- come known," and therefore with "discovered." [Former Procedure — Continued] It is obvious, in the foregoing ruling, that the loss arose in 1918. The true net income could only be determined by filing an amended return. It is assumed that the loss was an extraordinary one ; otherwise it should have been absorbed in 1919. 982 DEDUCTIONS Determination and Measurement of Property Losses The determination and measurement of losses due to a diminution in the value of property involve the same problems of procedure as those which are discussed in detail for the determination and measurement of profits from transactions in property. (See Chapter XVII.) It happens that the im- portant cases which have been decided by the Supreme Court have arisen from additional assessments imposed by revenue officers because of alleged failure to report property gains in full, but the principles established in these decisions apply with equal force to property losses. Property acquired before March i, 19 13. — The 19 16 law in referring to individuals specifically declared "that for the purpose of ascertaining the loss sustained from the sale or other disposition of property, real, personal and mixed, ac- quired before March first, nineteen hundred and thirteen, the fair market price or value of such property as of March first, nineteen hundred and thirteen, shall be the basis for deter- mining the amounts of such loss sustained. "^^ Using practi- cally the same language, section 10 of the 1916 law established this basis for corporations also. In other words, only losses sustained after March i, 19 13, are deductible. The principle laid down in the 19 18 law was the same.^^ "[Former Procedure] The 1913 law did not contain this specific provision and for a time there was doubt as to proper procedure. Under the 1913 rulings losses when deductible were prorated over the whole time the property was held, and that part of the loss apportioned to the taxable period appeared in the annual returns. The apportionment was made as of January i, 1909, in the case of corporations and March i, 1913, in the case of individuals. This procedure was disputed and there were many un- settled cases. These may now be adjusted in the light of the Supreme Court decisions discussed in detail in Chapter XVII. " [Former Procedure] It will be noticed that in the following ruling under the 1918 law no consideration was given to the cost of property acquired prior to March i, 1913. RuLiXG. "A taxpayer who. prior to March i, 1913, purchased bonds which had a market value as of March i, 1913, above par, and which were redeemed at par in 1919 is entitled to deduct, as a loss in 1919, the diflfer-. FOR LOSSES 983 The 1 92 1 law/* however, restricts losses deductible in respect of sales or other disposition of property acquired prior to March i, 191 3, to the lesser of the differences between the sale price and the cost or March i, 1913, value, respectively. Shortly stated and eliminating depreciation, obsolescence and depletion (which the law states are to be calculated upon ence between the market value on March i, 1913, and the value received in 1919 upon the maturity of the bonds." (C. B. 2, page 132; O. D. 506.) Under the 1921 law the loss would be allowed as computed in the above ruling, only if the cost prior to March i, 1913, was equal to the value of the bonds at that date. If the cost was less than March i, 1913, value the deductible loss would be correspondingly reduced. An important question to be considered is whether this restriction of the 1921 law is to be deemed to be interpretive of the corresponding loss provisions in previous laws. During 1921 the Supreme Court decided in the cases of Goodrich v. Edwards and Brcivstcr v. Walsh, that an apparent profit representing the difference between value at March i, 1913, and sub- sequent sale price was taxable only to the extent that it exceeded original cost of the property. In other words, only actually realized income was intended to be or could be taxed. The Solicitor General, in a brief filed in these cases, contended that if the taxable gain should be limited to the excess of sale price over value at March i, 1913, or cost, whichever was higher, the allowance for losses should be restricted to the difference be- tween value at March i, 1913, or cost, whichever was lower. The court, however, expressed no opinion with respect to the manner in which losses should be computed as this question was not at issue. Nevertheless, immediately after the decisions in the Goodrich and Brewster cases (prior to the passage of the 1921 law), the Treasury amended its regulations pertaining to the determination of profits or losses on sales of property acquired prior to March i, 1913, embodying therein the method of computation now prescribed by the 1921 law. In the author's opinion these regulations were illegal. The basis of taxing gains must be governed by the sixteenth amendment ; there is no inhibition regarding allowable deductions. Congress could allow taxpayers to deduct 150 per cent of losses if it cared to, but it could not increase taxable income i per cent. As the 1918 and prior laws permitted deductions on the basis of March i, 1913, values irrespective of cost, the allowance stands until December 31, 1920, when it was taken away by the 1921 law. Taxpayers who prior to 1921 were entitled to larger deductions for losses, if based on the language of the 1918 and prior laws, than are allowed under the Treasury's regulations as amended in 1921, should pay under protest any taxes assessed on the latter basis. The question has not been decided in court but it is of sufficient importance to litigate. '* Section 202 (b). 984 DEDUCTIONS March i, 1913, value irrespective of prior cost), any appre- ciation at March i, 19 13, which does. not continue until reali- zation cannot be allowed as a deduction. This is fair enough. A bond cost $700 in 1910; its market value was $900 on March i, 191 3 ; it is sold for $700 in 1922. There is no allow- able deduction for the apparent loss, based on March i, 19 13, value. If sold for $600 there is an allowable loss of $100. If the value of the bond on March i, 1913, was $600, and it is sold for $500, the allowable loss is only $100, whereas the actual loss as compared with cost is $200. In practice the 1921 law restricts allowable losses to March i, 1913, values when such values were below cost, and to cost when cost was lower than March i, 19 13, value, under the theory that what- ever taxpayers had on March i, 19 13, was their capital. The law works equitably as long as full deduction can be made when any part of such capital is lost. But when deduction is denied because March i, 1913, value is less than cost and de- duction is also denied because appreciation at March i, 1913, did not continue, the comment "fair enough" applied to the latter contingency is w'ithdrawn because the principle of capi- tal value March i, 19 13, irrespective of cost is departed from. The measure of deductible losses is not the same as that of taxable gains; but as the computation in case of gains is so nearly like the computation in the case of losses, it is easier to discuss and illustrate the computation in one place. There- fore, the discussion will be found on page 569 et seq. Property acquired after March i, 1913. — ■ Regulation. For the purpose of ascertaining the gain or loss from the sale or exchange of property, the basis is the cost of such property, or in the case of property which should be included in the inventory, its latest inventory value (Art. 1561.) Determination of value on March i, 1913 — The pro- cess of determining the value at March i, 1913, of prop- erty purchased before that date is fully discussed in Chapter FOR LOSSES 985 XVII. Suffice it to say here that the question is of enough importance to justify the collection of data which may serve to establish true values as of that date. In the absence of such data the Treasury would probably have assumed (prior to the 1 92 1 law) that the March i, 19 13, value was the same as original cost less depreciation. In view of the new defini- tion of losses deductible upon disposition of property acquired prior to March i, 1913, which is contained in the 1921 law [Section 202 (b)], it is quite conceivable that the taxpayer may be required by the Treasury to prove that the March i, 19 1 3, value was at least equal to cost of the property before allowing a loss claimed for difference between cost before and sale price after March, 1913. The 1 92 1 law provides that exchanges and reorganiza- tions are closed transations (a) when property received has a readily realizable market value, and (not "or") (b) the prop- erty received is of a different nature than that parted with.^^' These requirements are fully discussed on page 536 ct seq., and need not be repeated. Shortly stated, losses cannot be deducted unless there is a closed transaction.^® Establishment of loss by inventory method. — Inventories are now prescribed as "necessary in every case in which the production, purchase or sale of merchandise is an income- producing factor."^'' Prior to 191 7 the use of inventories was ])ermitted for the purpose of establishing gains or losses only in the case of merchants and manufacturers. For a full dis- cussion of this subject the reader is referred to Chapter XV. Permission to use the inventory method has been extended to '° [Former Procedure] The 1918 law, section 202 (b), provided that "when property is exchanged for other property, the property received in exchange shall for the purpose of determining gain or loss be treated as the equivalent of cash to the amount of its fair market value, if any." "For discussion of closed transactions see also Income Tax Procedure, 1 921, page 793 and Chapter XV. " See page 453. 986 DEDUCTIONS dealers in securities. Valuation at "cost or market whichever is the lower" is permitted/^ Inventoried shrinkage in securities deductible only BY DEALERS. — Stocks and bonds owned by others than dealers may not be revalued periodically and losses may not be charged off by the inventory method. Neither can amounts invested in foreign money be so treated when merely due to a fall in ex- changed^ Excepting when investments became worthless,^'' they must mature or be sold to establish a loss. Regulation. A person possessing stock of a corporation can not deduct from gross income any amount claimed as a loss merely on account of shrinkage in value of such stock through fluctuation of the market or otherwise. The loss allo\val)Ie in such cases is that actually suffered when the stock is disposed of (Art. 144.) When deduction for shrinkage may not be claimed BY holders of life OR TERMINABLE INTERESTS. Regulation. No deduction shall be allowed in the case of a life or a terminable interest acquired by gift, bequest, or inheritance, where the estate or trust is entitled to a deduction under the statute but there is no reduction of the income of the life or terminable in- terest. For example, an estate or a trust in a certain State sells securities at a loss; if, under the laws of that State, the beneficiary suffers no actual loss, then even though the estate or trust is permitted to deduct such loss in making its return, the beneficiary whose income has not been diminished thereby is not entitled to a deduction on ac- count of such loss but must include in his return the full amount dis- tributed or distributable (Art. 295.) '* [Former Procedure] Before December 19. 1917, shrinkage in the value of securities was not allowed as a deduction even when they were the stock-in-trade of a dealer. This position is illustrated by the following Treasury decision : Regulations. "This ruling, in so far as it relates to depreciation .... is not to be construed as recognizing any gain or loss due to fluctuations in the market value or arbitrary changes in the book value of securities and like assets, the gain or loss with respect to which will be determined only when such assets mature, or are sold or disposed of — that is, when there is a completed, a closed, transaction." (T. D. 2077, November 21, 1914.) "Losses of this character are only ascertainable when the securities mature, are disposed of, or cancelled." (T. D. 2152, February 12, 1915.) ^«C. B. 4, page 155; O. D. 764. "■" See page 988. FOR LOSSES 987 Section 215 (b)"'' of the 1921 law, on which the above article is based, enacted into law the procedure laid down by the Treasury in article 347 of Regulations 45. That article gave effect to an interpretation for which there was little or no warrant in the law itself." German investments — when determined worthless. — When securities bought in Germany for 300,000 marks (value at time of purchase $9,000) are sold for 500,000 marks (value at time of sale $5,000), the loss of $4,000 is deductible from income.^^ Ruling. Receipt is acknowledged of your letter of the loth inst., in which you state an American corporation owns some German investments. You desire to be advised whether or not this corpora- tion can charge ofif such investments as an actual loss and deduct the same in preparing its return of annual net income with the under- standing that any amounts subsequently received will be credited to income in subsequent years. In reply you are informed that the tax law makes an allowance for a deduction from gross income of all losses actually sustained by a corporation during the year for which the return is made. However, in the case you mention it does not appear that a loss which is definitely known has been sustained from a closed and completed transaction. Therefore, it is necessary to hold that the American corporation in question can not deduct an amount repre- senting a part or the whole of the German investments inasmuch as at best this deduction would be merely estimated and not a loss from a closed and completed transaction. (Letter to Lybrand, Ross Bros. & Montgomery, New York, signed by Deputy Commissioner L. F. Speer, and dated September 18, 1918.) Russian investments. — Ruling. Because of disturbed political conditions in Russia there is little hope that bonds of the Imperial Internal Russian 4 per cent loan of 1894 will be redeemed. A holder of such bonds which were purchased in 1916, who was unsuccessful in finding a market for them during the year 1919, is entitled to a deduction from his gross income for that year to the extent of the amount actually paid for them, provided, however, that such amount is "See Chapter XXXVII for text. "This question was discussed at some length in Incnme Tax Procedure, 1921, pages 1040-1046. ^C. B. 4, page 234; O. D. 809. 988 DEDUCTIONS charged off the taxpayer's accounts for tlie year 1919 and a cor- responding reduction made in his surplus account. ( C. B. 3. page 167; O. D. 748.) Losses on Liberty bonds distributed in dividends. — The recipieiit of a dividend paid in Liberty bonds or other securi- ties should return the dividend for taxation at the market value of the securities at the time of their receipt."* The cor- poration paying the dividend should charge to dividend ac- count the market value of the securities distributed. If the market value at time of distribution is less than the price paid for the securities, the difference should be charged off as a loss. The Treasury held in an earlier ruling that such a loss is not an allowable deduction,"^ on the ground that a transaction conducted by a corporation with its stockholders is not of a character to affect the amount of its net income. This argu- ment was inconsistent with the Treasury's rulings, to the effect that the corporate entity must be disregarded when used to avoid the payment of tax on income. This inconsistency was evidently recognized, since in a later ruling^® the Treasury allowed as a deduction the net difference between the market value at March i, 1913, of securities and their value when distributed as a dividend in 191 7. When deduction may be claimed for shrinkage. — Regulation However, if stock of a corporation be- comes worthless, its cost or other basis determined under section 202 may be deducted by the owner in the taxable year in which the stock became worthless, provided a satisfactory showing of its worthlessness be made, as in the case of bad debts. Where banks or other corpora- tions which are subject to supervision by Federal authorities (or by State authorities maintaining substantially equivalent standards) in obedience to the specific orders or general policy of such supervisory officers charge off stock as worthless or write it down to a nominal value, such stock shall, in the absence of affirmative evidence clearlv '-* See article 1544, page 579. ='C. B. I, page 28; O. D. 262. '' C. B. 4. page 27 ; A. R. R. 435. FOR LOSSES 989 establishing the contrary, be presumed for income tax purposes to be worthless.-' .... (Art. 144.) Heretofore when a taxpayer has had worthless stocks he has been compelled to go through the farce of selling them to someone for a dollar before the loss could be deducted. Losses on sales of securities.— There has never been any question as to the deductibility of losses sustained by corpora- tions arising out of the sales of securities (treasury assets) at less than cost, because there were no limitations in the sec- tions of the laws relating to corporations such as formerly ap- plied to individuals. But a loss must be actually "sustained" to be an allowable deduction. It must have more evidence than a book entry to support it. When sales of assets are made to stockholders at less than book value the burden of proof is on the corporation to show that the sales prices are fair and reasonable. Otherwise it can hardly be held that an actual loss has been sustained. If sales to stockholders are made at less than book value, and also at less than market or fair value, the stockholders have, in effect, made a "bargain" purchase. If sales by the individuals are made subsequently at prices higher than cost the resulting profit no doubt will be reported, but such pro- cedure will not offset the fictitious loss created on the cor- poration's books if the corporation has taxable income sub- ject to the excess profits tax. Corporations selling securi- ties to their own stockholders at less than fair or market value cannot expect to secure credit for any book loss created thereby. If, however, the corporation is not permitted to deduct the loss, the stockholders cannot be charged with having made a bargain purchase, and upon any resale they would be taxable ■'' [Former Procedure] Reg. 45 (iyi8), Art. 144, specifically excluded "dealers in securities" from the provisions of that article. The omission in the present article has no significance in that "dealers in securities" are allowed to inventory their securities on hand. 990 DEDUCTIONS only upon the price realized in excess of the book value of the securities as shown by the books of the corporation.^^ The basis for determining the loss when securities of the same issue, which were bought at different prices, are sold at a loss is given on page 587. Ruling, (i) Where a new corporation is organized having the same stockholders with the same stockholdings as the old cor- poration, to which the old corporation transfers a large amount of stocks and bonds at a loss, less than one per cent of the purchase price being paid in cash and the balance being paid for by notes secured by the stocks and bonds sold, possession of which was re- tained by the old corporation with power of sale in case of default, the new corporation having no other assets, the whole transaction will be regarded as a sham and a subterfuge to evade taxation and the loss will be denied (C. B. 3. page 160; L. O. 1035, re- vised.) In the foregoing ruling the Treasury did not hesitate to disregard the corporate entities. Contributions by stockholders. — The stockholders of a cor- poration "on the verge of bankruptcy" in 1920 surrendered 70 per cent of their stock to the creditors. The owner of 100 shares had paid $10,000 for it; he retained 30 shares. The Treasury held that the 30 shares must be carried as worth $10,000 "until the stock now held is sold or otherwise dis- posed of, or becomes worthless, in whole or in part."^** The ruling fails to pass on the allowable deduction. In view of the imminence of bankruptcy, it would seem that the $10,000 had become worthless "in part" at least, to the extent of $7,000. Assessments on stock. — Regulation An assessment paid by a stockholder of a national bank on account of his statutory liability .... may in certain cases represent a loss (Art. 293.) -* Reg. 62, Art. 147. For full discussion see page 994. ^1-3-33; I-T. 1 168. FOR LOSSES 991 Application of tax-free distributions in computing losses. — Law. Section 201. .... (b) .... If any such tax-free distri- bution has been made the distributee shall not be allowed as a deduc- tion from gross income any loss sustained from the sale or other dis- position of his stock or shares unless, and then only to the extent that, the basis provided in Section 202 exceeds the sum of (i) the amount realized from the sale or other disposition of such stock or shares, and (2) the aggregate amount of such distributions received by him thereon Regulation A distribution made by a corporation out of earnings or profits accumulated or increase in value of property accrued prior to March i, 1913,-"'^ is exempt from tax, even if in excess of the cost or other basis provided in articles 1561-1563 and 1568, of the stock on which declared. However, where any tax-free distribution out of earnings or profits accumulated or increase in value of property accrued prior to March i, 1913, has been made, the distributee can not deduct any loss from the sale or other disposition of the stock unless and then only to the extent that the cost, or other basis, exceeds the sum of (i) the amount realized from the sale or other disposition of the stock, and (2) the aggregate amount of such distributions re- ceived by him thereon. Example. — A purchased certain stock subsequent to March i, 1913, for $10,000 and received in 1921 a distribution thereon of $2,000, paid out of the earnings of profits of the corporation accumulated prior to March i, 1913. This distribution does not constitute taxable income to A. If A subsequently sells the stock for $6,000 a deductible loss of $2,000 is sustained. If he sells the stock for $12,000, a tax- able gain of $2,000 is realized. No gain or loss is recognized if he sells the stock for an amount ranging between $8,000 and $10,000 (Art. 1543.) In the foregoing example the question of whether cost or value at March i, 19 13, is to be used as a basis for computing gain or loss is not considered since the stock was acquired after March i, 1913. Assume A owns 100 shares of stock purchased in 19 10 for $10,000, and that at March i, 191 3, the value of such stock was $15,000. In 1918 and 1919, A receives $2,000, "dividends" paid out of earnings accumulated prior to March "" See pages 715-718. 992 DEDUCTIONS I, 1913, or out of appreciation accrued at that date.'^ In 1921, A sells his 100 shares for $7,000. Under section 202,^^ A would determine his loss by deducting the sales price ($7,000) from the cost ($10,000) (since the March i, 19 13, value $15,000 is higher than cost). The resulting loss is $3,000. But "the amount realized from the sale" ($7,000) plus the tax-free "dividends" ($2,000), or a total of $9,000, when compared with the cost ($10,000), results in a loss of only $1,000. In other words, the loss which would ordinarily be deductible ($3,000) is reduced by the aggregate amount of the tax-free "dividends" ($2,000). In case a gain is realized, the tax-free distributions are ignored. If in the illustration above the 100 shares had been sold in 1 92 1 for $20,000, the profit would be $5,000 (excess of sales price, $20,000, over ]\Iarch i, 19 13, value $15,000). Stated in tabular form we have : Case "A" (a) Cost of Stock- before 1913 $10,000 (b) Value of Stock March i, 1913 $15,000 (c) Tax-free 'Dividends $2,000 (d) Sale Price $7,000 (e) Loss under Section 202 (a-d) $3,000 (f) Loss to be Reported in Tax Return (a-c-d) $1,000 Case "B" (a) (b) (c) (d) (e) (f) Cost of Value of Tax-free Sale Gain Gain to be Stock Stock "Dividends" Price under Reported in before March i. Section 202 Tax Return 1913 1913 (d-b) same as (e) $10,000 $15,000 $2,000 $20,000 $5,000 $5,000 It is well to note that if the sales price falls between the reduced basis (cost, or market value March i, 191 3, minus tax-free dividends) and said basis before reduction by the amount of tax-free dividends, no gain or loss is recognized. For example, if in case A above, the sales price had been $9,000, ^' For discussion of appreciation realized through depletion charges, see Chapter XXXIII. '' See page 569. FOR LOSSES 993 there would be no loss. In case B above, if the sales price had l)een $14,000, there would be no gain because the sales price lies between cost ($10,000) and value March i, 1913, ($15,- 000). In the latter case the tax-free "dividend" ($2,000) is ignored. ^^ "Wash sales" for the purpose of establishing losses. — So long as accrued losses (shrinkage in values of securities) are not deductible until "evidenced by closed transactions" it is only natural that attempts should be made to convert. paper losses into actual losses in order to obtain the benefit of the deduction. If securities are sold at a loss to a bona fide buyer, with no agreement to repurchase nor any similar agreement, the loss has been legally established and becomes an allowable deduction. Sales through a stock exchange are actual and completed transactions because the seller has no control over the buyer. Subsequent repurchase of a similar amount of se- curities does not affect the bona fides of the transaction be- cause the buyer takes a chance of having to pay a higher price and the transaction is in fact a new deal.^^ Nevertheless the following section of the 1921 law must be considered : ^^For illustrations of gain or loss from liquidating dividends, see Art. 1545, page 749- " [Former Procedure] Prior to the passage of the 1921 law, "sales to establish losses" were not in most cases questioned by the Treasury, as is evidenced by the following ruling issued in 1919: Ruling. If a taxpayer makes an actual bona fide sale of securities at a loss in 1918, the loss is deductible even though the taxpayer repur- chases the securities in the succeeding year at the same price for which they were sold. However, the burden of proof will be on the taxpayer to show that the sale was not fictitious. (C. B. i, page 124; O. D. 103.) In another case a taxpayer offered stock at public auction, with in- structions to buy it in for his account if there were no other bidders. It was bought in for his account at a nominal price. The Treasury held that "the facts failed to disclose an actual sale of the stock in question. .... A person cannot be both seller and purchaser in the same transaction." (I-S-53; I- T. 1181.) Under the 1921 law such a loss would also be disallowed because of the repurchase "within 30 days." gg^ DEDUCTIONS Law. Section 214. (a) .... there shall be allowed as deduc- tions : (5) .... No deduction shall be allowed under this paragraph for any loss claimed to have been sustained in any sale or other disposition of shares of stock or securities made after the passage of this Act where it appears that within thirty days before or after the date of such sale or other disposition the taxpayer has acquired (otherwise than by be- quest or inheritance) substantially identical property, and the property so acquired is held by the taxpayer for any period after such sale or other disposition. If such acquisition is to the extent of part only of substantially identical property, then only a proportionate part of the loss shall be disallowed; .... The following regulation outlines the procedure under the 1 92 1 law: Regulation. An individual, other than one in the trade or busi- ness of buying and selling securities, or a corporation, other than a dealer in stocks or securities, can not deduct any loss claimed to have been sustained from the sale or other disposition of stock or securi- ties made after November 23, 1921, if within 30 days before or after the date of such sale or other disposition the taxpayer has acquired (otherwise than by bequest or inheritance) substantially identical property, and the property so acquired is held by the tax- payer for any period after such sale or other disposition. If such ac- quisition is to the extent of part only of substantially identical prop- erty, then only a proportionate part of the loss shall be disallowed. .... This provision is designed to prevent a taxpayer who owns securities, other than one in the trade or business of buying and selling securities, from selling and immediately repurchasing them or from purchasing substantially identical property and immediately selling the original securities and claiming as a deduction in com- puting net income the so-called "loss" sustained therefrom. Gain or loss, however, is realized in the case of the "short sale." Under this section a taxpayer owning a hundred shares of stock in the X company, who purchases another hundred shares of stock in the X company and within 30 days thereafter sells the first purchased stock of the X company, can not deduct in computing net income any loss claimed to have been sustained from the transaction ; if he sells the entire 200 shares of stock, a gain or loss from both transactions is realized at that time ; and if he sells the stock of the X company in- cluded within the second purchase a gain or loss is realized thereby. (Art. I47-) The 192 1 law and the regulations are fair enough and will not result in any great hardships. FOR LOSSES 995 It is to be noted that sales made on or prior to November 23, 1 92 1, (the date the 1921 law was passed) are not affected by the above provision. The status of such sales is the same as it would have been under previous laws. The foregoing section applies to individuals but there is a similar provision applicable to corporations"^ which includes the statement, however, that the loss is to be allowed if "such claim is made by a dealer in stock or securities, and with re- spect to a transaction made in the ordinary course of its busi- ness." The section quoted above,^® applicable to individuals, does not contain a similar statement because individuals or partnerships recognized as dealers in securities would not claim deductions for their losses on securities, under section 214 (a-5), but under section 214 (a-4), which latter section allows a deduction for "losses .... incurred in trade or business." Section 214 (a-4) does not contain the thirty-day limitation on re-acquirement of securities sold at a loss. Where deductions are not allowed under section 214 (a-5) or 234 (a-4), the securities acquired are deemed to have taken the place of the securities sold. In the case of subsequent sale of the acquired securities the cost or March i, 1913, value, of the original securities would form the basis of loss sus- tained or gain derived therefrom. [See Section 202 (d-3) of the law, and article 1567.] Losses arising from the sale of property acquired by gift. — Prior to 1921, deductible losses arising from the sale of prop- trty by donees were comparatively easy to determine. Losses consisted of the difference between the value of gifts when received and the proceeds of sales. Under the 192 1 law the basis of loss^^ is "the same as that which it would have in the hands of the donor or the last preceding owner by whom it was not acquired bv gift." '" Section 234 (a-4). "Section 214 (a-5). " Section 202 (a-2). 996 DEDUCTIONS In discussing gains realized by donees,^^ the difficulty of securing information was mentioned. It will no doubt be more difficult to secure data from donors regarding gifts when values have declined. In such cases donees will fail to receive the benefit of deductions to which they are entitled. It may be that any loss will be denied on the ground that the transaction was not entered into for profit, but the Treasury has specifically ruled that losses arising from property ac- quired by gift or inheritance may be deducted. ^^ The provision of the law is of doubtful legality and ex- pediency but its evolution will be interesting. Congress may have invented a new method of reducing taxes. A taxpayer not subject to tax, owning investment property greatly depreciated in value, may make a gift of such prop- erty to another taxpayer subject to high surtax rates and the latter may sell the property and claim a very large loss. Losses in speculation. — If a taxpayer buys "futures," hop- ing to sell the contracts at a profit, and instead is compelled to sell at a loss and claims credit for the loss in his income tax return, it becomes specifically an unlimited deduction under the 192 1 law, and would also have become so under the 1918 law. Under the 1913 law the loss would not have been de- ductible. Under the 19 16 and 19 17 laws the loss would have been deductible to an amount of profits derived from similar transactions. *° Losses on sale of capital assets. — The chapters on appre- ciation in values (XVTI) and sales and exchanges (XVI) ^' See page 623. ^ See page 620. *" [Former Procedure] Decision. "Losses incurred by a member of a partnership, engaged in manufacturing jute bags and bagging, through his individual dealings on a cotton exchange are not incurred in trade within the meaning of section II, subdivision B of the act of 1913, and therefore are not deductible in computing net taxable income under that act." Mente v. Eisner, 266 Fed. 161 ; T. D. 3029. FOR LOSSES 997 deal with the principles which underlie the deductibility of losses as well as the taxability of profits. It is therefore un- necessary to repeat under this subject heading the comments which are found in the chapters mentioned. Losses must be sustained bona fide. — The Treasury has ruled that when property acquired by gift is transferred or ostensibly sold for considerably less than its actual value, the difference between actual value and the sales price is a gift and is not an allowable loss to the donor.*^ The ruling is sound. Deductions for losses should be those sustained bona fide. Losses due to scrapping of buildings and machinery de- ductible. — Regulation. Loss due to the voluntary removal or demolition of old buildings, the scrapping of old machinery, equipment, etc., in- cident to renewals and replacements will be deductible from gross income in a sum representing the difference between the cost of such property demolished or scrapped and the amount of depreciation sustained with respect to the property prior to its demolition or scrapping, and allowable as a deduction in computing net income. .... (Art. 142.) Depreciation is an allowable deduction but not a com- pulsory deduction. If insufficient or no depreciation has been charged over a term of years, it is true that a strictly accurate method of accounting would call for the reopening of accounts for the entire past period, the restatement thereof and the preparation of revised profit and loss accounts. But business could not be conducted that way. Neither can it be expected that tax returns for past periods can be amended every time an item applicable to prior years turns up. The foregoing regulation if strictly construed would call for amended re- turns for as many years as elapsed during the time when in- sufficient or no depreciation was charged. If the amount in- volved is substantial, amended returns must and should be C. B. 4, page 45; O. D. 847. 998 DEDUCTIONS prepared. The regulation, however, can hardly be intended to control the usual adjustments which are always necessary in dealing with depreciation, because exact rates will never be available. In most cases it will be sufficient to charge off the entire book loss during the period in which it is ascertained. The law itself seems to permit this. Ruling. When property is discarded and salvaged, the deprecia- tion allowance plus the salvage value may slightly exceed or fall slightly below the cost of the property. In the case of a gain over cost this must be treated as income. If the depreciation allowance plus salvage falls below the cost, the difference may be treated as a loss. The fact that a taxpayer in past years neglected to allow for suffi- cient depreciation does not make the resulting discrepancy between the book values of equipment and its salvage value at the time it is retired from service deductible as a loss within the intent of Section II G(b) second, act of October 3, 1913. In such cases the taxpayer may avail himself of a larger deduction for depreciation by submit- ting amended returns for previous years, and showing that the pre- vious depreciation rate was not reasonable. (C. B. i, page 120; S. 1217.) Cost of demolishing old building on new site not deductible as loss. — Regulation When a taxpayer buys real estate upon which is located a building which he proceeds to raze with a view to erecting thereon another building, it will be considered that the taxpayer has sustained no deductible loss by reason of the demoli- tion of the old building, and no deductible expense on account of the cost of such removal, the value of the real estate, exclusive of old improvements, being presumably equal to the purchase price of the land and building plus the cost of removing the useless building. (Art. 142.) This regulation is sound because all so-called expenses in construction enterprises are proper capital expenditures, and the cost of demolition of an old building is a capital charge. This rests on the principle that there can be no operating loss or expense in a new' business until after the business com- mences to operate. Rulings. A taxpayer sustains no deductible loss in the demoli- FOR LOSSES 999 tion of 80 per cent of his building for the purpose of reconstruction. The amount expended is an investment of capital and should be considered as a part of the cost of reconstruction. (C. B. 4, page 164; O. D. yyi.) Improved real estate consisting of several frame dwellings was purchased primarily for the purpose of enlarging a business plant. No deductible loss was sustained by reason of the sale of the build- ings apart from the land for their salvage value, notwithstanding the fact that the taxpayer would have paid considerably less for the property had it been aware at the time of purchase of a fire regula- tion, then in effect, which prohibited the moving of the buildings. The value of the land exclusive of the buildings is presumed to be equal to the purchase price of the land and buildings less the amount received as salvage. (B. 37-21-1816; O. D. 1031.) Business Losses The language of the statute is so broad in dealing with business losses that the problems of procedure are few and simple. Losses incurred in transactions entered into for profit.-^— Under section 214 (a-5) of the 1921 law an individual may deduct all net losses "if incurred in any transaction entered into for profit, though not connected with the trade or busi- ness." The chief factors which decide the deductibility of this dass of losses are : 1. The loss must be an actual one. It must be more than conjectural. Generally speaking, the taxpayer must be "out of pocket" the amount of the loss. 2. The loss must have been sustained during the tax- able year. If at the end of the preceding taxable year a tax- payer had mentally "charged off" a loss, it would not come within the Treasury's interpretation of when a loss occurs. The Treasury in its regulations dealing with a closed trans- action fixed the date practically at the time of the obsequies and not at the time of death. For example, if a taxpayer pur- chased stock for $100 a share in 1921 and sold it on January 2, 1922, for $1 a share, the Treasury holds that the loss looo DEDUCTIONS was not sustained until 1922, even though the value of the stock on December 31, 192 1, was the same as on January 2, 1922. 3. The transaction must have been undertaken for profit. If a man buys an automobile for pleasure purposes at one price and sells it for a lower price, the loss sustained is not deductible. If a man buys or builds a residence for his own occupancy and sells it for less than cost, the Treasury holds that the loss is not deductible.*^ 4. As heretofore stated, it must be a net loss. Any in- surance, etc., received must be credited against the gross loss sustained. Rulings. Section 214 (a) 5, Revenue Act of 1918, does not contemplate that a distinction shall be made between an investment in property or securities with the object of deriving an income from the capital employed, and an investment which is made for the pur- pose of realizing a profit on the resale of the property or securities purchased. (C. B. i, page 124; O. D. 138.) A loss sustained from the sale of property acquired by gift, be- quest, devise, or descent (whenever property so acquired is as a matter of fact acquired for purposes of profit) is a deductible loss from gross income. Ordinary investment property so acquired is to be treated as having been acquired for purposes of profit unless the conduct of the recipient furnishes evidence to the contrary. (C. B. i, page 122; T. B. R. 35.) If a taxpayer purchases royalty interests in tracts of oil land (not including title to the land itself) and such interests prove worth- less, as evidenced by all wells drilled proving dry or failing after producing very small quantities of oil, the loss sustained is an allow- able deduction from gross income. (C. B. 2, page 128; O. D. 375.) Losses arising from cancellation of contracts. — Ruling The question under consideration is whether a sum paid in 1919 by a company to be relieved from a contract for de- livery of goods in 19 18 and 1919 is deductible in 1918, the year in which the matter was negotiated, though the final agreement and adjustment and payment was not made until 1919 Reg. 62, Art. 141. See page 1002. FOR LOSSES lOOl In the present case the amount to be paid for the cancellation of the contract was not determined nor paid until 1919. The loss was not a closed and completed transaction until that time. Negotiations were entered into in 1918, but the final outcome of the same or the amount to be paid as liquidated damages, was not, and from the nature of things would not be, known until the final agreement and adjustment had been made It is held that where a corporation pays liquidated damages in 1919 to be relieved from the terms of a contract which called for the delivery of goods in 1918 and 1919, the loss so incurred is deductible from gross income for the year 1919 rather than 1918. (C. B. i, page 217; S. 983.) The foregoing ruling may be sound when apphed to the specific facts in the case under review. The general prin- ciples laid down are, however, subject to criticism. In the case of government contracts canceled prior to but unsettled at December 31, 1918, the Treasury took the position in Regulations 45 that upon settlement thereof after 1918 any additional profit must be accounted for in 1918.*^ The foregoing ruling holds to the contrary. Since the Treasury shifts its position according to the nature of the case, it is not wise to apply general principles to any case. In a later ruling it is held that amended returns may be made to adjust items applicable to prior years.** Losses sustained by individuals. — Losses deductible by an individual are described in the law by three phrases : first, losses incurred in trade or business; second, net losses sus- tained in transactions not connected with trade or business, when the transactions were entered into for profit; third, net losses sustained in transactions not connected with trade or business if arising from fire, storm, shipwreck or other casu- alty or from theft. In all the foregoing it will be noted that the losses must be "net" losses — that is, the actual money loss sustained by the taxpayer. If reimbursed in whole or in part by an insurance ■"''For adjustment of government contracts, see page 532, Chapter XV. "C. B. 3, page 147; A. K. K. 273. I002 DEDUCTIONS company or compensated in any other way, the loss is not a net loss except as to any part not reimbursed. This is not intended to mean that the taxpayer cannot de- duct a loss based upon a revaluation. This point is covered on page 569. It may be further amplified in case the bene- ficiary of an estate subsequently sells stocks, bonds or any kind of property at a price less than the fair market or ap- praised price at the time when the property was received. ^^ The measure of deduction is based entirely upon the valuation at the time when the property changed hands, and the loss is just as much deductible by the beneficiary of the estate as if the beneficiary had paid in cash the amount of the appraised value. This, of course, is subject to a general rule that de- preciation must be always taken into consideration, but the rule depends on whether depreciation is an allowable deduc- tion or not.*** Furthermore, the loss must be a property loss. Losses from casualties, thefts and other causes produce consequential losses which are in addition to and grow out of property losses, but the words "arising from" cannot be construed broadly enough to include anything but the loss of property itself. Rulings. An amount paid by a former director of a bank in compromise of a suit against him by a receiver for dereliction and neglect of duty as such director is deductible as a loss within the meaning of section 214 (a) of the Revenue Act of 1918. (B. 45- 21-1908; O. D. 1091.) Damages paid by a taxpayer engaged in the real estate business pursuant to a judgment against him for misrepresentation of land sold are deductible from gross income under section 214 (a) 4 of the Revenue Act of 1918. ( B. 29-21-1734; O. D. 978.) Loss on sale of individual's residence. — Regulation A loss on the sale of residential property is not deductible unless the property was purchased or constructed Regarding losses on gifts, see page See page 573. FOR LOSSES 1003 by the taxpayer with a view to its subsequent sale for pecuniary profit (Art. 141.) If a taxpayer buys or builds or inherits a house (which he occupies as a residence), and sells it for less than cost, or value March i, 1913, it cannot be claimed that the loss has been sustained in trade or business. Profits from any source are taxable, but losses are deductible only to the extent mentioned. If, however, the house is destroyed by casualty and not com- pensated by insurance, the actual loss is deductible since it happens to fall within a specific provision of the law. Rulings. A loss sustained by an individual from the sale of residential property is deductible in determining net income for pur- poses of the Revenue Act of 1918 only when the property was pur- chased or constructed by him with a view to its subsequent sale for pecuniary profit. The intent in purchasing or constructing the prop- erty is a question of fact determinable in each case by evidence which should be submitted with the return. (C. B. i, page 117; O. 780.) A loss resulting from the sale of a taxpayer's residence caused by the acceptance of a business proposition requiring his removal to another part of the country is not a loss incurred in business or trade which is deductiljle under the Revenue Act of 1917. (C. B. 2, page 129; A. R. R. 96.) The subletting of an apartment by a tenant on account of being required to make his residence in another city is held not to be a "transaction entered into for profit." Therefore any loss sustained through such transaction is not deductible from gross income. (C. B. I, page 124; O. D. 42.) The last quoted ruling is not sound and should be con- trasted with a more recent office decision wherein it was held that a taxpayer who lives in an apartment where it was the custom of the residents to sublease their apartments for the summer months, may deduct the rent paid during the time the apartment was sublet. ■*' Ruling. A taxpayer purchased ])i()])erty in 1917 for use as a personal residence, for which he paid 14.1' dollars. He made additions and betterments costing 4.1- dollars. He used the property as a per- sonal residence until 1919, when he moved elsewhere and rented it. " B. 50-21-1972; O. D. 1 134. I004 DEDUCTIONS In 1920 he sold the property for I3>^a' dollars, and claimed a deduction of 4y2X dollars as a loss arising from the sale. It is held that if a loss is deductible at all it is deductible under section 214 (a) 5 of the Revenue Act of 1918 as a loss sustained in a transaction entered into for profit. However, the mere renting of property purchased without the intention at the time of purchase of making a pecuniary profit thereon does not constitute a "transac- tion entered into for profit" within the meaning of the statute, and as the taxpayer in the instant case purchased the property for a home, it was not his intention at the time to subsequently sell it for profit. It is therefore held that any loss sustained is not deductible for the purposes of the Revenue Act of 1918. (B. 52-21-1992; O. D. 1 148.) The question may well be raised, however, whether, after a taxpayer has discontinued using a dwelHng for his resi- dence and rents it to others, he has not at that time entered into a transaction for profit — the ownership of the dwelHng no longer representing property held for personal use but ah income-producing investment — so that if any loss w^ere sus- tained upon eventual sale of the property it would be properly deductible. Losses of the nature of personal expense not deductible at all. — It should be observed, first of all, that certain indi- vidual losses are not covered by any of the law's provisions. The law apparently considers as personal expense such losses as are not incurred in business or trade, nor due to casualty or theft, nor incurred in transactions entered into for profit outside one's own business. The Primer gives the following examples of losses of this non-deductible type. Rulings. John Doe, while driving an automobile, ran down and injured another person. He either paid over a certain sum, or paid a judgment rendered against him, in settlement of the injury done. Can he claim the amount so paid as a loss? No. It was not a loss which was incurred in the conduct of his business or trade, or which resulted from a transaction entered into for profit.''^ {Income Tax Primer, 1918, question 81.) A professional man or a merchant owns and operates a ''fancy C. B. 4, page 159; A. R. R. 444. FOR LOSSES 1005 stock farm." The expenses of operation exceed the gross receipts. Can the difference be claimed as a deduction under the head of '"losses"? No. It is held that where a farm is operated for purposes of recreation or pleasure, and not primarily for profit, but as a hobby, that farm is not to be classed as a commercial enterprise, that it does not form a part of its owner's business or trade and until it is placed upon a profit-paying basis the gross receipts are not to be reported under "gross income" and the expenses are not to be claimed as a deduction. This ruling, of course, precludes the claiming of the difference between the two amounts as a loss. (Income Tax Primer, 1918, question 85.) Individual's share of partnership losses deductible. — Regulation. Where the result of partnership operation is a net loss, the loss will be divisible between the partners in the same pro- portion as net income would have been divisible, and may be used as a deduction by the individual partners in their returns of income. (Reg. 33, 1918, Art. 30.) The loss must be as ascertained at the end of the fiscal year of the partnership. If an individual has not changed his taxable year from the calendar year (as he is permitted to do) to a fiscal year which agrees with that of his firm, never- theless the item of deduction representing his share of the partnership loss will be the amount shown by the partnership books, and, if a loss has accrued to the partnership between the end of its fiscal year and December 31, the individual must not claim credit therefor until the following year. By that time the apparent loss to December 31 may be absorbed by profits thereafter. The point to observe is that the amount of the deduction should agree exactly with the partnership books (subject to adjustment for tax-exempt interest, etc.) as closed for one full fiscal year.*^ Individual's share of corporation losses. — When an indi- vidual is compelled to pay all or part of a corporation's losses it is important to consider the transaction from the points of view of both sides. It has been decided that a debt forgfiven See Chapter XXIV, page 803 et scq. Rx^i DEDUCTIONS is iu>t income to tlio (.lobior. If not income to the debtor, be- cause it was a t;iTt, it would not be deductible by the giver.''° In many cases, however, the giver is fully justified in wishing to deduct the payment as a loss and is not concerned with how the debtor treats it. When payments are made to a corporation to pay its debts or to wipe out a deficit or for any reason other than that of furnishing new capital to continue in business, the giver should specify that the amounts paid to the corporation are loans or advances and not additional payments of capital. If the loans cannot be repaid the amounts advanced may be charged off as bad debts. Regulation. The cancellation and forgiveness of indebtedness is dependent on the circumstances for its effect. It may amount to a payment of income or to a gift or to a capital transaction (Art. 50.) Ruling. The surrender of stock for the purpose of wiping out an operating deficit can not be made the basis of a deduction in the returns of the individual stockholders. (C. B. i, page 126; O. D. 216.) If the foregoing ruling is sound (which is doubtful, because some elements of a realized loss are present) the stockholders should be able by sale or otherwise to conform to the tech- nical requirements of the Treasury and establish the loss. Losses in illegal transactions may be deductible. — The Treasury has taken the position that profits arising out of illegal transactions are taxable, but the new- regulations are silent as to deductions for losses sustained on illegal transactions.''^ Section 214 (a-5) specifically permits the deduction of all losses if incurred in "'any transaction entered into for profit." As stated on page 447, recent federal law^s have omitted the word "lawful" and income from gambling transactions is unquestionably taxable. If a taxpayer enters into an illegal '""IJ. S. V. Orcgon-ll'ashiiifjfon R. & Nav. Co., 251 Fed. 211, 1918. " [Former Procedure] Reg. 45. Art. 141, provided that "losses in illegal transactions are not deductible." FOR LOSSES 1007 transaction he naturally hopes to make a profit out of it. If such profit is realized it is taxable. If it results in a loss, under the law it would seem to be a deduction. The law does not say "any lawful transaction," but does say "any transac- tion." When gambling is lawful losses are deductible. — Ruling It is accordingly held that: (i) The entire amount of winnings from all wagering contracts should be returned in gross income under section 213 (a) of the Revenue Act of 1918, irrespective of the nature of the transaction, whether legal or illegal and notwithstanding the laws of the state in which such contracts are made. (2) If, under the laws of the state in which the wagering con- tract is made betting or gambling is prohibited, such transactions are illegal and no deduction may be claimed under section 214 (a-5) of the statute for losses sustained in such illegal transactions, but if the laws of the state in which the wagering contract is made do not prohibit betting or gambling, such transactions are lawful and the entire amount of the losses sustained in the transactions may be deducted from gross income under section 214 (a-5). (Letter to The Cor joration Trust Company, signed by Acting Commissioner Paul F. Myers, and dated July 12, 1920.) It would seem from the foregoing that losses at Monte Carlo are fully deductible. I^osses which are considered capital expenditures. — A cor- poration, in order to obtain possession of its property, and faced with a lawsuit, compromised with a third party by pay- ing an amount in settlement of certain claims. Ruling. The Committee finds that an amount paid by the M Corporation to C in 191 7 either constituted the purchase price of the interest which he had acquired through the arrangement originally entered into before incorporation between A and B^ stockholders, and himself, or that the amount was paid to him by way of compromise to perfect the title of the corporation to certain property. In either event it was not a loss nor was it properly chargeable to the current expenses of the year. It was a capital expense and recoverable through depletion and depreciation deductions over the life of the property. (B. 51-21-1982; A. R. R. 701.) ioo8 DEDUCTIONS Losses Arising from Fire, Casualties, Theft, etc. The law includes among the allowable deductions, in the case of individuals and corporations, all "property" losses "arising from fires, storms, shipwreck or' other casualty or from theft, and if not compensated for by insurance or other- wise." Such losses are deductible in full by an individual irrespective of whether or not the property lost was invested in a business or trade. "^^ Ruling. If an automobile is purchased with the intention of using it in a business and it is appropriated to business uses primarily a loss sustained through its sale may be deducted in computing net income notwithstanding its occasional use for pleasure purposes. (C. B. 4, page 163; O. D. 943.) Since there is provision in the law for business losses, and since Congress provided also for "other" losses, it may be pos- sible to include losses due to destruction of, or damage to, automobiles, yachts and all sorts of personal property. The author is of the opinion that such losses should be held to be personal or family expenses, and not the sort of property losses properly deductible; but if Congress has deliberately provided otherwise, taxpayers cannot be criticized for claim- ing the deduction. RuLiNG-s. A loss sustained by reason of the damage of a pleasure automobile, due to an accident attributable to the icy condition of the streets, is not deductible under the provisions of section 214 (a) 6 of the Revenue Act of 1918, as a loss sustained by "other casualty." (C. B. 3, page 158; O. D. 629.) A loss may be claimed by the owner of a business truck demolished in collision with a pleasure car provided that the truck was in use "[Former Procedure] Under the 1913 law the Treasury took the opposite position. Thus T. D. 2005 (July 8, 1914) definitely asserts that only those losses are deductible which are sustained during the tax year "in trade." Section 5 [a] fifth, of the 1916 law permitted a limited deduction of losses in transactions entered into for profit but not connected with one's business or trade. The words "other casualty" and "theft" appeared first in the 1916 law [section 5 (a)]. The phrase "and from theft" in the 1916 law is superseded by the phrase "or from theft" in the 1918 law, but the change is purely verbal. FOR LOSSES 1009 in connection with the business of the taxpayer at the time of the collision. No deduction may be claimed by the owner of the pleasure car wrecked in the collision. (C. B. 4, page 160; O. D. 857.) The reason for disallowing the losses claimed in the cases covered by the foregoing rulings is not clear. The law states that deductions are to be allowed for "losses sustained .... of property not connected with the trade or business .... if arising from .... casualty . . . ." An automobile is surely "property," whether used for business or pleasure pur- poses. A "casualty" is defined in the Standard Dictionary as "a . . . . serious accident . . . . ; that which occurs by chance: chance." Both the cases covered by the foregoing rulings would seem to come within the scope of section 214 (a-6). Rulings. A ring lost by its owner and owing to the circum- stances attending the loss he is in doubt as to whether it was stolen or merely misplaced or lost from his finger. Unless he can establish the fact that the ring was stolen no deduc- tion can be allowed on account of the loss. Such a loss does not come within the meaning of the term "other casualty" as used in section 214 (a) 6 of the Revenue Act of 1918. This term embraces losses arising through the action of natural physical forces and which occur suddenly, unexpectedly, and with- out design of the one suffering the loss. (C. B. 2, page 130; O. D. 526.) A taxpayer employed a contractor to build his house. The con- tractor absconded, leaving certain bills for material used in the con- struction of the house unpaid, and the taxpayer was required to pay such bills. Held, that the additional amount paid represents additional cost of the building and is not deductible as a loss. (C. B. 4, page 213; O. D. 925.) The amounts misappropriated by a guardian of a minor in the years 1917, 1918, and 1919 are allowable deductions for those years under the provisions of the Revenue Act of 19 16, as amended by the Act of 1917 and the Revenue Act of 1918. (B. 50-21-1974; A. R. M. 144.) Determination of the loss deductible. — Regulation When loss is claimed through the destruc- tion of property by fire, flood, or other casualty, the amount deductible lOio DEDUCTIONS will be the difference between the cost of the property, less proper adjustment for depreciation, and the salvage value thereof. In the case of property acquired before March i, 1913, however, the de- ductible loss is the difference between the fair market value of the property as of that date, less proper adjustment for depreciation, and the salvage value thereof. In any event the loss should be reduced by the amount of any insurance or other compensation received. .'. . . (Art. 141.) Rulings. A taxpayer's personal residence located on a beach was damaged by a storm, which washed away part of the foundation and so undermined the building as to render its destruction certain if it was not immediately removed. In removing the building to a safer location it was further damaged. The damage caused by the direct action of the storm and by the removal to avoid further probable damage is held to have arisen from storm and deductible from gross income as a loss within the meaning of section 214(a) 6 of the Revenue Act of 1918. If the building was moved to prevent further loss from the storm in ques- tion, the expense of moving it is also deductible as a loss; but if it was moved to prevent probable losses from future storms, the ex- pense of moving it is regarded as a capital expenditure and should be added to the cost of the building in computing profit in the event of its sale, since the removal to a safer locality presumably increased its value. (C. B. 3, page 159; O. D. 698.) Damage to the flooring and furniture in the residence of a tax- payer caused by the freezing and bursting of water pipes, and not compensated for by insurance, constitutes a deductible loss. The amount of such loss is the difference between the cost of the flooring and furniture (or the fair market value on March i, 1913, if acquired prior thereto, and such value was less than the cost), less depreciation sustained thereon, prior to the casualty, and the salvage value of the property. (B. 43-21-1885; O. D. 1076.) The Treasury has held that when depreciation has not been an allowable deduction, as in the case of a taxpayer's resi- dence, depreciation need not be considered in determining the gain or loss arising from the sale of the residence." It would appear that the same principle should apply when determining losses in cases such as the one covered by the ruling immedi- ately preceding. ^'' See page 581. FOR LOSSES lOll Damages for personal injury. — Ruling. Plaintiff recovered damages on account of injuries sustained in a fall occasioned by reason of tripping over a wire stretched along the curb in front of defendant's residence. Held, that the amount paid by the defendant does not constitute a loss from "other casualty" within the meaning of section 214 (a) 6 of the Revenue Act of 1918, and that he may not deduct it from his gross income for income tax purposes. (C. B. 4, page 155; O. D. 779-) Accounting procedure. — Losses by fire, storm, etc., not compensated by insurance should be ascertained without delay and proper entries should be made therefor on the books. The law specifically permits the deduction of such losses "sustained during the year." This means the taxable year, fiscal or calendar, of the individual or corporation. If at the time of closing the books it is known that a loss has occurred and no adjustment has been made, the closing of the books should be deferred until an adjtistment shall have been made, because the loss will not be an allowable deduction in the next period. If the delay is for a considerable time a tentative return can be made and later an amended final return can be substituted therefor. Ruling. When an insured loss occurs in one taxable year and the insurance is not recovered during that year the taxpayer should com- pute his loss by deducting- from the total loss the estimated amount of the recoverable insurance. The loss so determined should be de- ducted from the taxpayer's gross income of the year in which the loss was sustained. If subsequent events demonstrate that this esti- mate was substantially incorrect, an amended return should be filf.d correcting the mistake. ( C. B. i, page 123; T. B. R. 55.) Losses by theft and embezzlement. — Losses by theft"'* are ^* [Former Procedure] The following ruling made in 1919 should be read in conjunction with Art. 146 of Reg. 62. Ruling. A loss incurred by a corporation through embezzlement is an allowable deduction from gross income for the year in which the embezzle- ment occurred. Where the embezzlement is not discovered in the taxable year but is later discovered and admitted by the embezzler, a part of the money being promptly recovered, the amount so recovered tends to diminish the amount of allowable deductions on account of the embezzle- 1012 DEDUCTIONS now specifically mentioned in the law among those which may he deducted.'^'* If recent newspaper reports are trustworthy there will be many claims by individuals not in the liquor trade, for losses from theft of liquors. The regulations hold that such losses constitute allowable deductions. The basis of deduction is cost, not market value. Rulings. A loss incurred by a corporation through the embez- zlement of securities held in bailment is an allowable deduction from gross income of the year in which the liability accrued, i. e., when demand was made by the bailors for the return of the securities and replacement thereof was made by the corporation. (C. B. 3, page 158; A. R. R. 269.) A loss sustained by a corporation through burglary in 191 7 is de- ductible in the taxpayer's return for that year only, although the question as to whether a burglary insurance company should repay all or any part of the loss to the company was not finally determined by the courts until 1919. (C. B. 4, page 143; A. R. R. 542.) A forwarded to his brother B, i^x dollars to be used in the pur- chase of a bank. During the negotiations for the purchase, C ab- sconded with the money. A expended x dollars as interest upon the sum lost, which was a loan, and x dollars in apprehending the thief. A's brother is unable to make good the loss and no recovery can be had from C. Held, that A is entitled to deduct the amount of I5.r dollars as a business loss and in addition the interest payment advanced to secure the loan. The amount expended in apprehending the thief, however, is regarded as a personal expense and may not, therefore, be de- ducted. (C. B. 3, page 156; O. D. 571.) During 1916, A was induced by B, who represented himself as an agent of a manufacturing corporation, to invest lo.r dollars. ment for the year in which the embezzlement occurred, and is ordinarily not returnable as income in the year when received. (C. B. i, page 118; O. 845.) °° It is interesting to note that in England losses by embezzlement by an employee have only recently come to be recognized as allowable de- ductions. "A loss by reason of embezzlement by an employee used to be looked upon as a loss by stratagem, and not one connected with, or arising out of, trade, and it used to be said that the amount could not be deducted. Such a loss, however, is now for income tax purposes deemed an expense of the year in which it is written off in the books." Murray and Carter, Income Tax Practice, page 281. FOR LOSSES 1013 represented by two notes of 5.r dollars each, in stock of the pro- posed corporation. A was to be made foreman of the proposed plant and the notes were to be paid by him out of the salary he was to receive from the corporation. B's representations were later found to be false and after discounting one of A's notes he absconded with the proceeds thereof, A having succeeded in recovering the other note. An investigation of the transaction was made in 1916 and it was then found that the parties who had put money into the enterprise would realize nothing from it. During 1917, A paid x dollars on the note discounted at the bank and renewed it for 4x dollars, which amount he paid in 1918, and claimed as a loss in computing his net income for that year. The question is raised as to the year in which the loss is properly deductible. Assuming that A kept his books on a cash receipts and disburse- ments basis, it is held that he would not be in a position to deduct any loss until he had actually paid the note, thereby evidencing a completed and closed stock transaction. A may deduct the pay- ments on the note in computing net income for the years in which such payments were made. The fact that the loss was discovered in 1916 is immaterial, because the date of discovery does not determine the date on which the loss was sustained. (I-3-32; I. T. 1167.) Corporate Losses In Issuance and Redemption of Securities Discount on bonds sold — a loss which may be prorated. — When a corporation sells bonds at less than par, it is because the nominal rate of interest as expressed in the bonds is less than the market rate. If a corporation has a high credit and there is a favorable market for securities, it will secure the advantage of a low rate of interest. Its 5 per cent bonds may sell at no. If, however, the market is not so favorable, even though the credit of the company be unimpaired, its 5 per cent bonds may sell at 90. In both cases, if one assumes the credit of the company to remain constant, it is the market rate of interest current at the time which governs the price of the bonds. Proper accounting calls for a reflection of the actual interest cost spread evenly over the life of the bonds, and this is readily accomplished by adjusting the mterest account. The regulations which formerly considered such discounts as losses rather than interest, now provide that (except for 11)14 DEDUCTIONS discounts on bonds purchased prior to 1909 and charged off) they niay be prorated equitably over the Hfe of the bonds. Regulations. Discount on bonds issued and sold prior to the year 1909, if such discount was then charged against surplus or against the income of the year in which the bonds were sold, is held not to be deductible from the income of subsequent years, for the reason that the charging off prior to January i, 1909, of the entire amount of the discount constitutes a closed transaction, and such transaction can not be reopened for the purpose of reducing the taxable income of a corporation for subsequent years by deducting therefrom an aliquot part of the discount. (C &■ A. R. R. v. U. S., Court of Claims; Reg. 33, 1918, Art. 149.) (i) (a) If bonds are issued by a corporation at their face value, the corporation realizes no gain or loss, (b) If thereafter the cor- poration purchases and retires any of such bonds at a price in excess of the issuing price or face value, the excess of the purchase price over the issuing price or face value is a deductible expense for the taxable year (2) (a) If bonds are issued by a corporation at a premium, [and] (b) If thereafter the corporation purchases and retires any of such bonds at a price in excess of the issuing price minus any amount of premium already returned as income, the excess of the purchase price over the issuing price minus any amount of premium already returned as income (or over the face value plus any amount of premium not yet returned as income) is a deductible expense for the taxable year (3) (a) If bonds are issued by a corporation at a discount, the net amount of such discount is deductible and should be prorated or amortized over the life of the bonds, (b) If thereafter the corporation purchases asd retires any of such bonds at a price in excess of the issuing price plus any amount of discount already de- ducted, the excess of the purchase price over the issuing price plus any amount of discount already deducted (or over the face value minus any amount of discount not yet deducted) is a deductible expense for the taxable year (Art. 545.) The foregoing follows very closely the language of article 544 of Regulations 45. When bond discount has been capitalized at the time of issuance of the bonds (as was frequently done and approved by public service commissions not many years ago), and when such discount has not been otherwise amortized, it appears to FOR LOSSES 1015 be permissible for income tax purposes to write off annually the pro rata amount. When bond discount was charged to profit and loss dur- ing the year in which the bonds were issued (if since 1909), or during subsequent years, in amounts greater than the proper proportion, it seems to be permissible to prepare and submit amended returns for such years, or upon any reopening of a corporation's books by the Treasury to make claim for ad- justment. Ruling. A corporation which issued its bonds at a discount and improperly charged the discount to profit and loss may correct its books to show the discount treated as interest paid in advance to be amortized over the life of the bonds. Amended returns reflecting correction in the books may be filed. (C. B. i, page 224; O. D. iii.) Decisions under the 1909 law, — The foregoing regulations are those prescribed by the Treasury under its authority to permit and require accounts to be kept on a basis which prop- erly reflects the true net income of taxpayers. Under the 1909 law the Treasury's hands were more or less tied. The law as written required accounts to be kept strictly on a cash receipt and payment basis. Therefore the decisions of the courts under the 1909 law are of interest only in connection with returns for periods prior to January i, 1913. Baldwin Locomotive Co. v. McCoach. — Ruling. The decision of the United States Circuit Court of Appeals for the Third Circuit, in the case of the Baldwin Loco- motive Works V. McCoach, Collector (221 Fed. 59), holds that if the loss sustained by selling its own bonds at a discount is an expense of the business of a corporation, the expense will not be paid until the maturity of the bonds, and should therefore be prorated over the life of the bonds. (T. D. 2185, April i, 1915.) Southern Pacific R. R. Co. v. Muenter. — • Ruling. Where a corporation sold bonds at a discount dur- ing 1906, 1907 and 1908 no deduction from gross income for the years 1909, 1910 and 191 1 of sums set aside by the corporation to pay such discount at the maturity of the bonds is permitted under lOi6 DEDUCTIONS the provisions of section 38, Act of August 5, 1909, authorizing corporations to deduct from gross income "(second) all losses actu- ally sustained within the year . . . ." and "(third) interest actually paid within the year on its bonded or other indebtedness " (260 Fed. 837.) (T. D. 2944, November 8, 19 19.) It will be noted that the court strictly construed the terms "losses actually sustained within the year" and "interest actu- ally paid within the year." Loss on bonds sold or paid at maturity. — When the amount received from the sale or redemption of bonds purchased prior to March i, 191 3, is less than cost, or fair market value March I, 19 1 3, (whichever was lower) the difference is an allowable deduction as a loss. If purchased on or after March i, 191 3, the deduction allowed is the difference between cost and the amount realized by sale or redemption.^*' It should be remembered that there has been a great de- cHne in the price of bonds since March i, 1913, so that prac- tically all bonds purchased or otherwise acquired prior to that time would show a loss if sold at this time. Regulation If it (a corporation) retires its bonds at a price in excess of the issuing price, such excess may usually be deducted as expense (Art. 563.) If bonds were purchased at a discount or premium and the taxpayer has amortized the difference between par and purchase price, the amount of the loss is based on the book values and not on original cost, except as the value at March I, 19 1 3, may necessitate further adjustment. Ruling. Amortization of premium or discount on bonds as con- templated in articles 544, 563, and 848, Regulations 45, is not per- missible in the case of the purchaser of bonds. The purchase price of the bond, even though different from par represents the investment. When the bonds mature or are sold the basis for determining the gain or loss is their purchase price, or their fair market value as at March i, 1913, if acquired prior to that date. (C. B. 2, page 211; O. D. 475-) '^^ Subject to modification by provisions of section 202 (a-2) of 1921 law as to property sold after December 31, 1920. This modification did not appear in the 1918 law. FOR LOSSES 1017 The foregoing ruling is at variance with good accounting practice. A bank bought 7 per cent bonds at no in 1910. In 1920 the bonds were paid off at par. If all the premium had been amortized the books would show no loss in 1920, but under the ruling a loss could be claimed. Ruling. Where bonds mature serially, a proper proportion of the total discount and expenses should be allocated to each series and each series then treated as a separate unit. The deduction applicable to each series should be prorated equally over the life of the bonds constituting the series, provided, hov^^ever, that if the corporation re- tired any of the bonds before maturity, the deduction for that year should be increased by an amount equivalent to the amount which would ordinarily be deducted during the succeeding years on ac- count of those particular bonds if they had not been prematurely retired. (C. B. 4, page 276; O. D. 936.) Premium on capital stock redeemed not a deductible loss. — Ruling. This ofifice is in receipt of your letter of the 6th instant, in which you ask for information on the following question : "A corporation in 1912 issued preferred stock for par. It was provided on the certificates that said stock was redeemable at no. The com- pany exercised its option and redeemed the stock at no by calling it in. The difference appeared on the books as a reduction of un- divided profits. Is this difference a lawful deduction?" In reply you are informed that this office will hold that the redeeming of the stock at a price in excess of par represents a capital transaction in which there can be no gain or loss to the corporation, and therefore the difference between the selling price of the stock and the price at which it was redeemed will not be deductible in a return of annual net income. (Letter to a subscriber of The Cor poration Trust Co., signed by Deputy Commissioner ,G. E. Fletcher, and dated April 11, 1917.) Regulations. The proceeds from the original sale by a cor- poration of its shares of capital stock, whether such proceeds are in excess of or less than the par value of the stock issued, constitute the capital of the company. If the stock is sold at a premium, the premium is not income (Art. 543. Reg. 45, Art. 542.) A corporation sustains no deductible loss from the sale of its capital stock (Art. 563.) The purchase or redemption by a corporation of its own capital stock is an operation of a nature entirely different from IOi8 DEDUCTIONS that involved in the retirement of bonds. The purchase or retirement of bonds at a premium involves a payment to a creditor. As explained above, the premium is nothing but a net expense spread over the life of the bonds. Payments to stockholders, on the other hand, must be out of profits (un- less liquidation is in progress). Such payments are usually in the form of dividends, but in the numerous instances when corporations purchase their own shares at a premium, this premium in effect is a payment to a stockholder. Most states forbid a corporation to buy its own stock except out of surplus. Since the payment of a premium on shares is the equivalent of a dividend, there is no ground whatever for a claim that such premiums should be allowable deductions in an income tax return. In no sense of the w-ord is such a pay- ment capital. Although not an allowable deduction from net income, premiums on stock can be paid only from profits and that is the method always followed. Consequently the author cannot agree wath the Treasury when it says that the payment of the premium in redeeming stock is "a. capital transaction in which there can be no gain or loss to the corporation." He does agree, however, with the conclusion that such payments are not deductible As such payments are not allowable deductions to the cor- poration, and must, therefore, be charged direct to surplus, it can be claimed that a distribution of profits, equivalent to a dividend, has been made. The corporation will have paid the normal income tax thereon and should notify its stockholders of that fact so that they may enter the receipt of the premiums as a dividend and thus avoid the normal tax. Losses of Holding Companies — Accounting Procedure The interests owned by holding companies in affiliated or subsidiary companies are usually represented by holdings of capital stock, bonds or other forms of indebtedness such as FOR LOSSES 1019 promissory notes, open book accounts, etc. When a holding company desires to reflect on its books the profits or losses of its subsidiaries, it does so by the accrual and reserve method," or by writing up or down the book valuations of the stocks or obligations owned. Under existing rulings, a mere writing down of valua- tions is not an allowable deduction. But many transactions ordinarily reflected by a change in valuations are more prop- erly recorded as "losses which are immediately deductible." If a subsidiary loses money and the holding company advances funds, which in effect are used to make good the deficit, and it is not likely that the subsidiary can repay the advance, it becomes a bad debt on the books of the holding company and should be charged off as a loss. The 192 1 law specifically authorizes the Commissioner to allow a deduction for a bad debts reserve; when he is satisfied that a debt is recoverable only in part, he may allow it to be charged off in part. Transactions of this kind are sometimes improperly han- dled. For example, the advance from the holding company to the subsidiary is often treated as a gift from one to the other. If this were really so, the holding company could not claim it as an allow-able deduction (because gifts are not de- ductible) ; but in fact this is not a gift. It is on the part of the holding company one of the necessary expenses incurred in its business or a loss of similar nature. Holding companies are formed to make money. When they lose in transactions from which profits were expected to arise, it is a trade loss — not a gift in the nature of a beneficence or anything of that sort. Therefore at the time when such transactions are en- tered, the true state of affairs should be disclosed and inad- vertent mention of a 8:ift should be avoided.''^ ^^ Auditing, Theory and Practice (3rd edition), by R. H. Montgomery, page 347 et seq. °* [Former Procedure] Article 115 of Regulations 33, 1918, re- quired that earnings of subsidiaries taken up on. the books of tiie hold- ing company be returned as income. If the regulations were sound, then the converse must be good practice: that is, where losses of sub- sidiaries are taken up each month on the books of the holding com- I020 DEDUCTIONS Decision. (Syl.) Where a railroad company upon being pro- Iiibitcd by State law from owning and operating docks and channels, organized a terminal company for that purpose, of which it owned all shares of stock except such as were necessary to qualify directors, and advanced as loans to it from year to year sums sufficient to cover its deficit, the railroad company may not deduct as operating expenses, in computing net income for the measure of the corporation excise tax imposed by the Act of August 5, 1909, the amount of such advances made during a taxable year. Where interest on loans made by parent corporation to its sub- sidiary accrued from year to year, but was not paid, the amount thus accrued during a taxable year cannot be considered income to the parent company within the meaning of the Act of August 5, 1909. (Walker v. Gulf and Interstate Ry. Co. of Texas, 269 Fed. 885.) The 191 8 law provides for consolidated returns in all cases in which one corporation controls another or an indi- vidual controls two or more corporations. Therefore, when consolidated returns are made, the loss of one subsidiary op- erates as a credit against the profit of another and no adjust- ments need be made in the books. It would not be wise, however, to depend on the desired adjustment being made through the medium of consolidated returns. State income tax returns wull require accurate re- ports from subsidiaries and in many cases no report at all will be required from the parent company or an affiliated company. Limitation nn losses incurred in transactions outside busi- ness or trade. — Under the 19 18 and 1921 laws all losses in- curred in trade, or arising from transactions entered into for profit, are deductible, but under former laws there were limit- ations on the deductions. For several years the author has contended that the Treas- ury did not properly interpret the earlier laws and that many losses which were disallowed were in fact allowable deductions. During 191 9 a case was decided in a United States district court wherein the court held that the Treas- pany, they could be claimed as allowable deductions. As the author questioned the soundness of the ruling as it affects income, the same criticism applies where there is a loss. FOR LOSSES I02I ury was in error in disallowing a loss which the taxpayer claimed as having been incurred in trade. The taxpayer re- ceived a large block of stock in an industrial company to whose affairs she evidently devoted some time and attention. Decision. The transactions .... were complicated in charac- ter, involved a very large sum of money, and must have required much of her time and attention, and I am of the opinion that they were of the character contemplated by Congress as "incurred in trade." [Bryce et al. v. Keith, Collector, 257 Fed. 133 (March 26, I9i9)-1 Ruling. Where a corporation is authorized by its charter or certificate of incorporation to purchase stocks on a margin, and where there are no laws in the State where it trades in stocks making marginal stock transactions by corporations illegal, if it sustains a loss as a result of marginal trading in stocks, such loss may be deducted in computing its net income, if sustained during the taxable year and not compensated for by insurance or otherwise, unless it appears affirmatively that the transaction was merely colorable and no bona fide purchase of stock was made. Where a corporation suffers losses as a result of its ultra vires act no deduction for such losses may be made in computing its net income. (C. B. 2, page 212; O. 968.) "Relief" Provisions of the 1921 Law * The radical changes expected in business conditions as a result of the cessation of the war made it seem imperative that losses arising from readjustments of inventories, which might occur within a few months thereafter, should be spread over a longer period of time. Similar conditions existed in the case of " [Former Procedure] Provision was made in the 1918 law [sections 214 (i2-a) and 234 (14-a)] whereby losses resulting from a subsequent decline of a material amount in the value of the 1918 inventory, might be deducted from the net income of that taxable year and the tax be re- computed. An allowance for rebates was also permitted. A full discussion of this subject will be found in Income Tax Procedure, 1921, page 787 et seq. As a condition to the allowance of a claim under this provision, the Treasury illegally requires that the disposition of the entire inventory at the close of the IQ18 taxable year be shown and that a net loss on the inventory must have been incurred. (Bulletin 30-21-1745; A. K. R. 544.) For rulings dealing with rebates, see Bulletin 31-21-1753; A. R. R. 590. 31-21-1754; A. R. R. 130. " 42-21-1871 ; O. D. 1067. 1022 DEDUCTIONS losses arising from sales or depreciation of plant and equip- ment acquired for war purposes. To meet these difficulties the 1 918 law provided certain so-called relief measures de- signed to assist in the re-establishment of normal conditions. Referring to these provisions Senator Simmons said :"" In addition to the relief amendments placed in the income tax title, but affecting profits taxes as well as income taxes, amendments relating to amortization and obsolescence, shrinkage in inventories, and so forth, the Senate added a general relief clause investing more or less discretion in the Commissioner of Internal Revenue and the Advisory Tax Board for relief in cases clearly establishing injustice, inequality or discrimination. The House conferees accepted these provisions of the Senate. Law. Section 204 (b) If for any taxable year beginning after December 31, 1920, it appears upon the production of evidence satisfactory to the Commissioner that any taxpayer has sustained a net loss, the amount thereof shall be deducted from the net income of the taxpayer for the succeeding taxable year; and if such net loss is in excess of the net income for such succeeding taxable year, the amount of such excess shall be allowed as a deduction in computing the net income for the next succeeding taxable year; the deduction in all cases to be made under regulations prescribed by the Commis- sioner with the approval of the Secretary There are two principal points of difference between the foregoing provision and the similar provision of the 1918 law : 1. The 19 18 law permitted the application of the loss first against income of the preceding taxable year (involving a re- computation of the preceding year's tax and a refund of that previously paid) and the application against the following year's income of any excess of loss over income of the pre- ceding year, whereas the 192 1 law permits application of loss of one taxable year only against income of one or two suc- ceeding years. 2. The net loss provision of the 1921 law is continuing in its character, whereas that in the 1918 law related only to net losses sustained in the years ended October 31, November 30 or December 31, respectively, of 19 19. It will be observed that neither the 19 18 nor the 1921 law '"February 11, 1919, Congressional Record, page 3776. FOR LOSSES 1023 makes any provision whatever for offsetting losses sustained in 1920 against the income of either preceding or succeeding years. Definition of "net loss." — Law. Section 204. (a) That as used in this section the term "net loss" means only net losses resulting from the operation of any trade or business regularly carried on by the taxpayer (including losses sustained from the sale or other disposition of real estate, machinery, and other capital assets, used in the conduct of such trade or business) ; and when so resulting means the excess of the deductions allowed by section 214 or 234,1^1 as the case may be, over the sum of the following: (i) the gross income of the taxpayer for the taxable year, (2) the amount by which the interest received free from taxation under this title exceeds so much of the interest paid or accrued within the taxable year on indebtedness as is not permitted to be deducted by paragraph (2) of subdivision (a) of section 214 or by paragraph (2) of subdivision (a) of section 234, (3) the amount by which the deductible losses not sustained in such trade or business exceed the taxable gains or profits not derived from such trade or business, (4) amounts received as dividends and allowed as a deduction under par- agraph (6) of subdivision (a) of section 234, and (5) so much of the depletion deduction allowed with respect to any mine, oil or gas well as is based upon discovery value in lieu of cost Section 204 does not apply unless a "net loss" has been sustained. When a taxpayer's profit and loss account shows a loss, as that term is commonl)^ used, further consideration is essential in order to determine "net loss." Regulation. The term "net loss" as used in the statute means only a net less resulting from the operation during the taxable year of any trade or business regularly carried on by the taxpayer. In- cluded therein are losses from the sale or other disposition of real estate, machinery, and other capital assets used in the conduct of such trade or business. In order to be entitled to claim an allowance for a "net loss" the taxpayer must have suffered an actual net loss in a trade or business during the taxable year. The amount properly allowable may be neither the loss reflected upon the return filed for the purpose of the income tax nor the net loss shown by the tax- payer's profit and loss account, but is to be computed according to the statute, as follows. *' Providing for deductions allowed individuals (section 214) and cor- porations (section 234). I024 DEDUCTIONS (i) In the case of an individual, it is the amount by which the de- ductions allowed under section 214, excluding: ((7) the amount by which the deductible losses not sustained in such trade or business exceed the taxable gain or profits not derived from such trade or business ; (b) so much of the depiction deduction with respect to any mine, oil, or gas well as represents the excess of value based upon discovery subsequent to February 28, 1913, over cost or value as of March i, 1913; and (c) the amount of deductions allowed under section 214 not connected with the trade or business, exceeds the sum of the following: (a) the gross income of the taxpayer for the taxable year as computed under section 213; and (b) the amount by which the interest received free from taxation under the provisions of the Act exceeds so much of the interest paid or accrued within the taxable year on indebtedness as is not allowed as a deduction under section 214 (a) (2). (2) In the case of a corporation, it is the amount by which the deductions allowed under section 234, excluding: (a) the amount received as dividends and allowed as a de- duction under section 234 (a) (6) ; and (b) so much of the depletion deduction with respect to any mine, oil or gas well as represents the excess of value based upon discovery subsequent to February 28, 1913, over cost or value as of March i, 1913, exceeds the sum of the following : (a) the gross income of the taxpayer for the taxable year as computed under section 233 ; and (b) the amount by which the interest received free from taxation under the provisions of the Act exceeds so much of the interest paid or accrued within the taxable year on indebtedness as is not allowed as a deduction under section 234 (a) (2). In computing statutory "net loss" the following restrictions are to be noted : (i) Interest received by the taxpayer on obligations or securities, the interest from which is exempted from taxation must be included in income, but this amount may first be reduced by the amount of any interest paid by the taxpayer on money used to purchase or carry such obligations or securities. (2) Where depletion is computed upon the basis of discovery value in lieu of cost or value as of March i, 1913, in making the computation, the deductions are reduced by that portion of the de- FOR LOSSES 1025 pletion representing the excess of the discovery value over actual cost or value as of March i, 1913 (Art. 1601.) Computation of "net loss." — The following official illustration is so clear that it needs no extended comment. The net losses to be carried forward are taxpayer's business losses. Therefore the statutory net loss as shown in the illustration agrees with the net loss shown by the taxpayer's books. Taxpayers may have an apparent loss in 1921 which they hope will serve as an offset against net income in 1922 or 1923. But careful consideration must be given to what constitutes statutory net loss before they can be certain that the loss or any part thereof is a loss applicable against the income of succeeding years under the provisions of the law. Regulation. The method of computation of net losses as out- lined in article 1601 may be illustrated as follov^s: A, an individual conducting- a trade or business, finds the following facts relative to a taxable year; (a) His deductions as computed under section 214 amount to $100,000. (b) Includetl in the deduction is an item of $10,000 for loss by fire of property occupied by him as a residence and not used in con- nection with his trade or business. (c) Deductible losses on account of transactions entered into for profit outside of the trade or business are $3,000. (d) Taxable gains from transactions entered into for profit and not connected with the trade or business are $5,000. (e) Donations to the Red Cross are included in the deductions in the amount of $1,000. (/) Depletion is claimed in the amount of $2,000, of which $500 is based upon the value of the mineral in the mine as of March i, 1913, and $1,500 is attributable to increase in valuation on account of discovery subsequent to February 28, 1913. (g) His entire gross income as computed under section 213 is $50,000. (h) Interest received from municipal bonds exempted from tax- ation by section 213 (b) (4) amounted to $10,000. (i) Interest was paid upon money borrowed to carry municipal bonds in the amount of $S,ooo, which amount is not deductible in accordance with section 214 (a) (2) : 1026 DEDUCTIONS Total deductions {a) $100,000 Deduct : Loss by fire (b) $10,000 Other losses (c) 3,ooo Total loss outside business 13,000 Less : Gain outside business ((/) 5,000 Excess of deductible losses not sus- tained in trade or business over taxable gains or profits not derived from such trade or business 8,000 Donations (e) i ,000 Depletion on basis of value after discovery (/) $2,000 Less: Portion based on value as of March i, 1913 500 Portion of depletion repre- senting discovery value in excess of cost or value as of Alarch i, 1913 1.500 Total exclusion from deductions 10,500 Total expenses directly attributable to the conduct of the trade or business $89,500 Gross income (g) $ 50,000 Add: Non-taxable interest received (h).. $10,000 Less : Interest paid on money borrowed to carry municipal bonds (/) 8,000 2,000 52,000 Statutory net loss $37,500 (Art. 1605.) "Net loss" of taxpayer having fiscal year. — Law. Section 204 (d) If it appears, upon the production of evidence satisfactory to the Commissioner, that a taxpayer having a fiscal year beginning in 1920 and ending in 1921 has sustained a net loss during such fiscal year, such taxpayer shall be entitled to the benefits of this section in respect to the same proportion of such net loss which the portion of such fiscal year falling within the calendar year 1921 is of the entire fiscal year. Regulation. The provisions of section 204 relative to net losses are not retroactive and apply only to taxable years beginning after December 31, 1920, with the following exception: Where a taxpayer has a fiscal year beginning in 1920 and ending in 1921, if the tax- payer produces evidence showing to the satisfaction of the Com- missioner that a "net loss" has been sustained during such fiscal year, the benefits of section 204 shall apply to the same proportion of such net loss as the portion of stich fiscal year falling within the calendar year 192 1 is of the entire fiscal year. The net loss shall be first computed ;is prescribed in articles 1601 and 1605 for FUR LOSSES 1027 the entire fiscal year ending" in 1921 in accordance with this Act as in effect on Jannary 1, 1921. The net loss allowable shall be the same proportion of the net loss for the entire fiscal year as the por- tion of the fiscal year falling within the calendar year 1921 is of the entire fiscal year. (Art. 1604.) The foregoing provision merely extends a proportionate de- duction to taxpayers whose fiscal years include only part of the year 1921. Can net loss of period of less than twelve months be car- ried forward? — Section 204 (a), which provides for the carry- ing forward of net losses, mentions tlie period during^ which the loss occurs as "any taxable year beginning after December 31, 1920." Section 204 (d) provides that fiscal year concerns may carry forward that part of net losses which accrue after December 31, 1920. Section 226 provides for returns for periods less than twelve months. Section 226 (a) deals with changes in fiscal periods and permits returns for less than twelve months. Sec- tion 226 (b) and (c) deal with the rates of tax and method of computation when returns are made for part of a taxable year. There is no specific provision in the 192 1 law''^ which deals with carrying forward net losses when changes in fiscal years occurred during 192 1 or which may occur thereafter. It is, however, clear that the intention of Congress is to extend the deduction in every case. There is no inhibition against the deduction when fiscal year changes result in returns for less than twelve months. Section 200 (T ) provides that the °'"' [Former Procedure] Tlie iyi8 law (section 204) provided lliat losses in "any taxable year beginning after October 31, 1918, and ending prior to January i, 1920," might under certain conditions be applied to prior or subsequent periods. As the intention of Congress was clear to limit deductions to the period and dates mentioned, the provision has been strictly construed. The ruling of the Attorney General regarding this matter will be found in C. B. 3, page 83; T. D. 3044; see also Bulletin 30-21- 1745; A. R. R. 554. The Treasury has held that in order to be entitled to the benefits of section 204 of the IQ18 law "The loss must be for a full taxable year (12 months)." (1-6-66; A. R. R. 743.) For other rulings and comment see Income Tax Procedure, 1921, pages 784-787. iojS deductions term " 'taxable year' means the calendar year, or the fiscal year ending during such calendar year." Concerns starting business must select the calendar year or fiscal year basis. This usually requires a first return covering less than twelve months. It would have been more satisfactory if sec- tion 200 (i) had specifically provided that in the case of new concerns and those changing fiscal periods the term "taxable year'' should include the first return after starting business or after changing fiscal periods, but in view of the intention of Congress to extend the deduction to all taxpayers, there should be no discrimination against those whose first fiscal periods fortuitously are less than twelve months. The provisions, or the intent, to tax for part of a fiscal period, even though it is not a taxable year, are broad enough to carry the implication that, if fully taxable for part of a period, taxpayers are fully entitled to the proportionate part of any benefits which apply to a "taxable year." Section 204 (d) may be deemed to control the action of the Commissioner in extending the right to carry forward net losses even though the net loss period is less than twelve months. The case is not analogous to the procedure under the 19 18 law, wherein the precise dates within which the loss was realized were prescribed. The reason for this was that the Armistice was signed on November 11, 1918, and net losses w^ere applied to the period w^hich it was assumed was specifically affected. The provision in the 192 1 law is intended to apply to all net losses sustained after January i, 1921. Partnerships, beneficiaries and insurance companies al- lowed benefit of net loss provision. — Law. Section 204. . . . . (c) The benefit of this section shall be allowed to the members of a partnership and the beneficiaries of an estate or trust, and to insurance companies subject to the tax imposed by section 243 or 246, under regulations prescribed by the Commissioner with the approval of the Secretary In the case of a partnership the deduction would be avail- able to the individual partners in the same proportion as the FOR LOSSES 1029 partnership income is allocated to them.*^^ A member, how- ever, cannot segregate the net loss from other income and carry it forward independently. To receive the benefits of the provision a member of a partnership must sustain a loss after including his entire income from all business sources.** Claim for net loss to be filed with succeeding year's re- turn. — Regulation. A taxpayer- sustaining a "net loss" such as set forth in section 204, for any taxable year ending after December 31, 1920, may file a claim therefor with his return for the subsequent taxable year. Such claim should contain a concise statement setting forth the amount of the net loss and all pertinent facts relative thereto, including a schedule showing computation of the net loss in accord- ance with section 204 and articles 1601 and 1605 of these regulations. If the evidence furnished satisfies the Commissioner that the taxpayer has sustained a "net loss" the amount of such net loss may be de- ducted from the net income of the taxpayer for the succeeding tax- able year and if such net loss is in excess of the net income for such succeeding taxable year the amount of such excess shall be car- ried over and credited against the net income for the succeeding tax- able year. (Art. 1602.) *^ But see page 803. " C. B. 2, page 58 ; O. D. 430. • [Former Procedure] The discussion of the limitation on losses under former laws is necessarily exhaustive and must be omitted from this vol- ume. See Income Tax Procedure, 1920, pages 660-664. Also see previous editions. For Treasury rulings in 1920 and 1921, see: C. B. 3, page 156; A. R. R. 242. C. B. 3, page 317; A. R. M. 96. Bulletin 44-21-1891 ; O. D. 1080. Bulletin 43-21-1880; O. D. 1071. C. B. 4. page 47; O. D. 932. Bulletin 13-21-1528; A. R. R. 435. CHAPTER XXX DEDUCTIONS FOR BAD DEBTS Two important changes are lonnd in the 192 1 law regard- ing bad debts. Taxpayers for the first time^ may now deduct : 1. A reasonable addition to a reserve for bad debts. 2. Part of a debt which is not fully recoverable. Taxpayers may continue on the old l)asis, i.e., they may de- duct only those bad deljts ascertained to be worthless and charged off during the year. This chapter will deal with the procedure to be followed when reserves are maintained, with the types of bad debts which may be fully deducted, and with the determination of the deductibility. Law. Section 214. [Individuals] (a) That in computing net in- come there shall be allowed as deductions: (7) Debts ascertained to be worthless and charged off within the taxable year (or in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts) ; and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part The deduction for corporations [section 234 (a-5)] is exactly the same. Regulation. Bad debts may be treated in either of two ways — ( I j by a deduction from income in respect of debts ascertained to be worthless in whole ov in part, or (2) by a deduction from in- come of an addition to a reserve for bad debts. For the year 1921 taxpayers may, regardless of their previous practice, elect either of these two methods and will be required to continue the use in later years of the method so elected unless permission to change to the other method is granted by the Commissioner (Art. 151.) '[Former Procedure] The 1913, 1916 and 1917 laws read: "debts due to the taxpayer actually ascertained to be worthless and charged off within the year." The change in the 1918 law was merely verbal. The author has always contended that a reasonable addition to a reserve for bad debts was legal under 1918 and prior laws and should have been allowed. For full discussion, see Income Tax Procedure, 1921, pages 833- 836. 1030 FOR BAD DEBTS 1031 Bad debt deductions for the taxable year 1921. — The fol- lowing regulation aims first to place both classes of taxpayers, i.e., those who in prior years maintained reserves and those who did not, on the same basis. Regulation. Taxpayers who have, prior to 1921, maintained reserve accounts for bad debts may deduct a reasonable addition to such reserves in lieu of a deduction for specific bad-debt items. Taxpayers who have not heretofore maintained such reserve accounts may now elect to do so, and in such case shall proceed to determine the amount of the reserve that should reasonably have been set up as at December 31, 1920 (which shall not be deducted in computing net income), and in respect of 1921 and subsequent years may add a reasonable addition to such reserve and deduct the amount in com- puting taxable net income (Art. I55-) Taxpayers who did set up reserves in ])ri()r years presum- ably will have at the beginning of the faxal)lc year T921 a re- serve for bad debts, the credits to which, when made, were not deducted in prior income tax returns. Therefore, when taxpayers who have not heretofore maintained reserves set up the proper reserve for bad debts at January i, 1921, or the beginning of their fiscal years, they are not permitted to de- duct the charge therefor from income. The proper charge is to surplus account. The adjustments which afTect the income account should be made at the end of the taxable period. Regulation Where a reserve account is maintained, debts ascertained after December 31, 1920, to be worthless in whole or in part, (a) if such debts were outstanding at December 31, 1920, should be charged against the reserve and may be deducted from in- come, in accordance with article 151; (b) if such debts arose after December 31, 1920, should be charged against the reserve, and not deducted from income. What constitutes a reasonable addition to a reserve for bad debts must be determined in the light of the facts, and will vary as between classes of business and with conditions of business prosperity. A taxpayer using the reserve method should make a statement in his return showing the volume of his charge sales (or other business transactions) for the year and the percentage of the reserve to such amount, the total amount of notes and accounts receivable at the beginning and close of the taxable year, and the amount of the debts which have been ascertained to be wholly or par- tially worthless and charged against the reserve account during the taxable year. (Art. 155.) ,032 DEDUCTIONS Tlie foregoing regulation permits in effect a double deduc- tion for bad debts in the year 1921, viz. : 1. Accounts outstanding at December 31, 1920, which proved to be worthless in 1921. 2. Accounts arising from 192 1 business which upon a reasonable estimate may be deemed to be bad. In the years after 192 1, only the addition (for the current year) to the reserve for bad debts is deductible. This might leave in the reserves amounts representing debts arising prior to January i, 1921, which would never appear as allowable deductions. Taxpayers may reasonably assume, however, that uncollected debts which arose prior to 1921, and which could not be collected in 1921, are all bad at December 31, 1921. Reserves for Bad Debts It may be assumed that taxpayers in active business carry reserves for bad debts and that those who are not in active business do not. Those who are not required under good accounting prac- tice to keep books on an accrual basis are not affected by the 1 92 1 law. When a debt is bad, it may be charged off. Tax- payers who do not keep books on an accrual basis should not ordinarily attempt to charge off only part of a debt. When accounts are kept on an accrual basis, a reserve for bad debts is set up annually or oftener. For the taxable year 192 1 the addition to the reserve may be claimed as a deduction. The year 192 1 is one of transition from the former prac- tice of deducting from income only those debts ascertained to be worthless and charged off, to the new procedure of deduc- ting from income the addition to a reserve for bad debts. Therefore, under the new procedure we must consider the deductibility of : I. Debts ascertained to be bad in 192 1 applying to sales of previous years. FOR BAD DEBTS 1033 2. Additions to a reserve for bad debts to include 192 1 transactions. Under the new regulations,^ taxpayers may now deduct for the year 1921 the items in (i) as well as those in (2). Be- ginning in 1922, the deduction in the income account for the year as stated in the books of account and in the tax returns will agree for the first time since 191 3. Accounting procedure. — When taxpayers have not main- tained reserves for bad debts and desire now to conform to good accounting practice and the regulations, the following procedure is suggested : 1. Set up a reserve for bad debts before closing the books as of December 31, 1921, which is to be credited with: (a) The amount of the reserve which should have been set up December 31, 1920. (b) An allowance for uncollectible accounts arising from the business of 192 1, based on the same percentage of the 1 92 1 charge sales which the uncollectible accounts were of the charge sales for the previous three or five years. ^ 2. Charge against the reserve suggested above all the accounts determined to be uncollectible and charged off during 1921 : (a) The aggregate of accounts accrued prior to January I, 1921. (b) The aggregate of accounts accrued during 1921. 3. The allowable deduction for bad debts in 1921 returns ''T. D. 3262 (issued December 21, 1921) did not permit the deduction of both items in (a) and (b). It is assumed that as Art. 155 of Reg. 62 (see page 1031) appeared after T. D. 3262 and before any returns for 1921 were made, T. D. 3262 should be wholly ignored. " This allowance must be adequate to provide for (a) the losses which experience indicates will probably be sustained on accounts arising from 1921 sales which are uncollected at December 31, 1921, and (b) any ac- counts for 1921 sales which were determined to be uncollectible and written off on or before December 31, 1921. I034 DEDUCTIONS is 2 (a) plus I (b). For subsequent years the deduction is 1 (b) for the current year. When taxpayers have main- tained reserves in prior years, the deduction for income tax purposes is exactly the same as outlined above. iVt the end of each year after 192 1 there would be credited to the reserve simply a percentage on the charge sales of the year; all accounts finally decided within the year to be un- collectible would be written off against the reserve plus specific extraordinary items, in whole or in part, which are not in- cluded in the normal percentage. After 192 1 it would not be necessary to distinguish as to the year's sales from which the written-off accounts arose. The 192 1 law provides that debts that are bad "in part" may be deducted, and the new regulations state that: "Partial deductions will be allowed with respect to specific debts only." At the end of each year the balance in the reserve account naturally will have to be reviewed for the purpose of deter- mining whether the percentage used in computing the credit to the reserve for the year is adequate or whether it may be either too high or too low, in view of more recent experience. The percentage will, of course, need to be modified to whatever extent additional experience indicates to be necessary. From the foregoing it is apparent that taxpayers who have not heretofore maintained reserves for bad debts should imme- diately adopt the reserve basis. In effect, they will secure a double deduction for 192 1. Taxpayers already maintaining reserves will secure a like benefit. Effect on invested capital of establishing reserve for bad debts at beginning of 1921. — Taxpayers who previously have not maintained reserves, if electing the reserve method, must set up "the reserve that should reasonably have been set up as at December 31, 1920 (which shall not be deducted in com- puting net income)." The charge will be to surplus. The re- serve may be included as invested capital from the beginning of the year, even though the amount of such reserve will be de- FOR BAD DEBTS IO35 ducted in effect from 1921 income through charging to such reserve during 1921 those accounts outstanding at the begin- ning of the year which prove in 192 1 to be bad. Such bad debts, under article 155/ may be deducted from 1921 income. The reserve at tlie beginning of the year is regarded as segre- gated surphis. The charges against such reserve affect the 192 1 income and therefore do not serve to reduce invested capital for 192 1. Again, the reserve set u[) at the beginning of 1921 will imt be deducted from accounts receivable in computing admissible assets, which means that the percentage of inadmissibles will be smaller/' Only Bona Fide Debts Deductible If an item claimed as a bad debt partakes of the nature of a gift more than of that of a loan, or if, arising during a pe- riod when it could or should have been reported, it has not been included in the federal tax reports as gross income, it is not deductible as a bad debt. Loans to friends or relatives. — A question in the Income Tax Primer reads as follows : Ruling. If, on account of friendship or relationship I advanced a certain sum to assist a needy friend or relative, and at the time such advance was made I had little or no reason to expect that the amount so advanced would ever be returned, may I now claim a deduction to cover such advance? No. Such an advance, partaking, as it does, somewhat of the nature of a philanthropic donation or a goodwill offering, is not held to constitute a bona fide debt. {Income Tax Frimcr, 1918, question 94-) Where the element of gift is absent, the Treasury permits the deduction. Ruling. A certain taxpayer was notified by his bank that a note * See page 103 1. ° For discussion of the treatment of reserves for bad debts in respect to inadmissible assets, see Chapter IX of Appendix A. 1036 DEDUCTIONS had gone to protest and that he, as one of the indorsers, was Hable for the payment thereof. In order to defend a relative who had forged the indorsement, the taxpayer gave the bank another note of the same face value. The taxpayer made arrangements with his relative whereby the relative was to pay the amount of the note on the in- stallment plan. The relative, however, made no payments in the year 19 19 and payment could not be enforced since he had no assets. During that year the taxpayer paid the note in full to the bank and deducted as a bad debt for the year 1919 the difference between the amount paid the bank and the amount by which lie had been reim- bursed by his relative. Held, that the amount deducted is allowable since it represented a debt due from the relative and not a gift to him. (C. B. 4, page 173; O. D. 934.) Income corresponding to bad debt must have been re- ported in tax returns. — Regulation. Worthless debts arising from unpaid wages, sal- aries, rents, and similar items of taxable income will not be allowed as a deduction unless the income such items represent has been included in the return of income for the year in which the deduction as a bad debt is sought to be made or in a previous year (Art. 152.) This regulation applies particularly to taxpayers who have rendered returns based on cash receipts and payments. It is well illustrated by the following quotation from the Income Tax Primer: Ruling. A professional man earned a fee in 1916. As he keeps no books, he reports his income for tax purposes on an actual receipt basis. As this fee has never been reported as income, can it be claimed as a deduction if collection can not be made? No ; never having been returned as income it can not be claimed as a deduction. {Income Tax Primer, 1918, question 96.) It must be understood, however, tiiat the rulings quoted do not debar one from claiming the deduction of an item as a bad debt, even though the corresponding income has not been reported, in case the account arose before the federal in- come tax laws were in force. The effective date for corpora- tions, under the excise tax law, is January i, 1909, and for individuals, under the general income tax law, it is March FOR BAD DEBTS 1037 I, 19 1 3. Debts existing and carried as good on these dates may be treated as allowable deductions if subsequently found to be uncollectible. The entire amount may be deducted in the return of the year during which the debt was found to be bad. Special Types of Bad Debts — How Valued Bankruptcy claim — extent to which deductible. — Regulation. .... Only the difference between the amount re- ceived in distribution of the assets of a bankrupt and the amount of the claim may be deducted as a bad debt. Claims against decedent's estate — extent to which deduc- tible.— The difference between the amount received by a creditor of a decedent in distribution of the assets of the decedent's estate and the amount of his claim may be considered a worthless debt (Art. 152.) Debt ascertained to be bad after decedent's death. — Ruling. The amount paid by the administrator as the decedent's share of a note upon which he was a coindorser, which amount was not determined at the time of the decedent's death, is not deductible in the return for the decedent, but is deductible by the administrator, if the debt is uncollectible, in his return for the estate for the taxable year in which it was paid and charged off on his books. The difference between the amount paid by the administrator in taking up paper indorsed by the decedent and the appraised value of the claim subrogated to the administrator is not deductible by the administrator until the claim has been disposed of and the transac- tion is closed and cunipleted. ( C. B. 2, page 137; (). D. 556.) Accounts receivable purchased — basis for deduction, — Regulation A purchaser of accounts receivable which can not be collected and are consequently charged oft' the books as bad debts is entitled to deduct them, the amount of deduction to be based upon the price he paid for them and not upon their face value. (Art. 152.) Notes receivable — basis for deduction. — Regulation If a taxpayer computes his income upon the basis of valuing his notes or accounts receivable at their fair mar- 1038 DEDUCTIONS ket value when received, which may be less than their face value, the amount deductible for bad debts in any case is limited to such original valuation (Art. 151.) The entry of notes at less than their face value is equiva- lent to the creation of a reserve for bad debts. The Treasury- denied the privilege to taxpayers evidently when it was not their "practice" to take up the notes at market value. Ruling. When a merchant has notes receivable for goods sold and grants the purchaser an extension of time within which to pay the notes, the Bureau is without authority to permit him to treat the fair market value of the notes as the price for which the goods were sold or to deduct from gross income as a loss the difference between the face value of the notes and their fair market value at the time they originally became due. (B. Digest 30-21-1742; O. D. 979-) The 192 1 law takes care of the foregoing situation, as the notes evidently were bad in part.*^ Regulation. Where bonds purchased before March i, 1913, de- preciated in value between the date of purchase and that date, and were in a later year ascertained to be worthless and charged ofif, the owner is entitled to a deduction in that year equal to the value of the bonds on March i, 1913. Bonds purchased since February 28, 1913, when ascertained to be worthless, may be treated as bad debts to the amount actually p-aid for them." Bonds of an insolvent corporation secured only by a mortgage from which on foreclosure nothing is realized for the bondholders are regarded as ascertained to be worth- less not later than the year of the foreclosure sale, and no deduction for a bad debt is allowable in computing a bondholder's income for a subsequent year (Art. 154. ) A new provision is found in article 154 of Regulations 62, permitting taxpayers to deduct part of the cost of bonds when it can be shown that the holder will recover a smaller amount. This is in accordance with the statute, which permits "part" of a debt to be deducted. Bonds of traction companies whose hope of revival is small are examples. " See page 1030. 'Reg. 45, Art. 154 (1919 edition), read: "but not exceeding their amortized value if purchased at a premium." Since the Treasury did not permit the premium on bonds purchased to be amortized, the limitation was unnecessary. (B. 17-20-887; O. D. 475.) FOR BAD DEBTS 1039 Regulation A taxpayer (otlicr than a dealer in securi- ties) possessing debts evidenced by bonds or other similar obligations can not deduct from gross income any amount merely on account of market fluctuation. Where a taxpayer ascertains, however, that due, for instance, to the financial condition of the debtor, or conditions other than market fluctuation, he will recover upon maturity none or only a part of the debt evidenced by the bonds or other similar obligations and is able to so demonstrate to the satisfaction of the commissioner, he may deduct in computing net income the uncollecti- ble part of the debt evidenced by the bonds or other similar obliga- tions. (Art. 154.) Debts held prior to March i, 1913 — basis for deduction. — Regulation To authorize a deduction for a bad debt on account of notes held prior to March i, 1913, their value on that date must be established.'' (Art. 154.) Obviously if a taxpayer in 1921 charged off a debt which had been carried as good since March i, 191 3, it would l^e reasonable to inquire whether or not on that date the debt was deemed to be good. But the mere fact that on that date there was some doubt as to its value would not mean that the deduction was an improper one in 1921. Until the passage of the 192 1 law, the Treasury always held that no debt could be charged off until it was 100 per cent bad. Subsequent transactions with a debtor would indicate prima facie that the debt was collectible at March i, 1913. Debts Must Be Actually Ascertained to be Worthless in Whole or in Part The law specifies that a debt to be deductible as bad must be "ascertained to be worthless'' [section 214 (a-7)], and it also specifies that "the Commissioner ma}^ allow such debt to be charged off in part." " [Former Procedure] Regulation. "All debts representing amounts that became due and payable prior to March i, 1913, and not ascertained to be worthless prior to that date, whether representing income or a return of capital, are held to be allowable deductions, under paragraph B of the law, in a return of income for the year in which they are actually ascertained to be worth- less and are charged off." (T. D. 2224, July 13, 1915.) I040 DEDUCTIONS When is a debt worthless? — in describing the deductions permitted to individuals the regulations set up the following general standards. Debts entirely worthless. — Regulations.'' .... Where the surrounding circumstances in- dicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of these facts will be sufficient evidence of the worthlessness of the debt for the purpose of de- duction (Art. 151.) Debts partly worthless.^" — Regulations Where all the surrounding and attending cir- cumstances indicate that a debt is worthless, either wholly or in part, the amount which is worthless and charged off or written down to a nominal amount on the books of the taxpayer shall be allowed as a deduction in computing net income. There should accompany the return a statement showing the propriety of any deduction claimed for bad debts. No deduction shall be allowed for the part of a debt ascer- tained to be worthless and charged off prior to January i, 1921, un- less and until the debt is ascertained to be totally worthless and is finally charged off or is charged down to a nominal amount, or the loss is determined in some other manner by a closed and completed transaction. Before a taxpayer may charge off and deduct a debt in part, he must ascertain and be able to demonstrate, with a reason- able degree of certainty, the amount thereof which is uncollectible. .... In determining whether a debt is worthless in whole or in part the Commissioner will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. Partial deductions will be allowed with re- spect to specific debts only. . . .■ . (Art. 151.) If part of a debt was ascertained to be worthless and was charged off prior to 192 1, the Treasury under previous prac- tice would not allow the deduction. The entire amount had to be worthless and be charged off. It appears that the Treas- ury wall not now allow the partial write-off, previously denied, ' [Former Procedure] The following sentence in Reg. 45. Art. 151, which does not appear in Reg. 62, indicates former procedure : "An account merely written down .... is not deductible." "* [Former Procedure] For rulings when compositions and other set- tlements were made, see Income Tax Procedure, 1921, pages 829-831. FOR BAD DEBTS IO41 to be deducted in the return until the entire amount of such debt is ascertained to be totally worthless. For example, if an account for $1,000 was written down to $600 in 1920, the $400 deduction was disallowed if claimed in the 1920 return. It would, however, form part of the reserve set up as of January i, 192 1, and if not collected by December 31, 192 1, the entire $1,000 would no doubt be deductible in 1921. When debtor corporation becomes insolvent. — The statements in the foregoing regulation are couched in terms broad enough to include all debts due the individual whether from corporations or from other individuals. Ruling. An insolvent corporation was lieavily indebted to A, its majority stockholder. A agreed to take as payment of the company's indebtedness to him, the free assets of the company and to assume its liabilities other than its bonded indebtedness. This transaction is considered a cancellation of the debt due to A and any loss sustained by him is deductible only in the return for the year when the trans- action took place, and not when the assets were disposed of subse- quently. The measure of the loss would be the difference between the liabilities assumed including the debt to himself, and the value of the assets at the time received by A. (C. B. 2, page 138; A. R. R. 30.) In the following ruling the solvency of the corporation was in doubt. Under the 192 1 law, in such cases taxpayers would be justified in charging off the debt in part. Ruling. In 1917, A loaned to a corporation loar dollars, taking a note secured by a mortgage upon real estate against which there were two prior mortgages, and in his 1918 return he deducted this in- debtedness as a bad debt and the question is raised as to the justifica- tion of the deduction. The debtor held at the end of 1918 this prop- erty, said to have been worth 75.^- dollars, which value was established by an appraisal made by B, a disinterested person, who later purchased the property. A second property held by the debtor at the end of 1918, consisted of land of the value of yx dollars, which property was held by the corporation as late as June, 1920. Against these two properties, having a combined value of 82^- dollars, there rested at the end of 1918 a total indebtedness of yix dollars (of which 53.1- dol- lars consisted of mortgages prior to A's), leaving the net worth of 1042 DEDUCTIONS the corporation i i.r dollars. The corporation was a going concern at the end of 191 8. Held, that A, under the circumstances, was not justified in claim- ing that the entire debt was worthless at the close of 1918, nor that a substantial part thereof would not be recovered, though from his knowledge of conditions as they existed at the end of 1918, he was undoubtedly justified in believing that, should foreclosure occur, his loan of lo.r dollars would result in a loss. (C. B. 4, page 172; A. R. R. 365.) If soon after the dose of 1918, A's judgment of the worth- Icssness of the debt was verified, the subsequent event would be affiriuative evidence that the deduction in 19 18 was proper. Loss due to seizure of property by Russian Soviet govern- ment. — Rulings. A in 1916 and 1917 purchased through a New York bank certain credits in two Russian banks. Subsequently A made several efforts to communicate with these banks but without success, and the New York bank is unofiicially informed that these particular banks were taken over in the latter part of 1917 by the Russian Fed- erated Soviet Republic and their assets dissipated, confused, and de- stroyed. The taxpayer has claimed the amounts paid for these credits as a loss in his return for 1918. The Committee is of opinion from what is a matter of common knowledge, and from the statement made as to the endeavor to com- municate with the debtors and the information received as to the banks' practical abandonment of their business, that the taxpayer was justified in charging off these credits in 1918 as a total loss. (C. B. 3, page 165; A. R. M. 64.) Bank deposits in Russian banks can not be considered as worth- less for the purpose of claiming a' deductible loss in a return for the taxable year 1919. The Bureau is informed that Russian rubles in the form of bank deposits were sold during the latter months of 1919, which would indicate that they were not at that time worthless. (C. B. 2, page 137; O. D. 535.) In order that a taxpayer may claim as a deduction Russian rubles owned by him and deposited in a Russian bank, it is necessary for him to submit evidence establishing the fact that the bank in which the deposits were made has lost its identity as a banking institution or that it has been taken over by the Soviet Government and its funds requisitioned, confiscated, or dissipated. (C. B. 4, page 173; O. D. 923-) FOR BAD DEBTS IO43 Accounts uncollectible because of moratorium in Cuba. — Ruling. As a result of the moratorium in Cuba certain accounts due from customers there were uncollectible at the close of the taxable year 1920. Held, that these accounts can not be deducted as bad debts until it has been definitely ascertained that they are worthless and are charged off the books. (C. B. 4, page 173; O. D. 891.) Under the 1921 law taxpayers may make a reasonable esti- mate of the amount uncollectible in such a case and deduct such amount from income. The loss claimed must be determined with respect to each account separately. Depreciation of collateral security. — When a debtor who has put up collateral is known to be unable to pay and the collateral security is worth substantially less than the amount of the debt, there is no good reason why the taxpayer should be compelled to sell the collateral, or make a "wash" sale of it, in order to charge off the loss which has been sus- tained. It is clear, under the 1921 law, than an accrued loss of 50 per cent of a debt, when determined by recognized methods of accounting, is as deductiljle as a loss of 100 per cent.^^ Bankruptcy as a test. — Regulation Bankruptcy is generally an indication of the worthlessness of at least a part of an unsecured and unpreferred debt.. Actual determination of worthlessness in bankruptcy cases is sometimes possible before and at other times only when a settlement in bankruptcy shall have been had.^- Where a taxpayer ascertained a debt to be worthless and charged it off in one year, the mere fact that bankruptcy proceedings instituted against the debtor are ter- minated in a later year, confirming the conclusion that the debt is worthless, will not authorize shifting the deduction to such later year. In the case of debts existing prior to March i, 1913, only " See also C. B. 3, page 167 ; A. R. R. 352. '- [Former Procedure] Article 8 of Regulations 33, 1918, stated that the "determination of worthlessness in such cases is possible only when settlement in bankruptcy shall have been had." Article 151, Reg. 45, read: "Bankruptcy may or may not be an indi- cation of the worthlessness of a debt." I044 DEDUCTIONS their value on that date may be deducted upon subsequently ascer- taining them to be worthless (Art. 151.) The new regulation distinguishes "unsecured and unpre- ferred debts" from others, indicating that in practically all cases of bankruptcy there may immediately be charged off at least a part of "unsecured or unpreferred debts." Foreclosure sale on a mortgage.^ ^ — Regulation. Where mortgaged or pledged property is lawfully sold (whether to the creditor or other purchaser) for less than the amount of the debt, and the mortgagee or pledgee ascertains that the portion of the indebtedness remaining unsatisfied after such sale is wholly or partially uncollectible, and charges it off, he may deduct such amount as a bad debt for the taxable year in which it is ascer- tained to be wholly or partially worthless and charged off. Where a taxpayer buys in mortgaged or pledged property for the amount of the debt, no deduction shall be allowed for any part of the debt. Gain or loss is realized when the property bought in is sold or disposed of. Accrued interest may be included as part of the deduction only when it has previously been returned as income. (Art. 153.) The foregoing regulation recognizes that the purchase of inortgaged property by the mortgagee for less than principal and accrued interest, demonstrates that the debt is bad "in part" and such "part" may be deducted. The Treasury has held that upon foreclosure, when the proceeds were sufficient only to satisfy the first mortgage, " [Former Procedure] Regulation. "Where under foreclosure a mortgagee buys in the mort- gaged property and credits the indebtedness with the purchase price, the difiference between the purchase price and the indebtedness will not be allowable as a deduction for a bad debt, for th?" property which was secur- ity for the debt stands in the place of the debt. The determination of loss in such a situation is deferred until the property is disposed of, except where a purchase money mortgage is foreclosed by the vendor of the property Only where a purchaser for less than the debt is another than the mortgagee may the difference between the debt and the net pro- ceeds from the sale be deducted as a bad debt." (Reg. 45, Art. 153.) T. D. 3264 and 3265 (both dated December 21, 1921) amended the regulations under the 1918 and 1917 laws, respectively, to read in accord- ance with Reg. 62, Art. 153, quoted above. FOR BAD DEBTS IO45 the amount of the second mortgage may be charged off if action against the mortgagor would be useless/* When a creditor bids up to the amount of his claim when property is offered for sale, it is prima facie evidence of its value, and the regulation is in order. But if it can be shown that the property acquired is not worth the amount of the claim, and that the bid was merely formal, the law permits the deduction of any part of the debt which is bad. Recoveries.— In some cases debts presumably "definitely ascertained to be worthless" have unexpectedly proved to be collectible in whole or in part. The following regulations provide for the taxation of such collections. Regulations Bad debts or accounts charged off subse- quent to March i, 191 3, because of the fact that they were deter- mined to be worthless, which are subsequently recovered, whether or not by suit, ccfnstitute income for the year in which recovered, re- gardless of the date when the amounts were charged off (Art. 51.) .... Any amount subsequently received on account of a bad debt or on account of a part of such debt previously charged off, and allowed as a deduction for income tax purposes, must be included in gross income for the taxable year in which received (Art. 151.) If collections are made from accounts charged off prior to March i, 191 3, it may be assumed that on that date there, was due at least as much as the amount collected, exclusive of interest. Therefore there can be no element of taxable income in such recoveries except as to interest accrued after March i, 19 13. The requirement that recoveries from ac- counts arising out of transactions since March i, 1913, be included in current income instead of reopening the accounts and returns of prior years, is reasonable. Loss of endorser or guarantor — when determined. — Upon the failure of the maker of a note to take it up at maturity, the endorser may have to pay and thereupon a debt due to the Bulletin 42-20-1244; O. D. 687. 1046 DEDUCTIONS endorser arises. Strictly speaking, it may not be ''ascertained to be worthless" immediately, but everyone knows that ordi- narily the chances are at least 99 to i that it will be a bad debt and usually it takes very little time to reach this con- clusion. After allowing a reasonable time in which to ascer- tain why the maker does not make good, the endorser should charge it off as a bad debt, taking credit for it in his return. The right to deduct the bad debt is governed by the regu- lations cited. There is no requirement that the obligation to pay a note as endorser or guarantor shall have arisen from business or trade, so that the restrictions of past years as to losses would not apply in any case. Ruling. Where a person purchases bonds for another, guar- anteeing said bonds against any loss, and a loss occurs due to subse- quent insolvency of the corporation issuing same, and the guarantor makes good the loss, the same is not deductible within the meaning of section 214, article 141, of the Revenue Act of 1918, unless such loss occurs in trade or business or in a transaction entered into for profit. (C. B. I, page 125; O. D. 241.) The author does not agree with the foregoing ruling. It is difficult at times to distinguish between a bad debt and a loss, but when a debt to the taxpayer is created and the debt becomes bad, the law permits a deduction therefor in all cases. Liability as endorser at March i, 191 3. — Ruling. The records in the case show that in the year 190- and subsequent thereto, A indorsed certain notes issued by the M Company and also certain notes issued by the N Company, which companies became insolvent prior to March i, 1913, and A there- upon became liable as indorser for payment of said notes, since which time he has made certain payments of principal and interest. .... it appears clear that A has never become primarily liable for payment of the principal of the said notes or the interest thereon, nor has he ever given any written agreement to make such payment. As the original notes became due they were renewed, in the names of the original makers and were indorsed by A. Had the latter, upon default in payment of the notes prior to March i, 1913, then given his own note or notes in payment, a debt would have been created upon his part which would have precluded the allowance of deduc- tions claimed to cover payments made in liquidation of his own notes, FOR BAD DEBTS IO47 inasmuch as payments made in liquidation of an indebtedness created prior to March i, 1913, can not, under the provisions of any income tax law enacted since that date, be allowed as deductions. In the opinion of the Committee, A suffered no actual loss through his indorsement of the said notes until he made his first payment in liquidation of their principal and interest thereon. When a payment was made it created a debt in his favor due from the makers of the notes, which debt was at the time it was so created definitely known to be worthless and uncollectible. Each additional payment created an additional bad debt. In view of the foregoing the Committee recommends that the action of the Income Tax Unit in disallowing the deductions claimed by A for the years 1917, 1918, and 1919 to cover amounts paid in liquidation of the said notes and interest thereon be reversed, and that the said deductions be allowed in the amounts as claimed. (B. 38-21-1837; A. R.R. 479-) The reasoning in the foregoing ruHng would apply to transactions after March i, 1913, as well, and enable taxpayers to take a deduction as payments are made on the theory that each payment ''creates" a debt from the maker, which is known to be worthless. Bad debts of banks and other corporations, under govern- ment supervision. — A new provision is found in the regula- tions under the 1921 law, as follows: Regulation Where banks or other corporations which are subject to supervision by Federal authorities (or by State authori- ties maintaining substantially equivalent standards) in obedience to the specific orders, or in accordance with the general poHcy of such supervisory officers, charge off debts in whole or in part such debts shall, in the absence of affirmative evidence clearly establishing the contrary, be presumed, for income-tax purposes, to be worthless or recoverable only in part, as the case may be. (Art. 151.) Illegal wari-^ants received by bank. — Ruling. A bank received illegal warrants from the auditor of a political subdivision of a State in payment of promissory notes which it held against the auditor and the treasurer. The treasurer made payment of the warrants by checks drawn on an account of the sub- division at the bank. In compromise of the claim of the subdivision for the money misappropriated the bank paid x dollars, which amount it set up as a claim against the officials in a special account of bills 1048 DEDUCTIONS receivable. Tlie bank brought suit against the ex-officials, and sev- eral years later, in 1919, final judgment against the bank was ren- dered. Upon the rendition of the judgment, the bank in 1919 charged off a portion of the debt and carried the remainder in the profit and loss account as a debit balance. Held, that the entire amount actually lost by the bank is deductible as a bad debt in 1919. Held also, that the court costs, attorney's fees, and other expenses incurred in attempting to collect the amount paid under the com- promise agreement are proper deductions from the income of the year in which such expenses were incurred. (B. Digest 27-21-1713; O. D. 965.) Debts Must Be Charged Off Within the Year Charging off bad debts. — The 1921 law requires in the case of individuals and corporations that bad debts must be charged off within the taxable year.^° These words w^ould seem to require that actual book entries be made by both corporations and individuals in case they desire to claim de- ductions for bad debts. However, the answer to question 90 of the Income Tax Primer interpreting the 191 7 law which used the same phrase in describing the conditions which are necessary to claim a debt as a deduction reads : "If hooks are kept it must be charged off within the year," plainly inferring that it is still deductible when no books at all are kept. "Within the year." — The phrase "within the year" refers to "the year for which the return is made."^" To be deductible the debts must be charged off or included in a reserve which is charged off. In the case of corporations, deductions for bad debts prior to the 19 18 law were classified as business losses and these, it will be recalled, had to be "actually sustained and charged off within the year." [1917 law, section 12 (a) second.] "^ [Former Procedure] The igi3, 1916, 1917 and 1918 laws all con- tained a similar requirement. "Reg. 33, 1918, Art. 151. FOR BAD DEBTS 1049 The term "within the taxable year" should be construed in an accounting sense, that is, if books of account are closed as of December 31 and an entry written in the books during January is dated December 31, the entry is deemed to have been made within the year ended December 31. CHAPTER XXXI DEDUCTIONS FOR DEPRECIATION Depreciation is a decline in the value of property such as may reasonably be expected to occur as a result of wear and tear and gradual obsolescence. It is due to the possession and use of assets, and therefore is a part of the cost of operation. P. D. Leake defines it as "expired outlay upon productive plant." The phrase "accrued renewals" sometimes used to describe depreciation is illuminating. It is to be noted that depreciation is usually treated as a comprehensive term which includes all declines of the nature described above. The Treasury's definition is : RuJ.iNG. Depreciation means the gradual reduction in the value of property due to physical deterioration, exhaustion/ wear and tear through use in trade or business. (Bulletin "'F,'" page 5.) The 192 1 law does not use the word "depreciation"' at all in describing the deduction permitted under this head. Law. Section J14 (a-8) [Individuals]: Section 234 ( a-7) [Cor- porations]. That in computing net income there shall be allowed as deductions : A reasonable allov>ance for the exhaustion, wear and tear of prop- erty used in the trade or business, ^ including a reasonable allowance for obsolescence. In the case of such property acquired before March ' [Former Procedure] 1913 law. (Individuals) Section II B. Sixth. "A reasonable allowance tor the exhaustion, wear and tear of property arising out of its use or employment in the business." (Corporations) Section II G (b). "A reasonable alluwance for depre- ciation by use, wear and tear of property, if any." 1916 law. (Individuals) The words "or trade" were added. (Corporations) The words "actually sustained and charged off" were inserted. The 1917 law made no change. 1918 law. Section 214 (a-8). A reasonable allowance for the exhaus- tion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. Section 234 (a-7) for corporations reads exactly the same as for in- dividuals. 1050 FOR DEPRECIATION IO51 I, 1913, this deduction shall be computed upon the basis of its fair market price or value as of March i, 1913; .... The last sentence quoted above was added in the 1921 law. Law. Section 215 (a) That in computing net income no deduc- tion shall in any case be allowed in respect of — I Individuals j (2) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; .... (3) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made;- .... The Hmitation on deductions by corporations (section 235) is the same as for individuals stated in section 21 c^ quoted above. In the regulations of the Treasury depreciation "applies to that which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence due to the normal progress of the art, as where machinery or other property must l)e replaced by a new invention, or due to the property becoming inadequate to the growing needs of the business."^ What may be termed ordinary obsolescence will be discussed in this chapter. Separate chapters in this book are devoted to extraordinary obsolescence and to depletion.* It will be clear from the context whether depreciation is used in the inclusive or in the restricted sense. Depreciation is often treated as though no accurate esti- mate of the life of assets were possible, with the result that in some cases excessive reserves are created and in other cases there are no reserves at all. Perhaps the controlling reason for this variation of practice is a desire to utilize this as an elastic factor to bring about a desired effect on the balance sheet and the profit and loss statement. In some cases it is also felt ^Subsections (2) and (3) are substantially the same as in the 1913, 1916, 1917 and 1918 laws. "Art. 162, Reg. 62. Art. 159 of Reg. 33, 1918, differentiated depreciation from "depletion, obsolescence and other losses." * See Chapter XXXII, "Deductions for Obsolescence," and Chapter XXXIII, "Deductions for Depletion." 1052 DEDUCTIONS that excessive book valuations may favorably affect the insur- ance adjustment in case of fire, but this fallacy is gradually losing ground. The recent improvement in methods of allow- ing for depreciation can be traced in large part to the installa- tion of cost systems, which have brought about an increasing recognition of this factor as a necessary cost of production. Another powerful influence in the direction of accurate and adequate reserves has been the enactment of federal and state income and other tax laws calling for returns of net profits. Altogether there has in recent years been a general awakening to the fact that depreciation is a vital issue in correct account- ing. There are still wide differences of opinion as to the amount of the allowance which should be made from time to time. Net profit means only one thing in the vocabulary of the pro- fessional auditor — a meaning which should be universally recognized — and that is the excess of income over operating costs, expenses and losses. It cannot be determined by taking into account all the income and a part only of the charges against income. Full provision for depreciation must be in- cluded among the costs of operation, or the result may not be accepted as representing net profit. Statements, some- times encountered in published reports, to the effect that a corporation has realized net profits amounting to a certain sum and that out of these profits an allowance for deprecia- tion has been made are both misleading and illogical. It is an unfortunate fact that the efforts of accountants to secure the establishment of proper depreciation reserves have in some respects been retarded and hampered by the atti- tude of certain inspectors in the administration of the income tax law. Part of the difficulty has been due to a mistaken general policy on the part of the government in favor of strict limitations on depreciation. In the first place, reserves for this purpose, if found in the future to be too large, will be ultimately taxable for any excess, and, in any case, the government cannot afford in the long run to ignore sound FOR DEPRECIATION 1053 economic principles in determining net income. Perhaps the greatest share of the trouble is due to the action of in- competent inspectors who sometimes arbitrarily insist upon a reduction of reserves to insufficient amounts. Fortunately their action is rarely sustained by the officers of the Treas- ury, whose recent attitude in the matter of depreciation and depletion has been in accord with good accounting practice. Applicability of rates of depreciation used in prior years. — Taxpayers who use substantial rates of depreciation have some- times been embarrassed by examiners who applied the rates used in 191 7 and 191 8 to their plant accounts for many years prior. In some cases this application of the rates practically wiped out the plant account as at January i, 19 17, (except for the additions of the years immediately preceding) and thus greatly reduced the allowable invested capital for excess and war profits purposes. Such a method, of course, is inaccurate and falls of its own weight. In most cases it is possible to prove that on January i, 191 7, the actual value of the plant, without taking apprecia- tion into consideration, greatly exceeded the theoretical valua- tion. Such result does not in itself prove that because the rates are incorrect as applied to prior years they are also in- correct as applied to 191 7 and 1918. The rates are incorrect as applied to prior years because during those years the renewals, repairs, maintenance and capital outlays charged to operations greatly reduced the reserve necessary to reflect accurately the net going value of the plant on the books of account. One concern charging high dei)reciation rates for 20 years prior to 1917 might show the same net plant values at the end of the period as a concern which charged off no depreciation, as such, during the entire period. The La Belle Iron Works decision^ clearly holds that tax- '41 Sup. Ct. 528. 1054 DEDUCTIONS payer's actual investment at January i, 191 /, is the proper measure of invested capital, irrespective of book entries. During the past year the Treasury has recognized that the practice of examiners in revising depreciation allowances set u\) on taxpayer's books or of making purely theoretical allow- ances where specific depreciation allowances had not formerly l)een set up as such in the taxpayer's accounts, was an improper act, and that the plant values at January i. 1917, should, with respect to depreciation accrued prior to that date, be accepted as they appear in the taxpayer's l)Ooks unless the revenue agents can |)roduce affirmative evidence that the book values of plant are in excess of their actual value at the beginning of the taxable year. The full text of the memoranda published by the Treasury on this subject appears in Chapter VIII of Ap- pendix A. Prior to the enactment of the 191 7 law, it made little difference to many concerns, from a tax point of view, what rates of depreciation were charged. Furthermore, dur- ing 191 7 and 19 1 8 there were good reasons for greatly increas- ing depreciation rates over those formerly used. The British War Ministry cannot be charged with holding a brief for American manufacturers ; therefore the rates of depreciation suggested in official memoranda of the War Ministry are of great interest as having direct bearing on conditions in the United States. When normal rates of de- preciation on machinery were yyi per cent per annum, it was suggested that there be allowed the following additions : Addition for unskilled labor up to 50% 3M% Addition for overtime 1 1 14 Total additions 15% Normal rate 73/2 Total 22i^% Maximum allowance 25% Engineers of the War Department of the United States reported that the British additional rates were too liberal and FOR DEPRECIATION- ' 1055 recommended that the maximum to be used in the foregoing example be fixed at 15 per cent. Taxpayers whose accounts are being examined should give careful attention to the actual conditions during 191 7 and 1 9 18 and when special depreciation was warranted by exist- ing conditions, as compared with previous practice, they should insist on proper allowances. Conditions Precedent to Allowance for Depreciation The general provision in the regulations which sets forth the conditions which must be met before a deduction for de- preciation is allowed reads as follows: Regulation. A reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business may be deducted from gross income. For convenience such an al- lowance will usually be referred to as depreciation, excluding from the term any idea of a mere reduction in market value not resulting from exhaustion, wear and tear, or obsolescence. The proper al- lowance for such depreciation of any property used in the trade or business is that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate) by which the aggregate of such amounts for the useful life of the property in the business will suffice, with the salvage value, and having due regard for expenditures made , for current upkeep, at the end of such useful life to provide in place of the property its original cost (not replacement cost), or its value as uf March i, 1913, if acquired jjy the taxpayer before that date (Art. 161.) "Useful life," as used in the above regulation, has been interpreted by the Treasury to mean "the period of time over which an asset may be used for the purpose for which it was acquired." (C. B. 4, page 178; O. D. 845.) It is proper that taxpayers should adopt a consistent plan and they should adhere to it until actual conditions call for a change. If it is calculated that machinery depreciates a given percentage under certain conditions, it is not inconsistent to change the percentage when conditions change. 1056 DEDUCTIONS Property depreciated must not be for personal use. — Regulation The deduction of an allowance for depre- ciation is limited to property used in the taxpayer's trade or busi- ness (Art. 162,) To quote the language of the Treasury : Ruling. If used chiefly for pleasure, no depreciation deduction is allowable. (Bulletin "F," page 6.) In the case of the farmer the regulations expressly permit depreciation on all farm buildings "other than a dwelling occu- pied by the owner.'"^ Depreciation of residence. — When a residence is used part of the year by the owner and is rented for part of the year, depreciation will be an allowable deduction for the period of the year when used for income-producing purposes. The depreciation is not necessarily based on the proportion of time during which the property is rented, because the actual depreci- ation during such time may be greater than during the time of occupancy by the owner. If the taxpayer owns a summer cot- tage and rents it for three months during the summer and occupies it personally during one month, it may be that the entire annual depreciation should be deducted since the facts would indicate that the property as a whole is held for in- come-producing purposes and that the occupancy by the owner for a short period is merely incidental. The test, however, would be the actual circumstances in each case. Regulation No such allowance may be made in respect of ... . building used by the taxpayer solely as his residence, nor in respect of furniture or furnishings therein, personal effects, or clothing; .... (Art. 162.) Residence used partly for business — or sublet. — Ruling. If a portion of the residence is used for business pur- poses, as in the case of a physician or any other professional man who has his office in his home, a proportionate part of the deprecia- 'Art. 171; see Chapter XXXIX. FOR DEPRECIATION 1057 tion sustained may be deducted, the amount to be based generally on the ratio of the number of rooms used for business purposes to the total number of rooms in the building. The same principle is applicable if a taxpayer rents a portion of his personal residence to other individuals. Under such conditions, however, the taxpayer must include in his gross income any amounts received as rentals. A taxpayer who is not allowed a deduction for depreciation of his personal residence may, in case he sells the property, disregard depreciation in computing any taxable profit derived from the trans- action. If a taxpayer owns residential property and rents it to other in- dividuals, he is entitled to a deduction for depreciation of the rented property even though the property is not used in his principal trade or business but must include in gross income the entire amount re- ceived as rentals. (Bulletin "F," pages 7 and 8.) "Cost" of residence is not reduced—by deprecia- tion. — Ruling. Inasmuch as no deduction for depreciation of the per- sonal residence of a taxpayer is allowable in his income tax returns, a taxpayer in determining the gain or loss arising from the sale of his personal residence, continuously occupied by him as such, is not required to reduce the cost of the property or its fair market value as at March i, 1913, by the depreciation sustained. (B. 30-20-1085; O. D. 600.) Property which may be depreciated.' — Regulation. The necessity for a depreciation allowance arises from the fact that certain property used in the business gradually approaches a point where its usefulness is exhausted. The allow- ance should be confined to property of this nature. In the case of tangible property, it applies to that which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence due to the normal progress of the art, as where machinery or other property must be replaced by a new invention, or due to the property becoming inadequate to the growing needs of the business. It does not apply to inventories or to stock in trade, nor to land apart from the improvements or physical development added to it. It does not apply to bodies of minerals which through the process of removal suffer depletion, other provisions for this being made in the statute. .... (Art. 162.) ' For depreciation of land, see page 1098. For depreciation of farm buildings, equipment and livestock, see Chap- ter XXXIX, "Farmers." 1058 DEDUCTIONS Potential earning power not subject to deprecia- tion. — Ruling. The potential earning capacity of an individual, his in- ventive genius or his literary ability may not be made the basis of an allowance for depreciation. (Bulletin ''F," page 6.) Replacements and renewals must not be twice deducted. — Expenditures for the upkeep of property range by imper- ceptible gradations from the most insignificant repairs to the replacement of the largest and most costly units. The law, of course, intends that all such expenditures shall be deducted, but the necessity arises of distinguishing between those which shall be deducted annually as expenses and those for which provision shalt be made through cumulative depreciation allowances. In making this distinction, care must be taken to avoid the double deduction of expenses. The problem is com- plicated by the fact that minor repairs are made upon the most expensive machines. While theoretically it may be conceivable that depreciation rates might under some conditions be so delicately adjusted as to provide completely and perfectly for the entire upkeep of a machine or other piece of property, as a practical matter it is so difficult as to be impossible. The accountant's solution is to draw a somewhat arbitrary line between the* small incidental items of repair, replacement and maintenance and the heavy items of renewal and replacement, charging the first group to expense and the second to depre- ciation reserves. The depreciation rates are calculated with this assumption in mind and consequently depreciation re- serves should be kept free from charges except those for un- questioned renewals or replacements of major parts. The regulations satisfactorily cover this point in the following statement. Regulations Property kept in repair may, nevertheless, be the subject of a depreciation allowance (Art. 162.) The cost of incidental repairs which neither materially' add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted FOR DEPRECIATION 1 059 as expense, provided the plant or property account is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appre- ciably prolong the life of the property, should be charged against the depreciation reserve if such account is kept (Art. 103.) The Treasury in its latest rulings recognizes the necessity for proper repair and depreciation charges. Ruling. Accordingly, amounts paid for repairs are not allowable deductions if they are duplications of allovi^ances for depreciation. It does not follow, however, that there may not be in the same case allowable deductions both for depreciation and payment for repairs. As a rule, property that has been subject to use even though main- tained in serviceable condition by repair has a shortened expectancy of usefulness. In such case there may be a deduction for payments for repairs and also a deduction for loss due to depreciation of the property which occurred despite the maintenance of such property in repair. (Bulletin "F," page 29.) Closely related to this question is the treatment of ex- penditures for making improvements. This is discussed in the following decision of a United States Circuit Court which holds that improvements which are not permanent in char- acter are deductible as expense : Decision. (Syl.) Amounts expended by a business corporation in enlarging or making improvements in its office or premises, not in the nature of permanent improvements to the property, but to facilitate the transaction of a growing business, should properly be deducted as necessary expenses of the business. (Connecticut Mutual Life Insurance Co. v. Eaton, 218 Fed. 206.) The principle outlined in the law and regulations appears to be clear, but considerable difficulty has arisen in its appli- cation because of the refusal of revenue inspectors to allow in some cases for both repairs and depreciation, on the ground that the former includes the latter. The practice is not uni- form, the inspectors frequently differing in their interpreta- tion of charges which may be either repairs or renewals. Naturally, they incline to the conclusion that where there is a doubt, the expenditure is a charge against the reserve, but good business practice requires that in case of doubt the loOo DEDUCTIONS repairs be charged to operating expenses. The true issue is merely the avoidance of a double charge against income. Inspectors have been known to hold that where a part of a machine which must be replaced frequently, such as a shuttle or a bobbin, which forms part of a loom, wears out or breaks, the replacement of such part should be charged against depreciation reserve, since this is intended to cover "deteriora- tion of property on account of its use, wear and tear." In some concerns parts of this sort are termed "supplies," and as such are charged directly to cost of manufacturing. Upon the original acquisition of a loom, its entire cost, including installation of every part and action, ready to run, is charged to capital. The same rule applies to a sewing machine. First cost would include a machine equipped with needles, but it is not customary to set up a depreciation reserve for the re- newal of needles. As purchased they are charged to supplies, or some similar account, and, subject to stock on hand at the beginning and end of the period, all purchases are charged to cost of manufacture, not to repairs. There is a sHght error here which is too trivial to consider in practice, but one that evidently worries some inspectors. It is, that the re- newal of a needle, costing perhaps one-tenth of one cent, should be charged to depreciation reserve, instead of supplies, because the first cost of the sewing machine was charged to plant. But this would be an impossible procedure, because re- newals of this character are frequent. Therefore, the only error lies in the fact that a small part of the machine, assumed to have a life of, say, ten years, may have been renewed from time to time up to the end of the useful life of the machine. Accountants must disregard such fine distinctions. Some manufacturing plants and mills produce in their own shops various parts of looms and other machines used to manu- facture the principal products of the mills. These parts range from the largest to the smallest unit of each machine, so that over a period of years the looms are continually being re- newed, particularly where the policy of the mill management FOR DEPRECIATION I061 is to maintain the plant at the peak of operating efficiency. In such cases complete analyses of the cost records should he kept in order to distinguish replacement items from those which are "incidental repairs." Depreciation of leased machinery. — Ruling. The M Company owns certain apparatus which it leases tinder contracts for a period of years at an agreed rental. The con- tracts provide that the lessor shall maintain the apparatus for the ])eriod of the contract without charge to the lessee and that the ap- paratus shall remain the property of the lessor. Although the ap- ])aratus is of some value at the expiration of the lease, such value is less than the cost of its removal and it is therefore abandoned by the lessor at the expiration of the lease. The expenditure for labor incident to the installation of the ap- ])aratus, being possible of allocation thereto, and the cost of the mate- rial entering into the installation are held to be capital expenditures, recoverable through depreciation spread over the term of the origi- nal lease. If the apparatus had a salvage value at the expiration of the lease it would be necessary to take this value into consideration in computing deductions for depreciation as provided in article 161 of Regulations 45. (B. 44-21-1894; O. D. 1082.) The costs of maintaining the apparattis under the terms of the contract are, of course, chargeable against current income. Depreciation of railway roadway off.set by mainten- ance AND appreciation. — In a recent case,^ the court held that: Decision. (Syl.) i. Deductions — Depreciation— Loss in Value of Roadbed of Railroad. No deduction for depreciation in value of the roadway of a rail- road may be taken where, because of repairs, renewals and replace- ments, the roadway as a whole is as valuable at the end of the tax- able year as at the beginning. 2. Deductions — Depreciation. The depreciation which may be deducted in determining net income is the decrease in intrinsic value due to wear and tear, decay, obsolescence, etc., of the physical property suffered during the tax- able year as distinguished from the market value. ^Nashville, Chattanooga and St. Louis Ry. Co. v. U. S.. 269 Fed. 351; certiorari denied, 65 L. Ed. — . 1q52 DEDUCllONS 3. Deduction — Depreciation — Loss in \^alue of Separate Units — Appreciation of Other Units. The roadway must be considered as a whole in determining whether depreciation has been sustained, and the loss in value of separate units of the roadway may be offset by appreciation in other units. 4. Evidence — Sufficiency of Repairs, Renewals, and Replace- ments to Offset Depreciation. There was sufficient evidence that the repairs, renewals, and re- placements made oft'set any loss in value, and that the roadway had not decreased in value, to justify the trial court in refusing to direct a verdict. The decision of the court reads in part as follows : Decision It was was admitted 'by defendant's chief engineer that the expenditures for 1909 "kept the road in a normal condition to carry on its business," that "its normal condition was a good condition," and that the expenditures "had made good the nor- mal amount of depreciation." There was testimony by competent witnesses of railway experience that "there may be depreciation in the units comprising the roadway, track, and structures of the rail- road, while there is no depreciation in the machine as a whole;" also that it is possible "to maintain the roadway, track, and structures so that there will be no depreciation if we consider the roadway, track, and structures as a composite whole;" also that "the service life of any normally operated and normally and well maintained railroad is per- petual, and it is maintained in the condition of property serving its purpose by annual renewals and replacements." The testimony, con- sidered as a whole, tended to support the conclusion that the amounts expended by defendant during the years in question for repairs, re- newals, and replacements should and would have fully oft'set the de- preciation in the various units, and that the defendant's railway and structures were, as a whole, maintained throughout the years in ques- tion in fully as good condition, and were of fully as great intrinsic value as at the beginning of the respective years. The jury would have been clearly justified in inferring from the testimony of de- fendant's chief engineer, taken as a whole, that the value of the road- way had not depreciated during the two years in question ; in other words, that the repairs and renewals that had been made were of such a character as to leave the road at the end of each year of value equal to that at the beginning of the year. That officer's testimony so impressed the trial judge, who stated his opinion from the evi- dence that "there is no reasonable deduction for depreciation estab- lished." Defendant did not directly controvert the situation so shown. Its chief, if not its only reliance, seems to have been on the proposi- FOR DEPRECIATION 1063 tion that in spite of it all there was inevitable annual depreciation in some of the perishable elements not entirely renewed or replaced, so justifying the contention that for this reason there was depreciation within the meaning of the Act, even though the roadway as a whole had not decreased in value. To this argument, as already said, we can not assent. It follows that the trial judge rightfully refused to instruct verdict for defendant. With reference to appreciation offsetting depreciation, the court in the same case said : The contention on which defendant seems to rest its chief criti- cism seems to be that, notwithstanding the roadway as a whole was intrinsically just as valuable at the end of the year as at the beginning of the year, that is to say, although depreciation in given units had been fully overcome by appreciation in others, the railway com- pany would still be entitled to credit for depreciation in such indivi- dual units as had depreciated. We think this contention of defen- dant not sustained by reason or authority, and that the court cor- rectly charged the true criterion. If, as is not entirely clear, it is meant to further suggest that the consideration of functional (as distinguished from physical) depreciation was not allowed by the charge to be taken into account, the suggestion is plainly without merit. Not only did the court define the roadway as including "struc- tures connected with the roadway, such as stations, tool houses and matters of that sort," but it included in depreciation a lessening of original values, "due to wear and tear, decay, gradual decline from obsolescence, that is, getting out of date and inadequacy." In our opinion the jury was given the correct rule for determining the ex- istence or nonexistence of depreciation, which accords with the "or- dinary and usual sense"' of that term "as understood by business men." Von Baumhach v. Sargent Land Co., 242 U. S. 503, 524. To say that property can depreciate without impairment of either intrinsic value or efficiency is to our minds a solecism. The foregoing opinion accords neither with good accounting principles, nor with the position of the Treasury. The case was hrought under the 1909 law and may not be considered as a precedent for procedure under subsequent laws. It is inserted at this point as an ilhistration of the uncertainty of court deci- sions. It is a Circuit Court, not a Supreme Court, decision. Certain repairs are properly capital expenditures. — Although it is an accepted rule that repairs and all other expenses of maintenance should be charged against profit and 1064 DEDUCTIONS loss, an exception to this rule is found in cases where partly worn-out or run-down plants are purchased with the intention on the part of the new owners to rehabilitate them so that they can be operated efficiently. It may be assumed that the pur- chase price takes the poor condition of the plant into consid- eration, in which case the entire cost of repairs and renewals may properly be capitalized. Regulation. Amounts paid for increasing the capital value or for making good the depreciation (for which a deduction has been made) of property are not deductible from gross income (Art. 293.) If the replacements are of a pcnnanent nature they are chargeable to capital. Ruling. The amount expended by a taxpayer during any tax- able year or period for improvements, replacements, or renewals of a permanent nature is a capital investment and is not deductible from his gross income for such taxable year or period. The amount so expended should be charged directly to the property account or to the depreciation reserve account, dependent upon how depreciation charges are treated in the books of account, and a pro rata portion thereof deducted as depreciation each year of the life of such im- provements, replacements, or renewals. (Bulletin "F," page 29.) Depreciation must be entered upon the books of a cor- poration. — Neither the 1921, nor the 19 18. law specifies that depreciation must be charged off on the books of an individual or a corporation," but in other sections of the law the Commis- sioner is given ample i)ower to enforce proper accounting methods. It may be assumed, therefore, that all corporations and all individuals who keep books must enter depreciation on their books or it will not be allowed as a deduction. The re- striction is a proper one.'" The author has no sympathy for " Sec page 1050. '" [Former Procedure] Such a restriction upon corporations was con- tained in section 12 (a), second, of the 1916 law. The 1913 law contained no such provision, but the Treasury never- theless ruled that "in order to be allowable .... the loss . . . must be so entered upon the books of the company as to constitute a lia- bility against its assets." (Letter to collectors, August 27, 1914.) This ruling, while it did not follow the law, conformed to correct account- FOR DEPRFXIATION 1065 any corporation which is not vvilhng to have its income tax returns agree with its Ijooks. The regulations of significance follow : Regulation. A depreciation allowance, in order to constitute an allowable deduction from gross income, must be charged ofif. The particular manner in which it shall be charged off is not material, except that the amount measuring a reasonable allowance for depre- ciation must be either deducted directly from the book value of the assets or preferably credited to a depreciation reserve account, which must be reflected in the annual balance sheet. The allowances should be computed and charged off with express reference to specific items, units, or groups of property, each item or unit being considered separately or specifically included in a group with others to which the same factors apply. The taxpayer should keep such records as to each item or unit of depreciable property as will permit the ready verification of the factors used in computing the allowance for each year for each item, unit, or group. (Art. 169.) Banks may keep additional records for depreciation purposes. Ruling. Held, that where banks under Federal or State statute are required to submit periodically to the Comptroller of the Cur- rency or to the State Banking Commissioner a statement of financial condition, additional records and books may be kept which reflect the correct investment account and net income for income and ex- cess profits tax purposes and that any adjustments made thereon with respect to the banking house furniture and fixtures, depreciation, etc., should be accepted as meeting the requirements of the law and regulations for income and excess profits tax pn''"oses. ( C. B. 4, page 64; A. R. R. Z77-) The reason for this ruling is that the statements rendered to the federal or state authorities frequently include adjust- ments, for instance, the writing down of investments to market ing. Accurate accounting requires that depreciation be shown on the books, but the mere existence of the book record does not make actual depreciation more or less. The courts rightly took the position that if a definite, easily proven diminution of value had occurred, the mere non-entry of it on books of account could not possibly serve to negative the fact. As in so many other matters, the Treasury was incon- sistent in its ruling on the book record of depreciation, because, in gen- eral, it took the proper position that book records are subordinated to facts, while in this respect its position was that the fact is subordinated to the book record. io66 DEDUCTIONS values or the inclusion in expenses of additions to the banking house or its equipment, which are not permissible for income tax returns. Only charges applicable to current year deductible. — Re- cent rulings have now settled beyond question the principle that only those depreciation charges which are properly appli- cable to the current year may be deducted in that year, and any readjustment must be made by filing amended returns (see page 1067). The Treasury has ruled: Rulings. The deduction for depreciation and obsolescence allow- able in the return for any taxable year or period is an amount suffi- cient to cover the reduction in value of property through exhaustion, wear and tear through use in the trade or business during such tax- able year or period. The fact that depreciation and obsolescence have been sustained in prior years but were not claimed as a deduction in returns of net income will not warrant the deduction of an increased amount during the current year. The taxpayer's remedy lies in filing amended returns for prior years in which such deductions may be claimed and claims for refund of excess taxes paid. (Bulletin "F," page 35-) .... It is further held that since the general plan of both the income and profits taxes is to levy a tax upon an annual basis, and as there is no authority in the statute for offsetting against income received in one year, losses sustained in a prior year by reason of depreciation, except as provided in sections 204, 214 (a) 12, and 234 (a) 14 of the statute, only such depreciation as was sustained during the taxable periods covered by the returns may be claimed. (C. B. 4, page 180; O. D. 948.) A regulations^ makes specific provision for an alteration in the rate of depreciation in cases where the life of the prop- erty has been underestimated, but does it, not by reconstructing the entire depreciation history of the property with readjust- ments in the returns for previous years, but rather by dis- tributing the remaining portion of the value not covered by depreciation over the estimated remaining life of the property. It would seem that the converse of this would also apply, viz., that if the life of the property was overestimated, the "Art. 166; see page 1081. FOR DEPRECIATION 1067 rate of depreciation should be increased during the remain- ing years of its Hfe sufficiently to cover the loss. Good accounting practice requires that lump sum purchases be segregated on the books of account. It is better to open too many accounts than too few, because experience demon- strates the fact that depreciation is more easily ascertained by the use of a number of ledger accounts than when undivided property or plant accounts are kept. When it is impossible definitely to allocate the cost, it should be prorated on some equitable basis or by a new appraisal made as of date of acquisition. Amended returns may be necessary. — It may be neces- sary to prepare amended returns from 19 13 to the time when the adjustments are made. If the amount involved is substan- tial there is no other way of correcting the former erroneous practice. The regulations are fair and reasonable in that taxpayers are required to make each year's returns include accrued de- preciation for only one year. The adjustment of accounts will work out to the advantage of the government and to the disadvantage of the taxpayer if the depreciation allowance is decreased during a period of high taxes and vice versa. But taxpayers should keep in mind that actual depreciation, in almost all cases, was far greater during the years 191 7 and 1918 than during the pre-war period. ^^ Amended returns acceptable to Treasury. — If orig- inal returns were made in good faith, they may be corrected if found to be erroneous. The following ruling also requires that any depreciation allowance claimed must be entered on the taxpayer's books. Ruling. The statement .... to the effect that the depreciation allowance must be charged off before it can be deducted does not mean that depreciation sustained during one year may be charged out of the income of another year for income tax purposes; neither See page 1053 et seq. io68 DEDUCTIONS does it mean that failure to deduct depreciation before closing ac- counts for the year will prevent its ultimate deduction by the tax- payer. It means that if the taxpayer inadvertently neglected to make the proper entries on his books before closing them for the year during which the depreciation was sustained and failed to make the proper deduction from gross income in his return for that year, he may reopen his books, make the proper adjustment entries on them, and file an amended return showing the proper deduction for depre- ciation, provided bad faith or gross negligence was not shown in the preparation of his original return and in the manner in which he kept his accounts. (Bulletin "F," pages 33-34.) Depreciation should be based on cost or value March i, 1913- — The 192 1 law specifically provides that in the case of property acquired before March 1, 1913, the value as of that date is the proper basis for estimating depreciation. If the property was purchased after March i, 1913, the cost of the property is the basis for computing depreciation. In the case, however, of property received as a gift after March i, 19 13, and before December 31, 1920, depreciation is based on the fair market value of the property at the time of the gift.^^ Regulation. The capital sum to be replaced by depreciation allowances is the original cost of the property in respect of which the allowance is made, except that in the case of property acquired by the taxpayer prior to March i, 1913, the capital sum to be replaced is the fair market value of the property as of that date. In the absence of proof to the contrary, it will be assumed that such value as of March i, 1913, is the cost of the property less depreciation up to that date. To this sum should be added from time to time the cost of improvements, additions and betterments, the cost of which is not deducted as an expense in the taxpayer's return, and from it should be deducted from time to time the amount of any definite loss or damage sustained by the property through casualty, as distinguished from the gradual exhaustion of its utility which is the basis of the depreciation allowance (Art. 164.) This rule, of course, departs somewhat from the usual accounting procedure because of the insertion of March i, 1913, as the date for establishing a value for purposes of de- preciation. The ordinary practice is to take original cost, *^ See page 620. FOR DEPRECIATION I069 determine a liberal depreciation rate and, when the reserve equals the original cost, discontinue depreciation. Ruling. Prior to the approval of Treasury Decision 2754 (Au- gust 23, 1918) depreciation allowances were required to be based on the cost of the property. This Treasury decision authorized deprecia- tion deductions based on the value of property as of March i, 1913, if acquired prior thereto. The basis in the case of property acquired on or after that date remained unchanged. In an opinion rendered by the Solicitor of Internal Revenue it was held that Treasury Decision 2754 is applicable to returns for 1913 and all subsequent years. This Treasury decision was based on a prior opinion of the Solicitor of Internal Revenue in which it was held that the depreciation charges allowable for any year represent the portion of the gross income of the year necessary to make good a capital shrinkage, that the charges should therefore be such as to amount in the aggregate during the life of the depreciating property to the value of that property as a capital asset; and that under the United States Supreme Court decisions in Doyle v. Mitchell Brothers Co., 247 U. S. 179, and Lynch v. Turrish, 247 U. S. 221, this capital value should be determined as of March i, 1913. (Bulletin "F," page 19.) If March i, 1913, value was substantially in excess of the cost less depreciation to that date, amended returns for sub- sequent years embodying revised depreciation allowances would 1)e in order. Future replacement ccst not a factor. — Ruling. Replacement value of property can not be substituted for the cost of the property as the cost of replacement at a time some years in the future is a speculative figure which can not be used as a basis for determining an annual depreciation charge. The deprecia- tion charge will replace the amount of the original capital outlay, which may be more or less than adequate to replace the item to which it applies. If less than adequate, new capital must be provided from surplus or otherwise to effect the replacement. (B. 21-19-524; O. D. 283.) Depreciation computation in case of reorganiza- tions. — Ruling. A corporation engaged in refining gasoline was liqui- dated and its assets including automobiles, office furniture and equip- ment, and absorption gasoline plants, were transferred to a partner- ship organized by its stockholders. The question is raised as to lO^o iDEDUCTIONS whether the partnership shall base its claim for depreciation upon the original cost of the assets or upon their original cost less depreciation charged off by the corporation If, in the liquidation of the corporation, the fair market value as of the date of the distribution of the assets received by any stockholder, was in excess of the cost of his stock or its fair market value as of March i, 1913, if it was acquired prior to that date, the amount of the excess represented taxable income subject to both the normal and the additional tax for the year of its receipi.. The fair market value of the assets as of the date of liquidation of the corporation will be held to be the cost of the assets to the stockholders who, as partners, turned the assets over to the partnership, and will be the basis for determining the deprecia- tion allowance to be claimed each year with respect to such assets. .... (B. 34-20-1148; O. D. 639.) The foregoing ruling is based upon the principle of a "closed transaction." If a transfer of title constituted a "con- tinuing" transaction, this change in the depreciation base would not be permitted.^* When assets are transferred, care should be taken to trans- fer them at gross book value and not after deducting any reserve that may have been set up on the books of the old firm. In some cases revenue agents have computed depre- ciation on such net figures at the old rates. This of course results in much smaller depreciation deduction for the tax- able year of the new concern. If the net value of the assets is used, the rate of depreciation should be increased to reduce the assets to salvage value at the end of their useful hfe. Revaluation as of January i, 1909, applicable to corpora- tion excise tax only. — In all cases relating to depreciation during the period January i, 1909, to February 28, 1913, the fair value of property at January i, 1909, is still a' factor. As to 19 1 3 and subsequent years, both for the purpose of determining taxable profits on sales and allowances for de- preciation, corporations may revalue their assets as of March I, 191 3, whether or not a similar revaluation was made at January i, 1909. If the value at March i, 191 3, was in ex- For discussion of what constitutes a "closed transaction," see page 536. FOR DEPRECIATION 1071 cess of the January i, 1909, valuation, no tax is imposed thereon even though realization takes place after March i, 1913- Assets revalued on a corporation's books as of January I, 1909, in an amount in excess of the book value at that date, revalued again as of March i, 191 3, in an amount in excess of the January i, 1909, valuation and sold since March i, 1913, at a still greater value, will be taxable only on the difference between the March i, 191 3, value and the price realized. No tax on appreciation can now be collected under the 1909 law, and no tax can be collected under the 191 3 and later laws on any appreciation which accrued prior to March r, 1913/' Depreciation of depreciable and non-depreciable property acquired after March i, 1913. — Regulation In the case of the acquisition on or after March i, 1913, of a combination of depreciable and nondepreciable property for a lump price, as, for example, land and buildings, the capital sum to be replaced is limited to that part of the lump price which represents the value of the depreciable property at the time of such a'cquisition. (Art. 164.) When depreciation deduction results in deficit. — Ruling. Corporate taxpayers in some cases compute their net income for the taxable period without having made allowance for depreciation and then distribute the entire net income so computed to their stockholders so that the books show no surplus or undivided profits. In such cases if a corporation subsequently desires to avail itself of the privilege of deducting an allowance for depreciation in its return for such taxable period it must first reopen its books and make the appropriate charges It will then be placed in the position of having paid a dividend from a depreciation reserve or from capital to the extent that the amount of dividend paid exceeds the true net income, meaning the net income after making proper charges for depreciation. The amount of the excess will be deemed a distribution in partial liquidation and taxed accordingly to the stockholders, and the invested capital of the corporation for excess profits purposes will be deemed to have been reduced to the same "For discussion of taxability of dividends paid from realized appre- ciation, see page 715. ' 10-2 DKDUCTIONS extent in accordance with article 86o'« of Regulations 45. (Bulletin "F," page 35.) Ruling. In computing the taxable net income of a corporation, it can not be denied a deduction on account of depreciation actually sustained and charged off, even though after paying dividends there remains an amount of surplus and earnings insufficient to cover de- preciation. In such case the book value of the assets must be re- duced by an amount equal to the difference between the amount of the depreciation actually sustained and charged off and the amount of the earnings and surplus available for depreciation at the end of the taxable period. (C. B. 4, page 180; A. R. M. 112.) When the depreciation cledtiction is in excess of the net earnings, a net loss results which under the 192 1 law may be carried forw^ard to a subsequent year.'" Depreciation in cases of permanent discontinuance. — Regulation. If the use of any property in the business is per- manently discontinued, although no sale or other disposition of the property has taken place, a determination of any gain or loss may be made; but any deduction in respect of any loss thereon must be disclosed in the taxpayer's return for the year in M^hich the determi- nation is made and a full statement of the facts and the basis upon which the computation is calculated must be attached to the return. Upon a sale or other disposition of the property, the consideration received shall be compared with the amount of the estimated salvage value used in computing the gain or loss as above provided, and the amount of the difference shall be treated as a gain or loss, as the case may be, of the year in which the sale or other disposition was made (Art. 170.) A loss arising from discontinuing the use in business of depreciable property may be due to obsolescence. That sub- ject is discussed in Chapter XXXII. Depreciation claimed by fiduciaries and beneficiaries. — The procedure is prescribed by the Treasury as follows : Ruling. An individual who receives income from a trust estate may not deduct from gross income in his individual income tax return any amount representing depreciation of property belonging to the estate. However, under the Revenue Act of 1918 it is permissible for '"See page Excess Profits Tax Procedure, 1921, page 251. " Net losses are discussed on pages 1021-1029. FOR DEPRECIATION I073 the fiduciary in ascertaining tlie net income of the estate or trust for which he acts to deduct a reasonable allowance to cover the deprecia- tion sustained during the taxable year, whether or not the terms of the will or agreement creating the estate or trust or a decree of court provide for taking care of the depreciation which may be sustained on the property held in trust. Estates and trusts are under certain circumstances treated as a unit, and in other cases may represent an aggregate of distinct inter- ests to all of which the fiduciary is responsible. Irrespective of whether the estate or trust is or is not treated as a unit, the fiduciary in computing the net income upon which he is required to pay the tax may claim a deduction for depreciation '- (Bulletin "F," pages 32-33.) Depreciation of property acquired by gift. — Ruling. If a taxpayer acquires depreciable property by gift, bequest, or devise, and uses it for purposes of trade or business, he is entitled to a deduction from gross income for depreciation of such property the deduction is based on the fair market price or value of the property at the date when acquired, or if acquired prior to March i, 1913, its fair market price or value as of that date, and its remaining useful life in the trade or business, proper adjustment being made from time to time by reason of improvements, additions, betterments, or losses since acquirement or since March i, 1913. (Bulletin "F," pages 9 and 19.) The foregoing applies to property acquired by gift before December 31. 1920. Section 202 (a-2) of the 1921 law provides that, for the purpose of computing gain or loss on subsequent sale, property acquired by gift after December 31. 1920, is to be deemed to have the same cost or March i. 19 13, vahie (if acquired prior thereto) as if still in the hands of the donor.^** The question arises as to what value the donee should use for depre- ciation purposes in case the gift consists of depreciable property. The donee. might conceivably use one of two values : (a) Valite at date of gift. (b) Cost to donor or March i, 1913, value if acquired by the donor prior thereto. "See discussion of depreciation allowances to beneficiaries, Chapter XXXVII. '° See page 619. 1074 DEDUCTIONS In case (a) the donee would be basing depreciation on an appreciated or depreciated value as compared with the cost to the donor which, under section 202 (a-2) is now assumed to be the cost to the donee. It would seem that if (b) is to be the basis on which the donee must compute gain or loss in case of sale, the Treasury will use the same basis for depreciation purposes. Depreciation divisible between joint owners. — Ruling. A joint owner of inherited property, collecting rents and profits from such property and managing the property on behalf of all the owners, pursuant to an oral agreement, is an agent and not a fiduciary. It is, therefore, necessary for each of the joint owners to file an income tax return and account for his share of the income from the property in addition to income received by him from other sources. In preparing such returns each joint owner may claim as a deduction for each year his proportionate share of the depreciation allowance for such year with respect to the property held in joint ownership. ^^ Reserves for Depreciation According to the regulations the particular manner in which the depreciation allowed as a deduction pursuant to the law is entered on the taxpayer's books, is not material except that the amount "must be either deducted directly from the book value of the assets or preferably credited to a depre- ciation reserve account,^^ which must be reflected in the annual balance sheet." (Art. 169.) Use of depreciation reserves. — The Treasury no longer holds the very narrow view it once held as to the investment of depreciation reserves in the concern's own plant. The amounts reserved for depreciation need not be spe- cifically invested. Ruling. While the presumption is that amounts credited to these accounts will be used to make good the loss sustained, either through ^ Bulletin "F." page 33. " [Former Procedure] For discussion of former regulations see Income Tax Procedure, 1918, pages 364-366. FOR DEPRECIATION I075 a renewal or replacement of the property or a return of capital, there is no requirement of law that the funds represented by these reserve liabilities shall be held intact or remain idle against the day when they may be used in making good the depreciation of the property with respect to which the deduction is claimed or in restoring the capital invested in the depreciated assets. (Bulletin "F," page 34.) Rates of Depreciation — General The law in regard to rates specifies merely that the de- preciation allowances shall be "reasonable," and the Treas- ury very sensibly makes no attempts to fix specific rates which shall be considered satisfactory. Regulation. The capital sum to be replaced should be charged off over the useful life of the property either in equal annual install- ments or in accordance with any other recognized trade practice, such as an apportionment of the capital sum over units of produc- tion. Whatever plan or method of apportionment is adopted must be reasonable and must have due regard to operating conditions dur- ing the taxable period. While the burden of proof must rest upon the taxpayer to sustain the deduction taken by him, such deductions must not be disallowed unless shown by clear and convincing evidence to be unreasonable. The reasonableness of any claim for deprecia- tion shall be determined upon the conditions known to exist at the end of the period for which the return is made.-- (Art. 165.) ^Methods of determining depreciation allowances: I. The fixed percentage basis. This method is the most popular and is the one in general use. It is applied as follows: (a) On a flat basis, e.g., if the life of a machine is ten years, one- tenth, or ID per cent, is charged off annually. (b) On a reducing scale basis, i.e., a rate is ascertained which, when applied to the original cost and the diminished value thereof as periodically determined, will reduce the book value to scrap value at the end of the machine's estimated life. 2. Sinking fund method. If it is proposed to set aside such a sum periodically as will equal the original cost of a machine (less scrap value) at the end of its estimated life, it is customary, after taking into consideration the average rate of interest which can be secured, to pay into a fund a fixed amount periodically. The aggregate thereof, together with the accumulated interest, will equal the amount required to renew the machine in question. This method is in practice seldom followed. There is good authority, however, for its use where a single large piece of property, such as an office building, apartment house or ship is being operated which is eventually to be replaced. 3. Production method. A method of making depreciation allow- ances which has its advantages under certain conditions is that of 10/6 DEDUCTIONS Ruling. It is the opinion of this office that neither the opening nor the closing balance of the asset accounts is the proper value upon which to base depreciation allowances for any taxable year in which improvements, additions, or betterments have been made to de- preciable property or in which depreciable assets have been abandoned or scrapped. If the opening balance is used in such cases the tax- payer will not be given the benefit of a deduction for the amount of depreciation sustained in the taxable year on the additions made during the year, while a deduction would be allowed for a full year's depreciation on the assets discarded during the year. On the other hand, if depreciation is computed upon the closing balance, the taxpayer would not be allowed a deduction for any depreciation sustained during the year upon the assets abandoned, while a deduc- tion would be allowed for a full year's depreciation upon the assets acquired during the year. This office is also of the opinion that in such cases the proper allowance for depreciation of the assets acquired or discarded during the year is that proportion of the de- preciation of such assets for the entire taxable year which the por- tion of the year during which the assets were used in the trade or business bears to the full taxable year. It is held, therefore, that depreciation should be computed for the entire taxable year only upon those assets which were properly included in the opening balances of the depreciable asset accounts and which were not abandoned or scrapped during the taxable year. Depreciation should be computed on each asset discarded during the year at the proper annual rate for the period from the beginning of the year to the date tlie asset was abandoned, and upon each im- provement, addition, or betterment made during the year the cost charging an established rate per unit of output. This is especially applicable in the case of, say, a blast furnace where the frequency with which the linings will need to be renewed depends on the extent to which the furnace is being used. If it is being nm at full capacity night and day, the wear on the linings is obviously much greater than if the furnace were not in continual use during the entire fiscal period. Another species of depreciation which may be said to come under the above caption is that caused in a plant by the exhaustion of the mines or timber lands for the operation of which the plant was con- structed. Most of the value of coke ovens, for instance, is gone when the mines for which they were constructed are worked out. Conse- quently, in determining the amount to be written off for depreciation of mining and lumbering plants, the factor of the probable future out- put of the mines or lands will be an important one and it will fre- quently be found advisable to base the plant depreciation charge on the output. Certainly this should be done where it is evident that the plant will outlive the exhaustion of the mines or lands. In such cases the depreciation charges should be sufficient to absorb the entire cost of the plant, less residual value, by the time the mines or lands are exhausted, even though at that time the plant may still be in good operating condition. Of course, any actual residual value must be considered. FOR DEPRECIATION 1077 of which is not detkictible from gross income as a business expense, at the proper annual rate for that portion of the taxable year inter- vening between the date the improvement, addition, or betterment was made and the close of the taxable year. It is to be understood, of course, that if in any case the improvements, additions, or better- ments made or the assets discarded were, during the taxable year, so numerous and in such small amounts that the time and labor in- volved in computing depreciation in this manner upon each separate improvement, addition, or betterment or asset abandoned would be so disproportionate to the resulting change in tax liability as not to warrant depreciation being so computed, such changes in the depre- ciable assets may be consirlered to have occurred ratably during the year and depreciation computed upon the average of the opening and closing balances of the asset account, such average being deter- mined by adding together the balances at the beginning and end of the taxable year and dividing by 2. (I-2-18; I. T. 1158.) The foregoing ruling merely states the rule that deprecia- tion can only be taken on "property used in the trade or busi- ness,""' and that where changes take place during the year in the amount of deprecial)le property, effect must be given thereto. Depreciation methods approved by Treasury. — The Treas- ury has approved only two methods, but is willing to adopt other methods if they are found to be more accurate. Fixed percentage method. — Ruling The "fixed percentage" method as applied by the Commissioner contemplates that the annual depreciation deductions with respect to any property should be equal ; that the rate of depre- ciation should be assumed to be uniform during the useful life of the property, as compared with the so-called "fractional method^ weighted years," "declining balance method — scientific or unscien- tific," "revaluation method," and "sinking fund method," the use of which is advocated by accountants, but none of which have been approved in their entirety by the Commissioner for income tax pur- poses. (Bulletin "F," page 31.) Production method. — Ruling. The only other method which has been approved by the Commissioner is an apportionment of the depreciation charges Section 214 (a-8). 1078 DEDUCTIONS over the total amount of work to be performed or over units of pro- duction. For example, a contractor may purchase machinery for use only in performing a certain contract, which machinery will be worthless or have little or no salvage value upon completion of the contract on which he will be engaged for the whole of one taxable year and half of the succeeding taxable year. But the number of units of work, or percentage of completion accomplished during the first period of 12 months and during the second period of six months, may be equal. The contract may call for the making of an excava- tion, and the same number of yards may be excavated during each of the above periods. Under such circumstances, if the contractor re- turns his gross income each year on the basis of percentage of com- pletion of the contract, he will be permitted to spread the total amount of the depreciation allowance equally over the two periods, deducting half of the total amount in his return for the first 12 months, and the other half in his return for the succeeding taxable period. If the contractor had returned his income on some basis other than that of percentage of completion of the contract, it would have been necessary for him to modify his basis for computing the de- preciation allowances. Thus, if the gross income was returned on the basis of time required for completion of the above contract, two- thirds of the gross income being reported in the return for the first 12 months, and the other third reported in the return for the suc- ceeding period; in that case two-thirds of the total depreciation allowance would be deducted in the return for the first period and the remainder in the next return. (Bulletin "F," page 31.) The intention of the foregoing illustration is to permit an equitable deduction for depreciation. When the allocation mentioned does not work equitably, it is permissible to adopt a method which reflects the true net income for each period. Dependence upon life of enterprise as a whole. — The ''number of years constituting its life" and the permissible revaluation as of March i, 1913, are vitally affected in the case of some types of property by the life of the enterprise in which it is used. In the case of a mine or an oil or a gas well, the deposit may be exhausted before the expiration of the nor- mal life of some of the buildings and machinery. The regula- tions provide that in the case of oil and gas properties the de- preciation shall be such "an amount, based upon its cost (or fair market value as of March i, 1913, if acquired prior to that FOR DEPRECIATION 1079 date), equitably distributed over its useful life, as will bring such property to its true salvage value when no longer useful for the purpose for which such property was acquired."^* A somewhat similar provision is made in the case of mining properties'^ and timber properties.^" In the case of a building constructed on leased land, if "the life of the improvement is less than the life of the lease, the depreciation may be taken by the lessee, instead of treating the cost as rent."^^ This, of course, is basing the depreciation rate on the life of the improvement, rather than on the duration of the lease. Ruling. Held, .... that the cost of the new boilers, less sal- vage value, may be recovered by annual deductions spread over the period of the estimated remaining timber supply, it being assumed that at the end of this period the cost of removing the boilers to a new timber region will be more than their worth in the new location. . . . . (C. B. 4, page 179; O. D. 871.) Enterprises affected by the close of the war. — The "useful life" of much war property did not extend beyond the end of the war. What is the proper term to use for the accruing expense or cost incident to idle plant? If depreciation were permitted only for wear and tear of a plant constructed to manufacture war materials, which has not been used since the war ended, the owner would be in a bad way. Many contracts let by the government itself specifically provided for extraordinary depreciation rates to be included as part of the cost of production of war materials. The muni- tions tax law permitted the amortization of plants used for war purposes over the estimated war production. The 192 1 law re-enacts the provisions of the 1918 law which takes care of depreciation due to war conditions. ^^ As the loss is one due to extraordinary obsolescence, the matter is fully discussed in Chapter XXXII. ""See Art. 225, page 1107. ""Art. 224; see page 1105 el scq. ''" Art. 227 ; see page 1234. ""Reg. 45, Art. 109; see page 903. "Sections 214 (a-9), and 234 (a-8). Io8o DEDUCTIONS Depreciation of plant or equipment devoted to war pur- poses acquired before April 6, 1917, is also discussed in Chap- ter XXXII. Depreciation a local issue. — The taxpayer must take local conditions into account in considering rates of depreciation. In one locality boilers may depreciate 7^ per cent annually; in another the rate may be 1 5 per cent ; and the variation may be entirely legitimate. It is not merely a question of the qual- ity of the boilers. No engineer or boiler manufacturer can give an intelligent estimate unless he knows the use to which the boiler is subjected, the climate, the water, the class of labor, the probabilities of shut-downs, etc. A similar situation exists in the case of almost all other classes of property which depreciate by wear and tear. Therefore, wherever rates of de- preciation are mentioned in this chapter, they must be taken as suggestions only and be treated as rough approximations of what may be expected under normal conditions. A table of depreciation rates applicable to specific depre- ciable assets, with the names of the authorities for the rates given, may be found at the end of this chapter (page 1123). Depreciation rate affected by "overtime" or "overload." — When machinery is run "overtime" there is little opportunity properly to repair and maintain the machines. Moreover, a two-shift system means divided responsibility, and with divided responsibility the machinery is sure to suffer. New workmen and those on night duty are often less efficient than the regular staff and there is a consequent ill effect upon the machines.^® In spite of all this some inspectors have been reluctant to al- low special depreciation when a plant was being run "over- time." Consequently the following is of great interest: Ruling. It is recognized also that property, for example, manu- facturing machinery, may be subject to extraordinary depreciation due to being operated overtime, at an overload, or being used for For British practice, see page 1054. FOR DEPRECIATION io8l some purpose for which it is not adapted. Under such conditions, a taxpayer may deduct in addition to the amount measuring the depre- ciation under normal conditions, a further sum to provide for the extraordinary depreciation. Jt does not necessarily follow that if a machine operated normally for 8 hours a day, is operated for i6 hours a day, it will depreciate twice as rapidly as when operated under normal conditions. The estimate of the extraordinary depre- ciation should be made by the taxpayer according to his judgment and experience and will be subject to the approval of the Commissioner. (Bulletin "F," page 27.) Adjustment of rates used in former years. — The author believes that deductions for depreciation claimed and allowed in returns during the years preceding the taxable year should be reopened only under special conditions. Corporations and individuals subject to the taxes in force during those years were on notice from the government as to the basis of the allowable deductions and were also on notice from ac- countants and bankers that proper provision for depreciation ^should be made. What was done at the time, while the facts were fresh in mind, should stand unless an explain- able mistake was made. Depreciation rates should be neither played with nor juggled. The rates of an income tax should not (because they do not) determine depreciation rates. Unless the Commissioner is convinced that a meritorious case exists, he should not permit amended returns to be made. When, however, it is discovered that depreciation was in- correctly calculated to a substantial amount in prior years, it is not good accounting practice to make the adjustment in the taxable and subsequent years. It is not fair either to the government or to the taxpayer. Regulation. If it develops that an error was made in estimating the useful life of the property, the plan of computing depreciation should be modified and the balance of the cost of the property, or its fair market value as of March 1, 191 3, not already provided for through a depreciation reserve or deducted from book value, should be spread over the estimated remaining life of the property. Inas- much as under the provisions of the income tax Acts in efifect prior to the Revenue Act of 1918 deductions for obsolescence of property were not allowed except as a loss for the year in which the property was io82 DEDUCTIONS sold or permanently abandoned, a taxpayer may for 1918 and sub- sequent years revise the estimate of the useful life of any property so as to allow for such future (not past) obsolescence as may be expected from experience to result from the normal progress of the art (Art. 166.) Under the foregoing regulation, obsolescence which has not been absorbed in depreciation charges, and which is ac- knowledged to have "accrued" prior to 1918, can never be deducted. For discussion see page 1130. Excessive rates — negHgence not imputed. — Ruling If understatements of taxable net income in re- turns are due to charging off depreciation in excess of an amount deemed reasonable by the Commissioner, negligence or intent to defraud will not be imputed to the taxpayer unless the position taken is so unreasonable as to indicate gross carelessness or bad faith. (Bulletin "F," page 27.) Special depreciation of excessive costs. — Ample provision has been made for special depreciation of plants and equipment constructed or purchased "for the production of articles con- tributing to the prosecution of the present war."'° The question arises as to what provision, if any, has been made for plants which cannot qualify in the war work class. Commencing in 191 5, almost all classes of materials ad- vanced in price until the cost of erecting and equipping a plant was perhaps double what it had been before the war. For example, take a plant which cost a million dollars to build and equip in 1913. The plant is duplicated in 1918 at a cost of two millions. What rates of depreciation shall be charged during 1919 on the two plants? If the proper aver- age rate on the old plant is 8 per cent, is that the proper rate on the new plant? Is $160,000 per annum for the new plant the equivalent of $80,000 for the old plant? Strictly speak- ing, it is equivalent because depreciation rates, when accu- rate, are based on the effective life of the plant, and if re- serves at the rate of 8 per cent per annum will provide a fund See Chapter XXXII. FOR DEPRECIATION 1083 sufficient to recoup the cost of the plant as it wears out, no higher rate is permitted under a strict interpretation of the existing law. There is, however, a sound foundation for a claim to extra depreciation on the part of those who have erected plants during this period of high prices, even when the plant will not become obsolete after the war.^^ It can be assumed that any- one who built a plant under the conditions which have existed during the recent past did so because he counted upon being able, through the profits of this abnormal period, to write off that part of the cost of the plant which was clearly super- normal so that he might be on the same cost basis after the return of peace as the proprietors of other plants built before or after the period of very high prices. The foregoing argument must not be construed to support increases in current depreciation rates where the cost of the property involved was normal although recently purchased, nor in any case where the property was acquired prior to 191 5. Depreciation of plant or equipment acquired before April 6, 1917. — The foregoing comments refer in general to all classes of plant and equipment no matter when purchased. The 192 1 law re-enacts the provisions of the 1918 law which provide full relief for losses on plant and equipment acquired after April 6, 1917; but no special relief for losses arising out of the subsequent fall in value of property acquired at the high prices which prevailed after 1915 and before April 6, 1917, is found in the law. The Commissioner, however, may hold that a reasonable allowance for depreciation as applied to special conditions means a higher allowance than under ordin- ary conditions. It is almost safe to assume that all plants erected during 19 1 6 and early in 191 7 were operated under adverse condi- "' See Chapter XXXII. For a discussion of the use of replacement funds in the case of losses through war hazards, see Chapter XV. 1084 DEDUCTIONS tions and that the actual depreciation which took place was probably double normal depreciation. Depreciation Rates and Practice — Specific Suggestions In the pages which follow, information"- is given which is intended to serve as a guide in deciding in what cases and at what rates depreciation shall be charged. The topics, which are arranged in alphabetical order, deal in some cases with specific objects or classes of objects and in other cases with types of enterprises. The list is not intended to be and ob- viously cannot be complete. The variations of the rates in some of the cases given indicate the futility of trying to set uniform rates applicable to given objects under all conditions. The theory of depreciation is that there should be a return of the investment by the end of the useful service life of the asset. The rate should be fixed accordingly. " The general sources are, for American practice, Auditing, Theory and Practice (3rd edition), by R. H. Montgomery, pages 621-654; and for British practice, Income Tax Practice, by Murray and Carter. Contrary to the practice in this country the British Treasury arrives at definite agreements with taxpayers regarding the general rate of deprecia- FOR DEPRECIATION 1085 tion which shall apply in various industries. The following table gives the latest available list of British "agreed rates of depreciation" (see "The Taxation of Excess Profits in Great Britain," by Robert Murray Haig, The American Economic Review, Supplement, December, 1920) : Schedule of Agreed Rates of Depreciation Industry, &c. Per cent Prime Cost or Written-down Value Nature of Plant Electric Light Un- dertakings Written-down Value Cables. " " Plant and machinery. Flax Spinning and Linen Weaving (Ireland) 7 'A Written-down Value Machinery and plant (except accessory plant such as pirns, pirn cages, spools, belting, driving ropes, damask cards, designs, patterns, models, fur- niture and fixtures). Flour Milling S Written-down Value Engines, boilers and main shaft- ing. 7% " " Other machinery. Gas Undertakings 3 other than those 10 owned by mu- nicipal or other public authorities Written-down Value Gasholders. Meters, cookers and gas fires. Motor Omnibuses"^ 20 Written-down Value Motor omnibuses. Paper Mills hA " ' • Machinery working day only. Machinery working day and night. Printing 7V2 10 Written-down Value Engines, boilers and shafting. Printing and binding machines. Type. Railway Wagons^ s Written-down Value Railway wagons. Shipping^ 4 3 l^rime Cost. Prime Cost. Steamships. Sailing vessels. Steel Manufacturers* 15 Written-down Value Machinery and plant used in the manufacture of steel. Timber Merchants, 5 Saw Millers, and Manufacturers of 7J^ Timber Goods Written-down Value Engines, boilers, main shafting. General saw-milling plant and machinery. Traction engines, tractors, motor- cars, and haulage plant. Tramways" Written-down Value Permanent way. Cables. Cars and other rolling stock. General pl^t and machinery, including standards, brackets, and work-shop tools. ' The rate of 20 per cent is to be re-considered at the expiration of four years com- mencing with 1916-17. This rate does not apply to commercial motor vehicles. ^ The allowance applies to all wagons owned by traders. In the case of railway com- panies the method adopted is to allow the actual cost of renewals year by year. ' With regard to ships purchased at secondhand at prices in excess of the written- down value at the date of purchase, the following arrangements have recently been made: — -(o) The allowance is made on the actual cost price of the ship to the owner for the time being without regard to the prime cost to a previous owner. (b) The rate of depreciation allowable is calculated by reference to the reasonable expectation of the life of the ship at the date of purchase from the previous owner. * The rate of 15 per cent represents 5 per cent for normal wear and tear, and 10 per cent for the additional wear and tear arising from war conditions. * An allowance per mile of track based upon the estimated life of the permanent way. lo86 DEDUCTIONS Alterations and improvements. — In some cases alterations are charged as an expense, being regarded as in the nature of repairs.^^ Tliis practice is not always correct. Many altera- tions are in the nature of improvements, and improvements are capital expenditures. This is the position taken by the Treasury as is shown by the following quotation : Regulations. No deduction from gross income may be made for any amounts paid out for new buildings or for permanent improve- ments or betterments made to increase the value of any property, or for any amounts expended in restoring property or in making good the exhaustion thereof for which an allowance for depreciation or depletion or other allowance is or has been made, .... (Art. 581.) .... (3) In any case in which the cost of capital assets is being recovered through deductions for wear and tear, depletion or obsolescence any expenditure (other than ordinary repairs) made to restore the property or prolong its useful life should be added to the property account or charged against the appropriate reserve and not to current expenses. (Art. 24. J The author reiterates his advice that liberal allowances should be made for repairs and depreciation, and that no ex- penditures should be charged to capital if there is any doubt about the items. Sometimes so-called alterations may prop- erly be charged off as a necessary expense of the business. If so, some name other than alterations should be found for the expense. Ruling. Expenditures by a taxpayer in altering a building to conform to a street widening, which alteration does not increase the value of the building, constitute a business expense for the year in which such expenditures are incurred, deductible only in the return of net income for that year, and any division of such deduction so as to spread the same over the returns for a period of years, whether called a depreciation charge or otherwise, is unauthorized. (Bulletin "F," page 8.) If the expenditures in such cases are substantial or exceed *' Decision. (Syl.) "Amounts expended by a business corporation in enlarging or making improvements in its office or premises, not in the nature of permanent improvements to the property, but to facilitate the transaction of a growing business, should properly be deducted as necessary expenses of the business." {Connecticut Mutiuil Life Insurance Co. v. Eaton, 218 Fed. 206; affirmed. 223 Fed. 1022.) FOR DEPRECIATION 1087 the income or if the alterations make the building unusable for a considerable period, it is possible that the cost should be capitalized. Any damages collected would be an offset against the cost. Apartment houses. — See "Buildings" (below). Automobiles. — Under ordinary conditions the rate of de- preciation on automobiles should be fixed at not less than 20 per cent per annum. This rate has been adopted by the tax commission of one of the states. The Primer states that "the estimated lifetime .... of automobiles used for busi- ness or farm purposes and farm tractors" is "four to five years. "^* A rate of depreciation based on an estimated life of three years may not be excessive if adequate provision is made for residual value. In the oil industry the Treasury allows 33/^ per cent.^^ While five years may appear to be a high estimate for the life of the average automobile it must be remembered that the nature of the asset permits repairs to be made on so extensive a scale as to reduce materially the necessity of complete re- newals. Tires are frequently renewed, motors are replaced and in some cases (e.g., the taxicab companies) bodies are entirely rebuilt. Depreciation, therefore, as distinct from re- pairs and renewals, may l)e a smaller factor than appears at first glance. Of course, full allowance nuist be made for "accrued" wear and tear. In some cases estimates of depreciation are based on mileage : The second illustration, supplied by a manufacturer of metal products, indicates that an estimate of depreciation based on expected performance can become very exact. This company calculates its depreciation on Ford cars used by its salesmen at 2 cents a mile and reports that the last thirty cars sold, exchanged or scrapped showed ^* Income Tax Pritner, 1918, question 99. ^'Manual for the Oil and Cas Industry (revised August, 1921), page 64. io88 DEDUCTIONS an average depreciation of 1.9 cents per mile and that these thirty cars were operated between five and six hundred thousand miles. ^^ Regulation No such allowance may be made in respect of automobiles or other vehicles used chiefly for pleasure, .... (Art. 162.) Books — business and professional. — The Treasury rules that the cost of professional books is not a business expense but is an investment of capital against which depreciation may be charged.'' Roughly speaking, books in a technical library depreciate at a rate sufficiently rapid to justify charging off the total year's purchases in the case of libraries which are being kept up to date. This obviates the necessity of an annual revaluation of the library. This plan has been approved by examiners who have satis- fied themselves that the deduction for new books did not exceed reasonable depreciation on the entire library. Buildings. — Obviously no general rate applies to build- ings, since methods of construction, materials used, purposes, etc., afifect the wear and tear incident to use. In a case re- lating to depreciation of apartment houses, the government allowed 3 per cent (see below). Perhaps this was a fair rate under laws which excluded the factors of inadequacy, change in character of neighborhood and other items of obsolescence. Under the 192 1 law^'' obsolescence must be taken into consider- ation. Three per cent is the rate frequently used by manu- facturers for slow-burning brick structures; and 2 per cent is the minimum rate for concrete, brick and steel fireproof structures. "Perhaps 23/2 per cent is more nearly correct. Where walls are subjected to unusual strain or vibration, a rate of not less than 4 per cent should be used. In a state in which the sul^ject has been carefully studied, a '""Depreciation — Its Tmitiiicnt in Production. Chamber of Commerce of U. S., October 15, 1921. "" Bulletin "F," page 11. "* Obsolescence was first allowed under the 1918 law; see page 1130. FOR DEPRECIATION 1089 rate of 2 to 2)4 per cent for cement or brick buildings and 3 to 5 per cent for wooden buildings has been adopted. The National Machine Tool Builders' Association uses these rates : brick buildings, 3 per cent ; frame buildings, 5 per cent. The Treasury states : Ruling. A frame building may remain serviceable for a period of 20 to 30 years, while a building of steel, concrete, and stone con- struction may have a life of 50 to 100 years. (Bulletin "F," page 7.) In the case of an apartment house the jury found that 3 per cent was a proper rate of depreciation."^ This was the rate allowed by the government, while the plaintiff claimed 5 per cent. The apartment house is situated at No. 320 West 84th Street, New York, a very desirable location. The jury was, of course, influenced by the charge of the court, which was in part as follows : There is no question that the plaintiff was entitled to a deduc- tion for wear and tear of this building, and the government allowed him, I believe, 3 per cent — he claims 5 per cent — and the question for you to determine is whether he is entitled to any greater allow- ance for depreciation over and above what the government allowed him, which is 3 per cent. The burden would be upon him reasonably to satisfy you from the evidence that he was entitled to an allowance of an amount greater than 3 per cent in order to obtain that allowance because, as I say, he is the plaintiff asserting the claim The allowance is for wear and tear when it relates to a building .... that means the physical deterioration that a building suffers during the tax year; it does not include the depreciation in value due to a loss in rental value, because of modern buildings going up with better facilities than the old building had — that is not the idea. The Treasury takes the following general position on the question of depreciation, which api)lies particularly to the case of buildings : Regulation No modification of the method should be made on account of changes in the market value of the property from time to time, such as, on the one hand, loss in rental value of the buildings due to deterioration of the neighborhood, or, on the Cohen V. John Z. [.owe, Jr., 2,34 Fed. 474 (i()i6). 1090 DEDUCTIONS other, appreciation due to increased demand. The conditions affect- ing such market values should be taken into consideration only so far as they affect the estimated useful life of the property. (Art. 166.) The foregoing regulation refers exclusively to deprecia- tion. When change in the character of a neighborhood or other causes result in an ascertainable loss the claim for de- preciation (which now includes ordinary obsolescence) should be correspondingly increased."'" Buildings under construction. — When buildings, par- ticularly factories, are partly completed the question arises as to the date from which to compute depreciation. In most cases the construction account is not closed until the building is entirely completed, even though a considerable portion of it may have been in use for some time. It has been suggested that the depreciation should be based upon an average date, except in cases in which depreciation could not be said to com- mence until actual completion. The same reasoning would apply to items other than buildings, such as storage tanks, etc., which are carried in construction account until a group of units is completed. Ac- counting practice, however, requires that all costs of con- struction be capitalized until operations commence; therefore the allowance for depreciation on an uncompleted plant, no part of which is in use, would be debited and credited to the same account. Ruling. The term "useful life" as used in article 161, Regu- lations 45, is interpreted to mean the period of time over which an asset may be used for the purpose for which it was acquired. In the case of a new building, this period starts at the time the building is completed and capable of being used. Buildings under construction are not subject to a depreciation allowance for income tax purposes. (C. B. 4, page 178; O. D. 845.) The foregoing ruling is broad enough to include cases in which a building may be partly occupied before being en- ' For full discussion of obsolescence of Iniiklings, see page 1140. FOR DEPRECIATION 1091 tirely completed. In such cases partial depreciation should be computed from the date of such partial occupancy. The following extracts from a recent address by a recog- nized authority on real estate and buildings emphasize the need for special study of each particular case.*^ The principal reason that depreciation was never considered as an important question up to the time that the fireproof building came into existence was a settled belief that New York land values would always increase not less than 2% per annum and many such owners as O. B. Potter declared that there would never be a time when well- located New York real estate would not increase 2% in value every year. For this reason they felt perfectly contented to let their build- ings run down on the theory that sooner or later a better class of building would be required and that there was no profit in making substantial outlays for the maintenance of old buildings. When it was found that New York real estate could depreciate in value much faster than it had appreciated, the problem of depre- ciation began to demand respectful attention. When we ask what is the probable length of life of a modern building it is like asking an insurance examiner what is the probable life of a man. The insurance examiner replies "tell me the history of the man, of his father and mother, of his habits, of his occupation his physical condition, and I will tell you, barring accidents, what his probable life will be." In considering the probable life of a steel structure or of an ordinary building, the problem must be approached in the same way. Who built the building? Who maintains it? How were its foundations laid? What is its use? To attempt to sum up the problem of depreciation for any building requires that we take into consideration, first, the design of the building and of its founda- tions ; second, the type as adapted to its locality and purpose ; third, its construction and material ; fourth, its operation and maintenance. Anyone who attempts to pass judgment without this information is merely guessing in the dark. As an illustration of what I mean, take the case of a hotel, 10 stories, 50 x 100, built in the very finest way at a cost of $225,000 by an experienced investor and apparently good for a life of 40 years. It is located at 157 W. 124th St. This splendid building depreciated so fast that it had to be de- stroyed as a hotel in seven years. Why? Because it was misplaced and was a failure. It cost $50,000 to convert it into a storage ware- house and it became a perfect building and good for perhaps 50 years for this purpose, provided it is reasonably maintained. But suppose it is neglected and abused, its automobile elevator allowed " "Depreciation of Buildings," by Frank Lord, vice-president, Cross & Brown Co., New York City. icr)2 DEDUCTIONS to wear out and no repairs made to keep it up to a reasonable standard of usefulness, how much can its natural life be shortened? The building, — West — Street, was worth $48,000 one year ago. The tenant spent $9,000 on it and it is worth $72,000 today or 50% appreciation. Who is to judge of these conditions and what is his judgment worth and who will accept it? If we say that the life of a hotel is 30 years; of an office building 40 years; of a loft building 50 years; of an apartment house 25 years, of a non-fireproof structure, or a mill construction 35 years, who is to successfully contradict us and on what conditions of use or abuse, of care or neglect, of bad management or wise management, is all this to be decided? In my opinion, the plan of estimating 2^0;^ on the mortgage is an- other way of guessing on broad general lines because in every case land value is part of the mortgage and leaves haphazard the pro- portion the building represents. Look at the beautiful Blair Building at 24 Broad Street and ask me how much this superb building in a superb locality with a generous upkeep will depreciate and I will reply that a structure under such ideal conditions may last for 60 years not only be- cause its design and construction are ideal, but its owners are ideal. The same may be said of the new Stock Exchange and the Bankers Trust Building opposite, but when you have named 20 or 25 buildings downtown and a dozen uptown, headed by the U. S. Rubber Building, you have exhausted the list of preferred risks and there are all sorts of grades and conditions to be class- ified. I do not say that they can not be properly classified and a reliable grading arrived at, for purposes of estimating probable depreciation, but as a practical question, the labor and cost is too great and in the end it comes back to definite considerations to be weighed for each building as to its birth, life and history coupled with engineering knowledge and judgment, and summed up by real estate experience and honest appraisal. In the absence of this kind of knowledge and appraisal, we must be content to accept the method generally adopted of taking 3% for brick and stone and 4% for frame buildings as a fair measure of depreciation, and where the danger signals are flying adapt our own judgment to each particular problem. The most pronounced cause of loss in real estate has been the failure of owners to set aside each year 3 to 5% of their income to make extraordinary repairs and to replace worn out buildings. When they find their income reduced to the vanishing point, they consult their lawyers who in turn consult some chance real estate broker who advises a sale for land value. The property is sold to some wise speculator who remodels it at a third of its original cost and rents it to such advantage that it pays better than ever before, proving that FOR DEPRECIATION 1093 the depreciation that wiped out the former owner's equity was the depreciation of had management and neglect. For fully 20 years I have heen advising investors to put 5% of their net income into a sinking fund to meet this prohlem, and one investor who had adopted this practice told me that one property had paid for itself out of surplus earnings above 7% on his invested capital. If I asked this gathering what Bethlehem Steel shapes were and their difference from fabricated steel and what effect they had on the cost and on the life of a building probably not one quarter of those present could answer. Yet nothing could be more instructive than to have one of Mr. Schwab's young engineers spend an hour with us in describing the Bethlehem process and what it means to building construction. Another unknown factor in large buildings is whether they are wind braced or not. There are many such factors in the constitution of a building buried securely from sight which go to the heart of the matter, and a life insurance examiner might as well try to pass an applicant by looking at him and talking politics with him as for one of us to decide conclusively what should l)e the depreciation of various types of structures from such general knowledge as may be obtained with- out careful investigation of a good builder and a capable engineer, coupled with experienced real estate judgment of the probable fitness of the building for the future and who its owner and manager is to be. Cash registers. — The average Hfe of a good cash register is from ten to twenty years, although some are in use to-day which were sold more than twenty years ago. The reduction in value during the eaily years is heavy, as with typewriters, and machines are frequently exchanged. This is due to in- adequacy more than to depreciation. If an annual rate is to be constant over the expected effective life of the machines, it would be unwise to fix it at less than 15 per cent. Chemical industry. — In the chemical industry buildings depreciate about 2^ to 3 per cent. The machinery and equip- ment depreciation depends largely upon the nature of the product manufactured, the average being about 15 per cent. Containers. — In certain kinds of business, such as brew- eries, milk depots, spring-water distribution, bakeries, etc.. I094 DEDUCTIONS considerable numbers of containers, such as casks, kegs, bot- tles, cases, cracker tins, etc., are owned, which are used prin- cipally for convenience of transportation and are supposed to be returned when empty. As to these, no specific rate of depreciation can be fixed. Each case must be considered on its merits. Rates given in the table on page 1 123 are suggestive of good practice. At balancing time an accurate inventory should be taken, if possible, but if not practicable, it will be necessary to make a calculation as to the number required for the normal opera- tion of the business. An inspection, of the reserve supply will serve as a check on the book valuation. In many cases concerns go on the assumption that all such containers are in possession of someone who will in due course return them, but experience proves that considerable numbers are lost, broken or stolen, and that to carry these as stock on hand is inaccurate. Contracts. — The Treasury now recognizes the position which the author has held for several years, viz., that any kind of property, tangible or intangible, may be amortized, depre- ciated or depleted either on the basis of market value at March I, 191 3, or upon cost since that time. The regulations are quite as liberal as could be desired." If an automobile dealer secures a valuable contract from a manufacturer, and turns it over to a corporation, the latter may claim as a deduction the cost of the contract spread over its life; but in this case as in all other similar cases the cor- poration cannot claim the deduction unless the payment for the contract was made in good faith and for proper considera- tion, and where there was any community of interest between the dealer and the company, the former would be compelled to return as taxable income the purchase price of the contract which the corporation claims to have paid to him. ^■Art. 163; see page 1097. FOR DEPRECIATION IO95 Copyrights. — Copyrights may be charged off under the same procedure as patents, except that the term is 28 years, which term, under certain circumstances, may be renewed for another 28 years. As most copyrights diminish rapidly in value, depreciation should not be based on their life. Reval- uation of each one is the only satisfactory solution. A list of copyrights owned should be compiled. Inquiry based on this list will develop evidence as to the actual worth of the asset. The Treasury is attempting to base the depreciation on cost or March i, 191 3, value spread over the term of the copy- right or the life thereof remaining after date of acquirement or March i, I9I3.'*"'' Ruling It is furlher held that depreciation of a patent or copyright acquired prior to March i, 1913, can be taken on the basis of the market value as of March i, 1913, only when affirmative and satisfactory evidence of such value is offered and, in the absence of such evidence the depreciation allowance must be based upon the cost Held also, that in view of the foregoing and in accordance with article 167 of Regulations 45, the annual allowance for depreciation of the copyright should be computed by an apportionment of the cost of the copyright over its life since its grant, and such cost must be limited to the author's actual capital outlay in securing the copy- right, including the actual cost to the author of produicng the book covered by the copyright, but not including any amount representing the value of the author's own time and labor. (B. 27-21-1721 ; O. D. 966.) Costumes — theatrical. — Regulation properties and costumes used exclusively in a business, such as a theatrical business, may be the subject of a depreciation allowance.''* (Art. 162.) If adapted for "occasional" personal use, claim for de- preciation is still allowable, but consideration must be given to the value of the personal use, depreciation in regard to which is not deductible. Art. 167. See page 1096 DEDUCTIONS Electrotypes, woodcuts, etc. — The arguments urged in case of patterns (see page 11 14) apply with equal force to electro- types, woodcuts, etc. Conservative publishers charge off al- most the entire cost of plates as a direct cost of a first edition and are careful to revalue the balance of the account frequently. If a book or other publication is successful, the cost of plates, etc., can be readily absorbed in its cost; but if it is not suc- cessful, no new orders can be expected and it would be folly to carry the plates on the balance sheet at any valuation ex- cept as scrap metal. A number of bankruptcies have occurred in the publishing business through disregard of this principle. Formulas. — Ruling. Formulas are not a character of property subject to an- nual depreciation deductions in a taxpayer's return; however, if after acquisition, a formula is found to be worthless, its cost may be charged off in toto in the taxpayer's return for the year in which its worthlessness was discovered. (C. B. 3, page 169; A. R. R. 339.) Foundries. — Depreciation does not average more than 4 per cent on foundry buildings. Depreciation on foundry equipment, with the exception of flasks, patterns and core boxes, should average not more than about 5 per cent; while on the articles mentipned the rate should range from 10 to 20 per cent. A high rate is necessitated by the fact that many patterns become obsolete because they are made in an ex- perimental way. Furniture and fixtures. — Furniture and fixtures have little residual value, and conservative concerns charge off by far the larger proportion of the cost. In most establishments many items, such as partitions, special shelving, etc., are charged to the fixture account. When frequent alterations and changes are made, most of such expenditure is in the nature of repairs and should be charged off at the time. If charged to an asset account, it should be distributed ratably over a few years' operations. FOR DEPRECIATION 1097 If it is important to write off actual depreciation only, it will be found that 15 per cent per annum represents a fair average allowance. The tax commissioner of one of the states has adopted a standard rate of 10 per cent, but in ex- ceptional cases allows as much as 25 per cent. Usually in a going business, assets are not treated on the basis of realization values, but in the case of furniture and fixtures so many changes are made to suit the convenience and whims of executives and clerks, and offices are moved so often from one place to another, that these assets have a most uncertain value. Leaving out of consideration the complex question as to what are and what are not landlord's fixtures, it may be laid down as a general rule that the minimum rate of depreciation upon machinery and fittings erected upon leasehold property should be sufficient to wipe off the book value before the ex- piration of the lease. In the case of machinery, etc., which will not become landlord's fixtures, a less rate may be per- mitted, but it is imperative that in such a case it be clearly understood and agreed what are to be the landlord's fixtures and what are not. Goodwill. — No claim for depreciation, as such, of goodwill, trade-marks or trade-brands should or will be allowed, but when goodwill was purchased or had a value March i, 1913, and later declines in value on account of such causes as state or national prohibition, depreciation in the nature of obsoles- cence will be allowed. ^^ Regulation. Intangibles, the use of which in the trade or busi- ness is definitely limited in duration, may be the subject of a deprecia- tion allowance. Examples are patents and copyrights, licenses and franchises.''^ Intangibles, the use of which in the business of trade is " See page 1144. " [Former Procedure] In the preliminary edition of Regulations 45 among the examples of intangibles subject to depreciation was "limited leases." The item was omitted in the April 17, 1919, edition and in the amendment of October 7, 1919. The omission of the re- striction on an allowance for goodwill, etc., arises out of an allow- able deductions for obsolescence of goodwill, etc. See page 1132. 1098 DEDUCTIONS not so limited, will not usually be a proper subject of such an allowance. If, however, an intangible asset acquired through capital outlay is known from experience to be of value in the business for only a limited period, the length of which can be estimated from experi- ence with reasonable certainty, such intangible asset may be the sub- ject of a depreciation allowance, provided the facts are fully shown in the return or prior thereto to the satisfaction of the Commis- sioner. (Art. 163.) The regulation fails to state that the value of the property at March i, 191 3, is subject to depreciation even though the asset was not acquired by capital outlay. Hat factories. — The depreciation on hat factory buildings is about 2^ per cent; on equipment from 4^/4 to 10 per cent; while on the molds used in the business it is the same as on the patterns in a foundry.'*^ Horses. — Horses become less valuable not only through age but also through hard usage. If depreciation is calculated on an annual percentage basis, the allowance should usually be from 10 to 25 per cent of the cost. The alternative method of basing depreciation on periodical revaluations is favored by many because it makes possible a closer approximation of actual deterioration. Certainly, in the case of horses, valua- tions can be established more accurately than in the case of most assets. Fairly frequent revaluations are therefore de- sirable. Intangible property. — Intangible property is held to be subject to depreciation and obsolescence. (See discussion under "Leaseholds," page 1099 and "Goodwill," page 1097.) Land. — The regulations deal with depreciation in the value of land as follows : Regulation The allowance .... does not apply .... to land apart from the improvements or physical development added to it.^8 .... (Art. 162.) "See pages 1088 and 1114. "See Chapter XXXIII, "Deductions for Depletion." FOR DEPRECIATION 1099 Generally speaking, land does not depreciate. Declines in values are not allowable deductions until sales are made, ai which time the resulting losses may be deducted as losses, and not as depreciation. But if it can be shown that depreciation, as the term is used in the law, actually occurs in land values, credit may be claimed, even though the foregoing regulation would seem to indicate otherwise. ^ The law*'' permits "a reasonable allowance for the exhaus- tion, wear and tear of property used in the trade or business." It would therefore seem that if land which is used in the business of farming depreciates in value because of its employ- ment, and not because of fluctuations from other causes, credit may be claimed therefor. If a farmer were to produce successive crops from his land without being able to restore the land to its former fertility it would be inequitable to compel him to return for taxation the value of the crops produced and prohibit the taking of credit for one of the chief items of cost of production — and depreciation in the value of land due to exhaustion can hardly be called anything but an operating cost. Declines in values due to erosion may more properly be dealt with as losses, but the law. seems to have specifically provided for depreciation due to exhaustion. ■ Leaseholds. — No mention of leaseholds is made in the 1916, 191 7, 1918 or 192 1 income tax laws. Because of the im- portance of this class of assets the Treasury has issued com- prehensive regulations dealing with its treatment. Many kinds of property are operated under leases which may be held or sold to others. A leasehold becomes the personal property of the lessee or purchaser. Its value or cost is an integral part of his investment. The owner uses or employs the prop- erty until its value is exhausted. Regulation. Where a leasehold is acquired for business purposes for a specified sum, the purchaser may take as a deduction in his re- " Section 214 (a-8). Iioo DEDUCTIONS turn an aliquot part of such sum each year, based on the number of years the lease has to run (Art. 109.) By reason of the temporary character of a leasehold its cost may be amortized during the term of its Hfe from the date of purchase or from March i, 19 13, so that an equal por- tion of its cost or of its value on March i, 1913, shall be charged against the operations of each year. A leasehold is property. Section 325 (a) of the 192 1 law- specifies leaseholds as tangible property for the purpose of the excess profits tax law. Neither can it be denied that a lease- hold loses its value by the mere effluxion of time. Conse- quently it is not only proper but necessary that its amortization be recorded on the books of its owner. In a ruling of the Committee of Appeals and Review the nature of a lease is well described : Ruling The facts appear to be that this company was organized with a small amount of capital stock, none of which was paid up, and later it secured a lease to wharf property, no bonus being paid for the lease. The business of the company is the sublet- ting of this leased property. It is clear that the income of the company is derived chiefly from the possession of a capital asset which is not capital in name only, but a real tangible asset, to wjit, its lease upon the wharf property. .... (C. B. 3, page 341; A. R. R. 315.) Depreciation allowed lessee. — Ruling. Ordinarily an allowance for depreciation may be taken only on account of property owned by the taxpayer and used in trade or business and may not be taken on account of property of which he is merely the lessee. This will not preclude the deduction each year by the lessee of an aliquot part of the cost or the bonus paid for the lease. In the case of additions, improvements, or bet- terments to the property made at the expense of the lessee, which, according to the terms of the lease, revert to the lessor at the termi- nation of the lease, the lessee may apportion the cost of such addi- tions, etc., over the life of the lease and deduct an aliquot part thereof each year. If, however, the life of improvements for business pur- poses made at the expense of a lessee is less than the life of the lease, depreciation may be taken by the lessee instead of treating the cost FOR DEPRECIATION IIOI as additional rent.-''^ Stockliolders of a corporation are not entitled to deduct in their individual returns any amount on account of depre- ciation of the property of the corporation from which they receive dividends. (Bulletin "F," page 32.) The foregoing covers only the period subsequent to March I, 1913. When a lease executed prior thereto had an ascer- tainable value on that date the value is capital and may be returned to the lessee free from tax. This principle is recog- nized in the following ruling. Value of lease at March i, 191 3, may be used for depreciation purposes. Ruling. The M Company obtained a lease in 189 — covering a period of 99 years, for which it pays nothing except the stipulated annual rent. The question raised is whether the company may set up the value of said lease as of March i, 1913, and charge off de- preciation over the remaining term of the lease. In the case of a lease held by the original lessee, who acquired it prior to March i, 1913, without any payment other than a stipulated annual rent, the presumption is that the lease had no value as at March i, 1913. Under this presumption there is no basis for a de- preciation deduction. This presumption can be overcome only by evidence showing conclusively that the lease had a value as of March i, 1913, for depreciation purposes. There is no prescribed method by which the value of a lease as of March i, 1913, in excess of its presumptive value as at that date may be established. The burden is upon the taxpayer to establish the basis for depreciation to the satisfaction of the bureau. (C. B. 3, page 145 ; O. D. 720.) In many cases evidence regarding the value of a lease on March i, 19 13, can be readily secured. When lessee must return property unimpaired. — Ruling. The M Company leased to the O Company certain street railway properties. By the terms of the lease the lessee is required to return the leased properties to the lessor at the end of the lease in the same condition they were in at the date of the lease. All of the stock of the lessor company is owned by the lessee com- pany. Inquiry is made whether for Federal income tax purposes. '" For obsolescence of improvements on leased land, see Chapter XXXII. II02 DEDUCTIONS the lessee company may charge depreciation of the leased properties on its books. Held, that inasmuch as tlie properties leased must be returned to the lessor company at the end of the term of the lease in the same order and condition as they were in at date of lease, there will be no depreciation of such properties while in the lessee's possession and therefore no deductions by the lessee for depreciation will be allowed. Amounts expended to keep the properties in good condition and repair are deductible as business expenses in the returns of lessee corporation for the years in which such amounts are expended. (B. 35-21-1794; O. D. 1014.) The foregoing ruling is not sound. Assume that before the end of the lease a large part of the equipment is scrapped in a single year because it has worn out. The lessee would have to replace it. The Treasury would not permit the replace- ment to be charged to income as "repairs." Although depre- ciation actually accrues year by year, the Treasury under the ruling would deny the deduction, and neither the lessee nor lessor would get the benefit clearly provided by the law. This reasoning is based on the fallacious theory that repairs and maintenance offset depreciation.^^ Machinery and equipment. — While specifically declaring that "each taxpayer must determine the probable lifetime of his property without regard to the .... figures given," the Primer makes the statement that "the estimated lifetime of ordinary machinery is ten years. "'^^ So many factors affect the length of the life of machinery that the only satisfactory solution is to assign to each machine its own individual rate of depreciation. What that rate shall be must be determined by experience with similar machines in similar circumstances. These circumstances vary widely. Two machines exactly alike in the beginning may show a con- siderable difference in length of life and service when installed in different plants. An uneven or unstable foundation may shorten the life of one machine. Cleanliness and lubrication, " See page 1059. "'' Income Tax Primer, 1918, question 99. FOR DEPRECIATION 1 103 care and skill in operation and continuity of service are im- portant factors. Climatic conditions often enter to compli- cate the problem, machinery in some sections of the country deteriorating more rapidly from this cause than in other sec- tions. Again the policy relative to repairs and maintenance affects aggregate renewal costs. A high standard of upkeep means lower depreciation rates. Often a considerable part of the ordinary wear and tear for which depreciation reserves are created is charged to operating expenses in the form of re- pairs and maintenance. Small parts of machines are con- stantly wearing out or breaking and are being renewed as an expense. Sometimes nearly every part of a machine is re- newable and in such a case it is quite conceivable that at the end of five or six years the machine may be so largely renewed as to be about as good as new. Where a condition of this sort exists the depreciation rate should be lowered. It is apparent that no hard-and-fast rule can be laid down. The nearest possible approach to a general rule is to state that in addition to charging all repairs and part renewals to operat- ing expense, from 7^ to I2}4 per cent should be written off annually from the original cost to provide for normal de- preciation. When double shifts are made necessary the rate is increased. In certain cases engineers have estimated that the increase in rates due to overtime and "diluted labor" is from 50 to 100 per cent. In the case of a heavy machine tool the life is usually con- sidered to be from fifteen to twenty years, ignoring the ques- tion of obsolescence; yet the rate of the National Machine Tool Builders — which is 10 per cent and is for favorable con- ditions and applies to the total original value and not to a decreasing value — should be given weight. It is invariably desirable that a subsidiary ledger be kept containing details not included in the machinery accounts of the general ledger. Such detailed records not only assist in the calculation of rates of depreciation but they are also of 1 104 DEDUCTIONS great value in determining the amount to be written off in case of a sale or fire^^ Mine equipment. — A company mining bituminous coal claimed depreciation on the following basis : Mine equipment 6 2/3% Power houses and machinery.... 62/3 Tipples, inclines and screens 62/3 Saw mill 62/3 Tenement houses 5 Buildings and other houses 5 The inspector refused to allow the deduction because the de- preciation was not entered on the books, but on appeal to Washington the rates were passed as reasonable. In this case, the quantity of coal in the ground was sufficient to warrant waiting off depreciation on an estimated life of twenty years. The quantity of unmined coal must always be taken into con- sideration. Regulations, (a) All expenditures for development, rent, and royalty in excess of net receipts from minerals sold shall be charged to capital account recoverable through depletion, while the mine is in the development stage. Expenditures made in order to maintain the mine at its normal output shall be deducted as an expense in the year in which the expenditure is made or accrues. Any expenditure for extraordinary development and equipment, such as stripping, shaft sinking, tunneling, and other work beyond that necessary to maintain the mine at its normal production or output should be carried forward and apportioned and deducted as an operating ex- pense in the years to which it is applicable. (b) All expenditures for plant and equipment shall be charged to capital account recoverable through depreciation, while the mine is in the development stage. Thereafter the cost of major items of plant and equipment shall be capitalized, but the cost of minor items of equipment and plant, necessary to maintain the normal output, and the cost of replacement may be charged to current expense of oper- ation (Art. 222.) " In a well-known English compilation, the depreciation rates of "American-made" machinery are from ^ of I per cent to 2 per cent higher than on the same class of machinery manufactured in England. No ex- planation is given. This is of interest when quotations from English reports or decisions are used as precedents. FOR DEPRECIATION II05 (a) The Act provides that deductions for depreciation of im- provements "according to the peculiar conditions in each case" may be taken by a taxpayer owning or leasing mining property. This is deemed to include exhaustion and wear and tear of the property used in mining of deposits, inchiding a reasonable allowance for obsolescence .... (b) It shall be optional with the taxpayer, subject to the approval of the Commissioner, (i) whether the value of the mining property plus allowable capital additions but minus estimated salvage value shall be recovered at a rate established by current exhaustion of mineral, or (2) whether the value of the mineral deposit on the basic date plus allowable capital additions shall be recovered through de- pletion and the cost of plant and equipment. less the estimated salvage value shall be recovered by reasonable charges for depreciation at the rate determined by its physical life or its economic life or, according to the peculiar conditions of the case, by a method satis- factory to the Commissioner. Estimated physical life. — (c) The estimated physical life of a plant or unit thereof ("includ- ing buildings, machinery, apparatus, roads, railroads and other equip- ment and improvements whose principal use is in connection with the mining or treatment or other necessary handling of mineral products) may be defined as the estimated time such plant, or unit, when given proper care and repair, can be continued in use despite physical deterioration, decay, wear and tear. Estimated economic life. — (d) The estimated economic life of a plant or unit thereof is the estimated time during which the plant or unit may be utilized effectively and economically for its intended purposes and may be limited by the life of the property or of that portion of the mineral deposits which it serves but can never exceed the physical life. Adjustment of depreciation reserves. — (e) Any difiference between the salvage value of plant and equip- ment and the depreciated value remaining at the termination of mining operations shall be returned as profit or loss in the year in which it is realized. Salvage value of equipment. — (/) Nothing in these regulations shall be interpreted as mean- ing that the value of a mining plant and equipment may be reduced by depreciation deductions to a sum below the value of the salvage when the property shall have become obsolete or shall have been llo6 DEDUCTIONS abandoned for the purpose of mining. In estimating the salvage value of the equipment at the end of its estimated economic Hfe due consideration may be given to its specialized character and the cost of dismounting and dismantling and transporting it to market. Land may not be depreciated. — (g) Nothing in these regulations shall be interpreted to permit expenditures charged to expense in any taxable year or any part of the value of land for purposes other than mining to be recovered through depletion or depreciation. (Art. 224.) Expenditures which benefit the future. — It is claimed by many competent mining engineers that good prac- tice in the mining industry permits the charging to mainten- ance of expenditures for improvements the benefits and ad- vantages of which extend over a period of years. Under ordinary accounting practice all expenditures which benefit the future should be set up as deferred assets and allocated to the succeeding periods which realize the benefits. The recent federal tax laws recognize that general principles may be modified in a trade or business. When the modi- fications are accepted as controlling and as good practice by a majority of concerns in such industry, general principles are superseded. The custom of charging improvements to maintenance does not extend to original development and equip- ment, but is limited to expenditures which are made after mines are in operation. The theory is that after operations have begun practically all so-called improvements "are really noth- ing but expenses required to keep the property from depreci- ating."'* Development costs. — Under article 223, a taxpayer is given the option of charging to expense or capitalizing ex- ploration expenditures, "drilling of wells, building of pipe lines, and development . . . ." The election once made is held to be binding in subsequent years. Rulings. A corporation which in 1916 and 1917 exercised its option and charged to capital account such expenditures as wages, 'J. R. Finlay, The Cost of Mining, page 65. FOR DEPRECIATION II07 fuel, repairs, hauling, etc., in connection with the exploration of property, drilling of wells, etc., may not subsequently amend its re- turns covering such period so as to transfer such items to operating expenses to accord with their treatment in its 1918 return. (C. B. 4, page 199; O. D. 796.) Held, that under article 223, Regulations 45, the exercise by a taxpayer of his option to charge cost of drilling wells to operations precludes a revision of the accounts to treat such items as capital expenditures. (C. B. 4, page 200; A. R. M. no.) Where a parent company which owns the stock of a subsidiary company elected under article 223, Regulations 45, to charge as operating expenses, the expense incurred by it during the period in which it operated oil leases, the subsidiary company, to which the oil leases were sold, is bound by the election of the parent organization and must charge development and exploration expenses made by it in connection with such oil leases and properties to oper- ating expenses. ( B. 34-21-1781; O. D. 1002.) In permitting" items, which are ordinarily regarded as capi- tal to be charged to expense, the Treasury recognizes the haz- ardous character of the oil industry. Depreciation of equipment of oil and gas wells. — ' Regulation. Both owners and lessees operating oil and/or gas properties will, in addition to and apart from the deduction allow- able for depletion or as hereinbefore provided, be permitted to deduct a reasonable allowance for depreciation of physical prop- erty, such as machinery, tools, equipment, pipes, etc., so far as not in conflict with the option exercised by the taxpayer under article 223. The amount deductible on this account shall be such an amount based upon its cost (or fair market value as of March I, 1913, if acquired prior to that date) equitably distributed over its useful life as will bring such property to its true salvage value when no longer useful for the purpose for which such property was acquired. Accordingly, where it can be shown to the satisfaction of the Com- missioner that the reasonable expectation of the economic life of the oil or gas deposit with which the property is connected is shorter than the normal useful life of the physical property, the amount annually deductible for depreciation may for such property be based upon the length of life of the deposit (Art. 225.) Detailed classifications of both oil and gas well equipment and the rates of depreciation applicable thereto have been iio8 DEDUCTIONS published by the Treasury.''^ So far as is known this is the only industry for which the government has officially sug- gested classifications and rates. The Treasury suggests that well equipment be depreciated at the same rate as that at which the oil or gas reserves are depleted. The reason for this method in preference to a straight line rate of depreciation such as lo per cent a year, is that after a well has produced for a few years there is prac- tically no salvage value to the casing and tubing. Casing and tubing are the large and small sizes of pipe which are put into a well to protect the oil or gas from physical encroach- ments in its passage from the producing sand to the mouth of the well. If a well has produced for five years, under ordinary cir- cumstances the casing and tubing would be useful for sev- eral years more if left in the well and the w^ell continued to pro- duce. If the well ceases to produce and the casing and tubing are pulled out, they may not be in such a condition as to war- rant the expense of transporting them any distance, espe- cially over a rough country, and putting them into another well for the remainder of their life. Furthermore, the opera- tions of pulling out casing and putting it down into a well are hazardous both as to the expense which may be involved and the risk of injuring the material. The recommendation of the Treasury to depreciate the well equipment at the same rate as the mineral contents are depleted is reasonable. There may be circumstances under which this method of depreciation will not apply. Some producers pull the outer casing as soon as a well begins to produce, and use it in pipe lines or other wells. When the newly drilled well turns out to be a dry hole, that is, it produces no oil or gas, probably all the casing and tubing will be pulled. Equipment rapidly deteriorates under these conditions. In these instances the rate recommended by the Treasury will not apply, and the Manual for the Oil and Gas Industry, 1921, page 63. FOR DEPRECIATION I109 equipment must be depreciated at a high rate for the period during which it has been in the well. Orchards. — See page 1414. Organization expenses. — Such expenses may not be de- ducted by way of depreciation.^" For comments on this point see page 907. Patents. — A patent derives its value from the fact that it is a monopoly. The moment the monopoly ceases because of the termination of the patent term, the value is wiped out. It is true that in many cases the momentum gained during the period of legal monopoly may give a marketing advantage which is of some value for a considerable period after the ex- piration of the term of the patent, but this is an asset closely akin to goodwill and as such -is not of a nature suited to serve as a basis for the establishment of depreciation reserves. In other words a proportionate part of cost or value March i, 1913, of a patent should be charged off periodically so that the cost may be completely extinguished by the expiration date. Since patents in this country are issued for a term of 17 years, 17 should constitute the maximum number of annual instalments. Life more than 17 years when application was PENDING March i, 1913. — When an application for a patent was pending March i, 191 3, and the patent was issued and dated March i, 19 15, the appraised value of the patent March I, 191 3, subject to depreciation should be spread ratably over 19 years. The capital value at March i, 19 13, is the amount to be returned through depreciation charges, and it is obvious that the property which existed at that date had a remaining life of 19 years and not 17 years. Of course, it by no means follows that a patent possesses 'Bulletin "F," page 12. See page 907. mo DEDUCTIONS value during- its whole life. Revaluations should be made fre- quently. They often reveal the desirability of readjusting depreciation rates and of charging off sums as losses." It may be that the process covered by the patent has become obsolete or that the article made is not in demand or is salable at a price too low to justify its manufacture. Again, if a patent is pur- chased after part of its term has expired, the rate should be based upon the unexpired term only. A patent which has been leased and not purchased should not be treated as an asset except to the extent of its actual cost in fees, etc., unless acquired before March i, 19 13. To capitalize a patent lease purchased since March i, 1913, at any sum in excess of cost would be as incorrect as to capitalize goodwill in excess of cost, although one or the other is a latent asset in every paying concern. Regulation. In computing a depreciation allowance in the case of a patent or copyright, the capital sum to be replaced is the cost (not already deducted as current expense) of the patent or copy- right or its fair market value as of March i, 1913, if acquired prior thereto. The allowance should be computed by an apportionment of the cost of the patent or copyright or of its fair market value as of March i, 1913, over the life of the patent or copyright since its grant, or since its acquisition by the taxpayer, or since March i, 1913, as the case may be. If the patent or copyright was acquired from the Government, its cost consists of the various Government fees, cost of drawings, experimental models, attorney's fees, etc., actually paid. If a corporation purchased a patent and paid for it in stock or securities, its cost is the fair market value of the stock or securities at the time of the purchase (Art. 167.) In many cases the market value of securities indicates the fair market value of the assets purchased with such securities, but in many other cases the value of the asset and the value of the securities issued therefor vary to a considerable extent. The chief reason for the variation is that the securities issued may be part of a larger issue or sales may be made under favorable or unfavorable conditions. '■ See page 652. _ • ?■ V , FOR DEPRECIATION I ill Depreciation based on fair market value at march I, 1913 — Regulation Depreciation of a patent can be taken on the basis of the fair market value as of March i, 1913,^^ only when affirmative and satisfactory evidence of such value is offered. Such evidence should whenever practicable be submitted with the return. .... (Art. 167.) "Satisfactory" evidence is a reasonable requirement and must be met. The taxpayer is entitled to produce evidence of subsequent development and success as bearing on the probable value at March i, 191 3. The estimates of inventors and others as to values, while not conclusive, are prima facie evidence when it appears that such estimates were made in good faith. The value placed upon patents by competition is difficult to ascertain but is sometimes available. The testimony of those who have valued patents, bought and sold them or par- ticipated in negotiations, is admissible. '^° Rate to be used when patent becomes obsolete. — Regulation If the patent becomes obsolete prior to its expiration such proportion of the amount on which its depreciation may be based as the number of years of its remaining life bears to the whole number of years intervening between the date when it was acquired and the date when it legally expires may be deducted, if permission so to do is specifically secured from the Commis- sioner. Owing to the difficulty of allocating to a particular year the obsolescence of a patent, such permission will be granted only if affirmative and satisfactory evidence that the obsolescence oc- curred in the year for which the return is made is submitted to the Commissioner (Art. 167.) When patent right is extended.- — A corporation ac- quired patent rights for a period of 23.5 months. Subse- °' [Former Procedure] Depreciation was permitted only on the basis of actual cost thereof and not on estimated value as of March i, 1913 (Reg. 2,2), 1918, Art. 174), but for some years the author has con- tended that the March i, 1913, value was permitted by the law. (See Income Tax Procedure, 1919. pages 572-573.) "^ For full discussion of value at March i, i<)i3, see page 651. 1 1 12 DEDUCTIONS / quently a new right to extend for a period of eight years was secured. The taxpayer claimed the right to spread the depre- ciation over the remaining eight years, which the Treasury denied. Ruling. In the determination of the depreciation allowance which may be claimed in the 19 17 return of the taxpayer, two factors must be known and are apparent in the record, to wit: the cost of the asset, and its life, as determined by the period for which the right under which the company operated in 1917, was to run. These factors as shown by the record are: cost of asset, x dollars; and life of asset, 23.5 months. It is the opinion of the Committee, therefore, that the depreciation allowance to which the taxpayer is entitled for the calendar year 1917 is an amount which bears the same ratio to x dollars as twelve months (the taxable year) bears to 23.5 months (the total period or life of the asset). (B. 44-21-1893; A. R. R. 520.) Patent litigation deductible as expense.®" — Ruling The conclusion of the committee is that the amounts expended by the corporation in the instant case in litigation, after the patent had been secured by B and had been transferred to the corporation, constitute necessary operating expenses and should not be capitalized (C. B. 2, page 105; A. R. R. 98.) When depreciation not taken in prior years. — Regulation The fact that depreciation has not been taken in prior years does not entitle the taxpayer to deduct in any taxable year a greater amount for depreciation than would other- wise be allowable (Art. 167.) The preliminary edition of art. 167, Reg. 45, provided that "a taxpayer may elect not to take a depreciation allowance but such election if made is final and will control the returns for all subsequent years." It is a fair statement that nothing is final in income tax practice, even regulations, because the sentence quoted was omitted from the April 17, 19 19, edition of the regulations. Taxpayers cannot be estopped from revising accounting procedure when it is discovered that past procedure did not properly reflect net income. See Chapter XXVI. FOR DEPRECIATION 1113 A patent may be purchased for $100,000. It may have ten years to run. During the first few years after purchase development work may be going on, there may be no gross income or net income, and it may be decided that no deprecia- tion has taken place, consequently none is charged. After sev- eral years the commercial use of the patent begins and gross in- come is received. It may then be decided that depreciation should be charged. Surely it could not be held that any de- preciation in the earlier years had taken place. Ruling In January, 1902, the M Company, then a newly organized corporation, acquired ownership of eight patents issuing therefor to A, the patentee, goox dollars of stock of the corporation. This amount was subsequently increased 2x dollars by expenses of acquisition. The patents so acquired, except one, issued in 1900, had expired prior to January i, 1917, but as of March i, 1913, all but one were in effect No depreciation was taken by the tax- payer on the patents which were capitalized, until the year 1917, when 1/17 of the book value was charged to expenses notwith- standing the fact that all except one of them had expired prior to January i, 1917 The basis for deduction authorized .... is the return of capital on an asset, the use of which in the trade or business is definitely limited in duration. The taxpayer did not elect, during the life of the patents acquired in 1902, to provide for this return of capital. Had he made this provision his surplus for invested capital pur- poses under the Revenue Act would have been correspondingly re- duced. He, therefore, can not now claim in a high taxable year, after the expiration of the life of the patents, an amount equivalent to one-seventeenth of the cost, thereby securing the benefit not only of a reduction in his taxable income for the year 1917, but the advan- tage of the investment, which in value is subject only to the definite limitations prescribed by the Act and the regulations (C. B. 3, page 172; A. R. M. 95.) It was possible, however, for the corporation to revalue any new patents acquired prior to March i, 1913, and unex- pired on that date. Depreciation on such revaluation would be allowed. It is legitimate and legal to make changes in bookkeeping methods and take advantage of deductions under laws which impose high tax rates, irrespective of the taxpayers' former methods. 1 1 14 DEDUCTIONS Life of patent or trade-mark in foreign coun- tries."^ — Country Term of Patent Term of Trade-Mark Great Britain 16 years. Extended from 14 years by act of Parliament, 1919 14 years renewable. France 5, 10, or 15 years from filing of appli- cation IS years renewable. Germany 15 years from next day after filing.... 10 j'ears renewable. Russia 15 years i to 10. Canada 18 years General unlimited ; special ' 25 years renewable. Australia 14 years 14 years renewable. Austria 15 years 10 years renewable. Switzerland 10 years for cliemical process. 20 years renewable. 15 years from filing. Sweden 15 years from filing 10 years renewable. Denmark 15 years 10 years renewable. United States 17 years 20 years renewable. Patterns, drawings, models, designs, etc. — The difficulty which the accountant encounters in the proper valuation of such patterns as are successful is to persuade proprietors to accept valuations which are reasonably conservative. Where patterns are used for stock or regular output, their value de- pends upon their life and upon the probability of renewed use. Where acquired or made for special jobs, the residual value is small, and the life of the patterns should be considered co- extensive with the life of the jobs themselves. In every case items such as these should be looked upon wnth suspicion, and convincing proof must be adduced before placing any material sum on their account as an asset. An auditor often meets with strong opposition in his efforts to reduce these items to reasonable amounts, for they represent the skill and often the affections of the proprietors, who dislike to see their value depreciated on the books. But the public demand is fickle, and patterns must be made to suit the changing taste. Even what appear to be standard patterns for stable businesses often change rapidly. Engineers make almost as many alterations in their "styles" as do milliners. When the demand ceases most of the old patterns should be scrapped. This rule applies to hardware designs as well as to patterns for women's dresses. "Bulletin 45-20-1293; O. D. 721. FOR DEPRECIATION 1115 An analysis of the sales, showing articles made from spe- cific patterns, is evidence that the patterns have a life beyond the year in which their cost was incurred. Such an analysis is particularly useful in those cases in which repeat orders are received sometimes several years after the original sale was made. Patterns used only rarely are often scrapped and new ones made as occasion requires. In such instances the drazving has the value. The charges against this account are usually cumulative, i.e., they follow the output almost automatically, thus indicat- ing that most of the old patterns, etc., are obsolete or have been discarded. Usually depreciation charges should equal the annual expenditures for new patterns, etc. Wherever feasible, the conservative course is to write down the book value to $1. Earlier regulations"^ have required that expenditures for successful patterns, etc., must be capitalized and specifically written off, the charge being based on their effective life. The regulations under both the 19 18 and 1921 laws give to the taxpayer the option of charging off such items as expenses or of capitalizing them. Regulation. A taxpayer who has incurred expenses in his business for designs, drawings, patterns, models, or work of an ex- perimental nature calculated to result in improvement of his facili- ties or his product, may at his option deduct such expenses from gross income for the taxable year in which they are incurred or treat such articles as a capital asset to the extent of the amount so expended. In the latter case, if the period of usefulness of any such asset may be estimated from experience with reasonable accuracy, it may be the subject of depreciation allowances spread over such esti- mated period of usefulness. The facts must be fully shown in the return or prior thereto to the satisfaction of the Commissioner. Ex- cept for such depreciation allowances no deduction shall be made by the taxpayer against any sum so set up as an asset except on the sale or other disposition of such assets at a loss or on proof of a total loss thereof. (Art. 168.) Ruling. The cost of tracings, patterns, and flasks necessary in the business of a corporation was charged to expense from 1909 '■■Reg. 33, 1918, Arts. 175-177- Iii6 DEDUCTIONS to 1912, no new equipment of that nature having been acquired sub- sequently. In order to restore the value of such equipment to capital account for the purpose of computing depreciation deductions, the corporation had an appraisal made in 1920, of the value as of March I, 1913, of such equipment still in existence and use, based on the cost of reproduction of the equipment as of March i, 19 13, such cost less depreciation from original acquisition being treated as the value as of March i, 1913. In the absence of other evidence of value, the Committee approves this method of valuation and recom- mends its acceptance, provided proper adjustment of the erroneous charges to expense from 1909 to 1912, be made in amended returns for those years. (C. B. 3, page 173; A. R. R. 2^2.) Printing. — The depreciation of printing plants is about the same as that in the textile industry (see page 1 1 19) with the exception of type, printers' tools, electrotypes, plates, etc., on which from 10 to 25 per cent should be applied annually. Some authorities recommend a rate as high as 25 per cent on type and electroplates. Professions— physician's claims for depreciation. — In New York a physician made the following claims for depreciation which were allowed : Residence, brick construction, on part occupied as offices only 5% Automobile 20 Books 20 Instruments 25 Office furniture 20 Country residence, wood construction, on part occupied as offices only 10 Radium — no depreciation allowed. — Ruling. Since the full life of radium has been scientifically estimated at such an extended period and since no appreciable de- preciation results from its continued use as a therapeutic agent, the depreciation occurring during the lifetime of any individual owner is practically negligible. It is held, therefore, that radium which is used as a therapeutic agent is not subject to depreciation for income tax purposes and its cost must be treated as a capital expenditure. The return of capital will be realized upon its sale or other disposition. (C. B. 4, page 178; O. D. 837.) FOR DEPRECIATION III7 Railroad sidings. — Ruling. A railroad company constructed a siding to connect the property of the ,M Company with its raih'oad. A part of tlic siding on land of the M Company is owned by the M Company. The cost was borne by the M Company and is recoverable through de- preciation allowances. A part of the siding on land of the railroad company is owned by the railroad company. The cost was borne by the M Company and is a business expense deductible for the year in which it was incurred. (Also sec. 214 (a) i, art. loi.) (B. Digest 36-21-1800: O. D. 1019.) Shipping industry. — Prior to 1920 satisfactory Ameri- can rates applicable to this industry weVe not available. The rates claimed by ship-owners were far from uniform."^ Bulk freight steamships — Great Lakes. — Ruling. Three per cent is held to be a reasonable allowance for depreciation of bulk freight steamships on the Great Lakes; however, when due to peculiar conditions, it can be definitely deter- mined that the established rate of depreciation will not be sufficient to return all of the capital invested, as at the date of acquisition or March i, 1913, whichever is later, by the time the vessel will be rendered useless, an addition to the regular rate to cover obso- lescence, may be allowed. The amount of this addition must be determined upon the basis of the facts in each particular case; that is, the type of the vessel ift question, the fitness for possible use in other lines of transportation and the date when it can be definitely foreseen that she will be no longer commercially useful in this par- ticular line of traffic. This rule does not necessarily apply to steamers engaged in other lines of traffic, for the reason that there are distinct differences in the method of construction and the matter of operation of package freighters and passenger steamers and the bulk freighters under consideration. (C. B. 2, page 139; .\. R. R. 27.) With reference to increasing the rate on account of ac- cruing obsolescence, the Treasury in the detailed ruling held : .... obsolescence should be limited to those cases where it can be shown that a type of vessel has been developed so much more economical than existing types, that no other than the new type will be built in future, and that a sufficient number of the new type to meet traffic requirements will in all reasonable probability be built For British rates see Income Tax Procedure, 1920, pages 733-735. Iii8 DEDUCTIONS within a certain definite period, thereby forcing the older type out of useful existence. Some of the United States Shipping Board vessels were operated under charters which gave the charterers the option to purchase the vessels. The initial cost of re-conditioning, which was borne Iw the charterers, was applied on the purchase price, less depreciation at the rate of 7^ per cent per annum. SlIIP-S REQUISITIONED BY SHIPPING BoARD. Ruling. Ships in process of construction under contract were requisitioned by the Shipping Board, completed, and then recon- veyed to the company from which they were requisitioned for an amount in excess of the contract price of the ships. Held, that the entire cost of the ships is a capital expenditure recoverable by al- lowances for depreciation, obsolescence, and amortization to the ex- tent allowable under the Revenue Act of 1918 and Regulations 45, and that the excess of the cost over the contract price is not de- ductible as a loss or a business expense. (C. B. 4, page 179; O. D. 851.) Ste.\m .schooners. — Depreciation of steam schooners engaged in the coastwise lumber trade was fixed at 5 per cent.*'* Soap industry. — Depreciation in this industry is about the same as in chemical factories.*'^ Textile industry. — In the textile industry the depreciation of buildings is somewhat heavy owing to the vibration of the machines. The rate assigned to the machinery is often made high because of the likelihood of obsolescence and the introduc- tion of new appliances. The average depreciation provides for about 3 per cent on the building, if of fireproof brick con- struction, and 6 per cent on the machinery. There is a. wide variance in practice as to the depreciation of textile machinery. In some districts where machines, per- haps fifty years old, are giving good service today, the disposi- Bulletin 42-20-1245 ; A. R. R. 279. '' See page 1093. FOR DEPRECIATION 1 1 19 tion is toward low rates. In this industry the continual re- newal of many different parts of a loom serves to reduce the depreciation rate. Experience proves, however, that some of these old machines are "pets," while more modern machines which have been worn out and replaced several times in the same period are forgotten. A writer in the Textile World Record suggested 3^ per cent as a rate for cotton and woolen machinery, including spinning and weaving machinery. A large Boston firm of textile mill engineers uses these rates : Woolen and worsted machinery 2-23/^% ^ Cotton machinery 3 Dyeing and similar machinery subjected to acid fumes, etc 5 Timber industry.'"' — Specific provision is made in the reg- ulations regarding depreciation of property used in a timber project when the probable life of the asset exceeds that of the project itself. The same rules as apply in the case of mining, oil and gas projects apply here, viz., that the life of the project shall be considered a limiting factor, due allowance being made for salvage value. Ruling. A lumber company contracts to cut and saw the timber on a certain tract of land, the estimated time required being two years. It erects buildings and installs equipment which by reason of prohibitive cost of removal will be worth only the salvage value upon completion of the contract. The cost of the property and equipment may be charged off and deducted as depreciation allow- ances on the basis of the time required to complete the contract, or in the proportion that the amount of timber cut and sawed each year bears to the total amount of timber available. (Bulletin "F," pages 31, 32.) Depreciation of timber . plants, improvements and equipment. Regulations. In the case of a timber property held for future operation by an owner having no substantial income from the property or from other sources, all expenditures for administration, protec- tion, and other carrying charges prior to production on a normal "For regulations rtlating to depletion of tinilicr lands, see Chapter XXXIII. II20 DEDUCTIONS basis shall be charged to capital account; after such a property is on a normal production basis such expenditures shall be treated as current operating expenses. In case a taxpayer, who has a substantial income from other sources, owns a timber property which is not yet on a normal production basis, he may, at his option, charge such expenditures with respect to such timber property to capital, or treat them as current operating expenses, but whichever system is adopted must be followed until permission to change to the other system is secured from the Commissioner. In the case of timber operations all expenditures prior to production for plants, improvements, and equipment, and thereafter all major items of plant and equipment shall be charged to capital account for purposes of depreciation. After a timber operation has been developed and equipped and has reached its normal output capacity, the cost of additional minor items of equipment and the cost of replacement of minor items of worn-out and discarded plant and equipment may be charged to current operating expenses, .... unless the taxpayer elects to write off such expenditures through charges for depreciation; how- ever, the method adopted must be followed consistently from year to year. (Art. 231.) The cost or value as of March 1, 1913, as the case may be, of development not represented by physical property having an inven- tory value, and such cost or value of all physical property which has not been deducted and allowed as expense in the returns of the taxpayer, shall be recoverable through depreciation. It shall be optional with the taxpayer, subject to the approval of the Commis- sioner, (o) whether the cost or value, as the case may be, of the property subject to depreciation shall be recovered at a rate estab- lished by current exhaustion of stumpage, or (b) whether the cost or value shall be recovered by appropriate charges for depreciation calculated by the usual rules for depreciation or according to the peculiar conditions of the taxpayer's case by a method satisfactory to the Commissioner. In no case may charges for depreciation be based on a rate which will extinguish the cost or value of the prop- erty prior to the termination of its useful life. Nothing in these regulations shall be interpreted to mean that the value of a timber plant and equipment, so far as it is represented by physical property having an inventory value, may be reduced by depreciation deduc- tions to a sum below the value of the salvage when the plant and equipment shall have become obsolete or worn out or shall have been abandoned, or that any part of the value of cut-over land may be recoverable through depreciation. (Art. 232.) In the computation of depreciation it is recognized that "the reasonable expectation of the economic Hfe" may increase FOR DEPRECIATION I12i the amount of depreciation. This principle also applies to depletion charges. '^' Tools, jigs, dies, etc. — As a rule the practice of depreciat- ing small tools by means of a percentage cannot be followed satisfactorily. So many such tools are used up, lost or stolen, that an inventory should be made periodically and all the tools on hand should then be revalued. If this plan is followed for several years and a trustworthy rate of depreciation is secured, it may be feasible to omit the revaluation for a year or two, ap- plying the rate previously ascertained. The tax commissioner of one of the states has adopted rates varying from 25 to 50 per cent or, as an alternative, the entire cost of replacements. In many manufacturing concerns the item of tools, jigs, dies, etc., not standard equipment, is a large one and the tendency is to overvalue it. Heavy depreciation should be ap- plied, because most of such equipment is made or adapted for special uses, and the inevitable changes in types and styles of production require corresponding changes in the tools. As stated heretofore under "Patterns, drawings, models, designs, etc.," (page 11 14), the book value shall be written down very rapidly. The minimum rate should not be less than 20 per cent. Edward N. Hurley, former chairman of the Federal Trade Commission, urges that special tools be charged off practically at once, and states that the neglect to depreciate this account rapidly enough has been responsible for many failures. Typewriters. — In the average ofihce, the life of a good type- writer, if properly cared for, is from three to five years. In some offices the machines are turned in and new ones purchased every two or three years. Such typewriters are repaired and resold and are used several years more by those who buy them second-hand. Repairs are not profitable after "^ Sec page 1231. 1 122 DEDUCTIONS the inachiiies have been used from six to eight years. An annual depreciation rate of 20 per cent is conservative. Uniforms — naval and military. — Under the provisions of article 291 of Regulations 62,*^^ the cost of an officer's uniform is not deductible from income, as it is deemed to take the place of clothing required in civilian life. It has now been decided that for the same reason depreciation cannot be claimed on uniforms. Ruling. A deduction may not be claimed to cover depreciation in the value of uniforms by an officer of the Navy. (B. Digest 32- 21-1761 ; A. R. R. 594.) A taxpayer claimed the same allowance as is granted in the case of theatrical costumes,*^^ on the ground that uniforms should be classed as business assets. The Committee on Ap- peals and Reviews held, however, that since they may be worn on other than official occasions, such as weddings, receptions, etc., they are not used exclusively for "business purposes." Wagons, trucks, etc. — In the case of wagons it will be found that 8 to 10 per cent per annum is an ample allowance, provided that all repairs, renewals of parts and maintenance are' charged to operating expenses. Wood-working industry. — On buildings and equipment in the wood-working industry the depreciation is low — about 2 or 3 per cent on buildings and 6 per cent on equipment. See page 867. See Art. 162, qvioted on page 1056. FOR DEPRECIATION 1 123 ^i m^ Oh N c3 Of o -MJS Si I SO .c«:t' ^ c8 PQ " 3 O ? i? '3 o -a c •c so << ii rt =1 d ■a 3 ^j= gi g^ S g^^ — rt *:; ^^ _, ^0) , H,' 01 «!2^w|c3 ^« -^fetcj"^^ «d 0.5 E x«Q -SSS-^c^ • tJ^-i^ ^ o S J;;;;'aca - I'm -1. :s2 o o 13 ro a;pq 3« ^ bibi"^' — =: C Cfci^ 3 rt 3 wwSai>pq OfflOw ^ ^ 1124 DEDUCTIONS Basi Indi Bas. tiliti -c 1 ,. .„« "O ,„ P3 hi -a Rate Gas Rate -lie U s Rate Data tilitie; ata tilities Rate C ec. &• Oil & ec. & of Pub ounts i =^1?^°^=^ 1^ =a ca 60 Q ".§« •f> <«.H „• .5 1 o w'Sis 00 0, .i^f -,^3 o "3 =a « 13 nj ^^ .s'-- 1^ r3 rj 3^ 1! ™ "Bra S a 3 St Datj & Rat( 1921 lunting , 1916 ^1^ > OJ . -M ^ oJ ^ v^ .S 3 1; d'-n ^f^ g 3 -3'|i _!» 3 "d ■£ < 6 p^ r-. > m fc H « < r^« U Q ^ UO w "3 CJCXMSh oaOPQ < ^ << <; H ^ r-t I Tl- O rO r- 11 rtWUU ^ ^pqu c/jpq uua OQ QPP 1 126 DEDUCTIONS CO W H < Pi o I— I H < l-H CJ w Pi p-( w Q to O W m pL, O -r. c o oo o rj o,-. 73 W • T3 I a> K iP W 60 O t; M M court QWW .s «.s ■s t^ s o S o u o 3 u " > o >> I 111 o Jri o I M ^ ,„- :UW a bD't O < -o; 5 ." B S W^5 ^ ° 5 ? .2 8 >.,= OJ^ O o p:H ;s< .„p-l I. 4^ 3 CTI «Q 5 «< XmUio oua o X :" .5:3 o .ii 41 rt O 00 „ ro -.-1 V-) 1 o m rt^ I I r^ ^ ^ ^ ^ „ "-< n -T ■ ■ *-. J-' 11 ™ en u ■„ oiH^ 3 "J 5 ,« > S 2 M « E J ^ bo l» . ^ O C 3 (A rt «J o o FOR DEPRECIATION 1 127 Q 2;-S ^8S< a <« ,o.S|^Q -KQ T3 O O o fj .rj bu :5 ^23 00 ^ A o.SS II 2 § |S8§«| 3 " O 3 o « o !3 •8 o. J5 u §0 o ^ « rt=8" .,;Q r^JSjZ ^ JI^:-.^ (Li W-- C 2 rt (L» OS I- 6^S I oil i| >^ rt rt! rt 0J3 "2=^ c«I^ ^o's3^ rt Vh .OJ goadg S „• != Ef3 Si) rt en £~ *" ^ Opqm-irj •-' f'" .o..p fD pq "U 3 fe tao << us ^ 3 •5 > jQQ , u p "0 m ■o 3 C ^ c 3 rJ-2 3 Vh 3 feHO^&H 3 Q ^3^ 1^5 eM> c i -0 v:Q «^c^.«Qi;.:«| .■3 *i £ a >.£ ^ ^ § u.i! c3 u ::: ca I, Cm tn KCmCQM OfflO ^= OCl, •g «im;S inQPn 0. C (u en ci 3— f B r3 V. 3 EPh Ph Ph rt Pho; 1 1 28 DEDUCTIONS CM .i;p5 2"- '^ " o *- o *- .:;>£> ::; u oJJ o o o o o Qopaa ~ ." -^ Q Ifi-E « c ~P^ — ,^ -x: w on of Pu :tion Com t Account o . o m 6 1- o U . c ■GO of Accounting luation of Pu 1, Deprcc. & luation of Pu Elect. Cost eview, 1910. 7 r =<5 " on luafi Trac Cos 3 C S >a| s ca .| c« -=>|>=^^ ^1 1 o g 3 d J|| _3 Manu. Eng. Valua Eng. Mech. Elect. ■f C 3 ■-GQf , ;-^ ni U .W . 3 < < ^ < ■3 -^ ■ O -■3=<3 cES .S=a t. Er3 ^ o 3 K c . O ; =a S K . ■ i! 3£ . *" OJ 3i: !- (U d£ Opa « ;<; CM CM ;?- n Tf "^ CM CM Jj^^ >- '" ^ 2"^- 2 o ^■" .n > " 0^ *- 'i a -^ = 3 5 5 & rt Pi c>: -X X X X FOR DEPRECIATION 1 129 o\ M ,, -2: rt aj Si 3 VO 3 3 -fc P 3 3 a i « 3 1; o-s=a w^ . . 1- d [/'■S £-Q . 3 fi,ui^ g ■>w >'E? 3 «= § ^ el's 3 HW CO fe ^j w > u:<'.> u w _ij u ^ s O 3 . W o 5 £^ . f= -^ H 3-5 Ci;< Or/ ^J= 3-3 g g 4j S rt 2 Cl m in u < — ' (fl i 'g g E >. < c e? a . 3 !*> N S ^ . ^.4 s-^s fePUfe - ^ t;« 3 r^=a 1: 3 S u'l oW . -^^ . 1; 2 >- . "^S c a i; 2 d d^i— 1 -w .00 •£,•<■« iluati mual lQ CO Q -clc m . ,oa .d=aH Sf^ g=^ 0.3 « fcHK> - O02) of the law are applicable. But 202 (b-2) is a general provision of the law and does not control any specific provision. Actual value at March i, 191 3, is the proper basis for obsolescence under sec- tion 214 (a-8), therefore if actual value at March i, 191 3. is $30,000, and $22,500 has been charged off since, the deduction under section 214 (a-8) clearly is $6,500, not $5,000. The principle is not changed because the machine is sold instead of l3eing discarded. If discarded the deduction undoubtedly is $7,500. It would be ridiculous to hold that l)y selling a machine for $1,000 the deduction for obsolescence is reduced from $6,500 to $5,000. In years of high tax rates it would put a premium on junking good machinery. It would be a violation of every known business and economic theory of efficiency. The Treasury in article 143 attempts to relate section 202 (b), which governs the taxable status of the sale of prop- erty in general, to a section of the law which has no reference to general gains or losses. Even if there is a relation, the specific provisions of section 214 (a-8) must control. Under the latter section value at March i, 1913, is the value to be recovered through depreciation and obsolescence. If not re- covered in one year it may be in another year. If depreciable property is sold, any value at Alarch i, 1913, which has not been recovered may be charged oft' in the year of final disposi- tion, not as a loss but as final depreciation or obsolescence. The sale or discarding of a machine is the final test of these allowances. If the calculations were accurate there would be no cjuestion of loss or gain; if inaccurate the balance is not a gain or a loss, it is a correction ui the inaccuracies. The law does not require taxpayers to go back and adjust the ac- counts of all prior years, but permits a reasonable adjustment in the year of determination. The theory of a limitation on losses as contained in sec- tion 202 (I)) is that tax])ayers whose property had appreci- FOR OBSOLESCENCE AND AMORTIZATION 1137 ated in value at March i, 1913, shall not receive the benefit of losses which represent, in effect, nothing more than failure to realize something which as appreciation formed part of their capital at March i, 19 13, but which subsequently depre- ciates in value. The section applies to property such as stocks and bonds which fluctuate in value ; it does not apply to de- preciable property which is the subject of depreciation and obsolescence allowances specifically permitted." Obsolescence accrued prior to taxable year not deduc- tible. — Ruling A number of 5,000-ton bulk freigbters were constructed in 1900. In 1910 the docks in tbe larger harbors along the Great Lakes were greatly enlarged and improved so that only vessels of 10,000 tons capacity or larger could be conveniently or economically accommodated. As a result of this condition the larger and newer type of vessels could carry freight at a cheaper rate than * the 5,000-ton vessels, and began at that time to dominate the lake trade and displace the smaller types. The physical life of the 5,000- ton vessels is generally conceded to be 33 years. However, for the reasons above stated, they have all been abandoned or will be aban- doned by the close of the year 1921. Their salvage value is estimated at 20 per cent. In the past depreciation has been allowed at the rate of 3 per cent, in accordance with A. R. R. 27 (C. B. 2, p. 139.) The owners now claim that 20 per cent of the cost of the vessels remains on their books as a loss by reason of obsolescence and seek to deduct this 20 per cent loss during the years 1918, 1919, 1920, and 1921 . : . . This office has consistently ruled that items of income received or accrued during any given taxable year must be returned for that year, and that losses incurred in one taxable year can not be deducted from the income of other taxable years. It has been held that the failure to take depreciation in any taxable year does not entitle the taxpayer to deduct in any other taxable year a greater amount for depreciation than would otherwise be allowed (Art. 167, Reg. 45). Article 166 of Regulations 45 provides: "Inasmuch as under the provisions of the income tax Acts in effect prior to Revenue Act of 1918 deductions for obsolescence of property were not al- lowed except as a loss for the year in which the property was sold or permanently abandoned, a taxpayer may for 191 8 and subsequent years revise the estimate of the useful life of any property so as to 'See Sections 214 (a-8) and 234 (a-7). 1 1 38 DEDUCTIONS allow for such future obsolescence as may be expected from ex- perience to result from the normal progress of the art." It will be noted that this article provides only for future obsolescence. There appears to be nothing, therefore, in the Act or in the regu- lations which indicates that it was intended that obsolescence which accrued in taxable years prior to 1918 could be accumulated and deducted from gross income in years subsequent to that date ; or that Congress had any intention that this particular provision should be given a retroactive effect beyond January i, 1918. The contention of the taxpayer is directly opposed to this well- established construction of the Act and ought not, in the judgment of this office, to be conceded The facts, as indicated by the affidavits of the tax- payer, show that obsolescence began in 1910, when the larger vessels began to displace the 5,000-ton freighters. Any loss due to obsolescence should, therefore, be spread over the period from 1910 to the date of abandonment (L. O. 862; C. R. i, p. 127), and it follows from what has been said above that only that portion of such obsolescence which accrued subsequent to January i, 1918, can be taken in returns for 19 1 8 and subsequent years. Any further loss not taken care of by depreciation and obso- lescence and not compensated for by insurance or otherwise may be taken in the year in which the vessels are sold or scrapped. It is concluded that obsolescence which accrued prior to January I, 1918, may not be deducted in income and excess-profits tax returns for 1918 and subsequent taxable years. (B. 31-21-1752; Sol. Op. 114.) The foregoing seems to mean that obsolescence accruing from 1910 to 1917 inclusive is not a deduction in those years, nor may it be taken in the year when the vessels are disposed of, under the theory that in the year of disposal the only allowable deduction in that year is for the obsolescence which accrues in the same year. Also see article 166; page 1081. The author wholly disagrees with the statement of the Solicitor that Congress intended that the allowance for obso- lescence in the 1918 law is a limitation of the deduction. Stated otherwise, the Solicitor contends that deductions for realized obsolescence theretofore allowed by the Treasury under laws which did not mention obsolescence were outlawed by the 19 18 law. \>ssels were constructed in 1900 costing $1,000,000 with FOR OBSOLESCENCE AND AMORTIZATION II39 an estimated life of thirty-three years. From 1900 to 19J7 depreciation accrued was allowed on a basis of the estimated life of the vessels. In 1921 the vessels were sold for $200,000. In 1918 it was known that the vessels would be obsolete in 1921. The opinion allows obsolescence for the years 1918 to 192 1 inclusive on the basis of obsolescence spread over the period 19 10 to 1921, which leaves a considerable book value after the sale. The opinion states that the book balance which represents the excess of obsolescence above depreciation for the 3^ears 19 10 to 191 7 may not be written off as obsolescence in 192 1, but fails to state whether or not it may be charged off in 192 1 as a loss. The reference to each year's accounts being complete in itself indicates that the only loss which arises in the year 192 1 is the year's share of the obsolescence. Under the opinion the net effect of the 19 18 law is to decrease the allowable deduction for losses arising from obso- lescence. No such meaning can be read into the law nor into the intention of Congress. The allowance tor obsolescence was inserted in the 191 8 law in conference. As with other sections of the 1918 law, the intention of Congress was to extend and amplify deductions. It is absurd to construe the obsolescence allowance as a foreclosure of a right to claim obsolescence, yet that is precisely what the Solicitor's opinion holds. When business is discontinued. — Ruling. The undepreciated cost of a dam constructed for the purpose of creating an ice lake by a corporation which later discon- tinued the ice business, the dam showing a substantial salvage value remaining, was charged off the taxpayer's books. The taxpayer con- tended that this was a "loss of useful value" as contemplated by ar- ticle 143 of Regulations 45. The Committee is of the opinion that property so improved can not, as a matter of fact, be valueless, and that there is no evidence establishing a real determinable and determined loss within the meaning of article 143. (C. B. 4, page 165; A. R. R. 498.) Since the business was discontinued, it is difficult to be- lieve that no obsolescence occurred in an asset that apparently 1 140 DEDUCTIONS was valueless for any other type of business. The taxpayer, however, must have failed to show that there was an actual loss in value. Buildings. — Ruling. No amount may be charged off in any year in antici- pation of obsolescence of a building which may become obsolete five or ten years later. However, a certain amount of obsolescence may be claimed from the time that it becomes certain that at a definite future date the building will be obsolete. The figure representing obsolescence should be, approximately, the difference between the fair market value of the building as of March i, 1913, or its cost if acquired after that date, less depreciation, and the estimated salvage value. This obsolescence should be spread over the period from the time such obsolescence becomes certain until the building becomes obsolete and should be claimed in the returns filed for those years. For instance, the fair market value of a building March i, 1913, was $30,000. Its depreciated value December 31, 1918, was represented by $18,000, and its estimated salvage value will be $5,000 in 1920. At that time (Dec. 31, 1918) it was definitely determined and certain that in 1920 the building would have to be torn down and rebuilt, due to its inadequacy to meet the growing needs of the industry it housed. The difference between the depreciated value December 31, 1918, namely, $18,000, and its estimated salvage value of $5,000 rep- resents obsolescence. This amount of $13,000 should be spread over the years covering the period. 1919 and 1920, and deductions claimed accordingly on the returns filed for those years. In cases where obsolescence is claimed it must be supported by facts which will enable this office to determine whether such claim is proper and allowable. ( C. B. 2, page 138; O. D. 381.) Some of the factors contributing to the obsolescence of buildings are : 1. Changing trade centers. 2. Change of fashion or design. 3. Improved methods of planning, construction and oper- ation. 4. Better lighting and ventilating. 5. .Vppreciation of land values demanding greater interest return. FOR OBSOLESCENCE AND AMORTIZATION 114T An eminent real estate authoril)' has stated f The change, to a marked extent, from the old, simple types of buildings to the modern complex form, may be said to have taken place about 25 or possibly 30 years ago and it was probably not for another 10 years that all interested in real estate, in mortgages and in construction, realized fully that a new problem, that of the loss of value in great buildings through changing hotel and trade centers, through wear and tear, through change of fashion in design, improve- ments in method of construction and operation, of planning and de- signing, was a great, a serious problem. Apartment houses. — .... It was first discovered in large apartment houses that tenants generally deserted an apartment as being obsolete within 8 or 10 years. Hotels became old in 12 or 15 years, due to better and finer buildings being constructed As apartment house planning and building progressed to a point where it was no longer possible to improve in planning and in appointments and in fireproof construction and especially when over-production ceased, the fashion of deserting the so-called old apartments changed, and it is now conceded that a well kept and well managed apartment house may hold its own with the new houses as they are built and maintain their earning power for 20 or 30 years instead of 8 or 10. There is an apartment house in New York City now being- constructed that has begun to depreciate before it is born. It will always be a liability as the planning and waste of money on four in- terior tower stairways, needless hallways and extravagant construc- tion at a time of high building costs dooms it to a heavy depreciation in value and usefulness through inability to compete with well planned, carefully built structures of the same class. This building should have an allowance for depreciation of 5%. Fireproof buildings. — At first it was generally believed that a fireproof building was good for 100 years and depreciation was hardly thought of. It soon became evident that with the vast investment for elevators and ma- chinery, for plumbing and fine appointments, and with the changing demands and types of architecture, there was a probability that the new would be obsolete in a comparatively short time. How short a time no one knew, but it was evident from the rapid passing of the new apartment houses into a condition of obsolescence that deprecia- tion was the most serious question involved in this new form of building. *■ Extracts from paper (;n "Depreciation" by Frank Lord, Vice-president Cross & Brown Co., New York City. 11^2 DEDUCTIONS Loft buildings. — Take for illustration an ordinary old type of 5 story loft build- ing. The average building of this type with its rope hoistway and a single set of plumbing on each floor was uniformly built between 1840 and 1890 for about $30,000, sometimes for $25,000, in a flimsy way, and sometimes for $35,000 in a superior way, many of them with stout walls and yellow pine beams. Such a building might depreciate in the first ten years of its existence from its first cost of $30,000 to a value of $25,000 or an average of ij^% per annum, thereafter it would depreciate possibly 1% per annum and at the end of 20 years would be worth $20,000. Another 10 years might reduce it to a value of $18,000, but the probabilities are that it would remain steadily worth $20,000 after its first 20 years of existence, owing to substantial upkeep. The reason for this stability lies in its measuring up in style to the prevailing standard of architecture of its day and the fact that the unchanging demands of business kept it from becoming obsolete. Its simplicity of construction, its honest, enduring qualities, kept it fairly on a par with its competitors and gave it equal rank with the newer buildings for rental income. With a little outlay they could be restored to their old time re- spectability and be made as serviceable as in their prime. As a matter of fact these old buildings have a value today of $25,000 to $35,000 and are earning so well for their owners that they are con- tent to take their revenues of 6% to 10% and never think of the gradual destruction they are bringing upon themselves by forcing the larger and more progressive merchants to seek modern facilities in districts uptown where such buildings are the rule rather than the exception. Effect of appreciation in land values. — When the 20 story Gillander building, 25 x 100, at the northwest corner of Wall and Nassau Streets was only 10 years old it was torn down to make way for the Bankers' Trust Building. It had become obsolete because the land could earn much more if given a higher class of building. In 1885 old buildings at the southwest corner of Wall and Broad Streets were torn down for the erection of the Wilkes Building, which in 1920 was demolished to permit the new 24 story Stock Exchange to take its place. Here was a fine building fully able to do good work for another 20 years cut off at the age of 35 years not for any real decay and disability but because it could earn only 30% of what a higher building, extending to less prominent and valuable land ad- joining can earn. If, for example, a certain 5-story building is paying 9% net on FOR OBSOLESCENCE AND AMORTIZATION "43 $80,000 and by demolishing the building and erecting a 12 story struc- ture at a cost of $135,000 plus $80,000 for the land, the new building will pay only 7% net on $215,000, the old building paying 9% has not depreciated but is in a state of efficiency and should be maintained in this form so long as no better return could be obtained from a new building. Change from retail to wholesale district. — Depreciation is not necessarily a slow process which may be covered by an allowance of 3 or 5%. There may be 50 or 100% de- preciation in a single year, as when 23rd Street changed from a re- tail to a wholesale district and buildings 25 x 100 each, capable of earning, say $30,000 a year, became unrentable and a liability, so that one owner of a building covering 7 lots demolished it to 'save taxes. Only a year or so before this building had a value of $200,000 to $250,000 (as a retail building) which depreciated entirely not through wearing out so much as through unfitness and inability to produce revenue. In the largest cities the enactment of "zoning" laws is serv- ing to give relief in those cases where in the past a sudden change might be wrought as in the last instance cited above, and must be considered in any estimate of probable obso- lescence. Fixtures. — In some types of business, such as retail candy stores, restaurants, etc., the volume of business achieved is, to an important extent, dependent upon the character and ap- pearance of the equipment and the attractiveness of the furni- ture and fixtures with which the visitor finds himself sur- rounded. The demand of the public for elaborateness and lavish display in this regard is a constant and potent factor; and competition in that direction imposes the necessity of pleas- ing the public, as otherwise there would be an immediate and pronounced decline in patronage. In respect of fixtures of this nature, the ordinary depreciation rates would not ade- quately represent the loss of useful value accruing, and a very material allowance should each year be made for obso- lescence. 1144 DEDUCTIONS Change under relp:asing or upon moving. — Ruling. A taxpayer in rearranging his business property in ac- cordance with a lease, permanently abandoned certain office furni- ture and fixtures, only a portion of the cost of which had been de- ducted as depreciation. The portion of the cost not so deducted, less salvage value of the property, is deductible as a loss of useful value under article 143 of Regulations 45. ( C. B. 4, page 164; A. R. R. 469.) Obsolescence of intangible property. — Ruling. Obsolescence is not ordinarily applicable in the case of intangibles but will be allowed in exceptional cases, as in the case of the discontinuance of a going business because of the exhaustion of its source of supply, where the cost of the good will, or its value as of March i, 1913, if acquired prior to that date, can be definitelv shown and the period of its obsolescence determined with reasonable accuracy. To sustain a claim for deduction for obsolescence of good will it must be shown that the good will will be of no value at the close of an approximately definite period, and that the taxpayer will be forced to discontinue the business and be unable to continue in any similar business. An allowance for obsolescence of good will will be made only in connection with such good will as is assignable, as distinguished from good will attaching to individuals owning or conducting a busi- ness, or to the premises at which it is or was conducted; and no allowance for obsolescence will be granted in any case where, in con- nection with the operation of the business, the good will will be valuable in another business after the termination of the business in which the taxpayer is engaged. A corporation engaged in the business of sampling ores is en- titled to a deduction for obsolescence not only of its plant and equip- ment but for value of good will existing and having a definitely established value as of- March i, 1913, or acquired thereafter by capital outlay, if it can be shown that the plant and equipment will be useless and the good will of no value at the close of an approxi- mately definite period by reason of exhaustion of the ores on which its business depends. (C. B. 2, page 141; O. D. 472.) Extraordinary obsolescence due to prohibition. — As stated in the regulation already quoted (article 143),^ an exception to the rule "requiring a sale or other disposition of property in "See page 1134. FOR OBSOLESCENCE AND AMORTIZATION 1145 order to establish a loss" is made "where new legislation di- rectly or indirectly makes the continued profitable use of the property impossible." A concrete illustration of loss occasioned by new legisla- tion is that caused by state and national prohibition. When the slavery question was a live issue there were many who thought that slave owners, who had vested property interests in slaves, should not be deprived of their property without compensation. Likewise there are many who think that those who had acquired property rights in the liquor business should not be subjected to loss without compensation. As with the slavery question, public sentiment is opposed to governmental compensation for losses sustained by the liquor interests, but when property losses due to prohibition are established those sustaining the losses are entitled to deduc- tions therefor in their income and excess profits tax returns.^" Property used in the manufacture of articles affected by prohibition. Ruling. Property consisting of a plant, including equipment for the manufacture of beer bottles, which because of restrictions and regulations by the United States government on the brewery industry can not be sold and in consequence the factory had to be closed, has to the extent the property or plant was constructed for the manufacture of beer bottles and is not suited or adapted for any other purpose without reconstruction, become obsolete. The corporation to that extent is entitled to a deduction for obsolescence. So much of the shrinkage in value of the plant, if any, as is not thus due to obsolescence can not be claimed as a deduction for loss until the property is sold or becomes worthless and the loss is defi- nitely ascertained. (C. B. i, page 133; O. D. 125.) Property used in a "related" business.— Ruling. In order that a taxpayer may be allowed a deduction for obsolescence for any given period, it is essential that the use of the property should have been abandoned during such period or that it become certain that the property must be abandoned at a definite future date. Therefore, where the use of property is continued in a related enterprise under the same ownership, there is no abandonment, '"For regulations, rulings and illustrations see Income Tax Procedure, 1920, pages 743-74Q- 1 146 DEDUCTIONS nor is it possible to say at the time of conversion that the property must be abandoned. Amounts expended in remodehng a building for the manufactur- ing of a different product are capital expenditures and can not be taken as a loss or an expense. (B. Digest 34-21-1780; O. D. looi.) The foregoing ruling is not sound, if as appears, the brewing company intended to abandon its business upon pro- hibition becoming effective and entered upon the manufac- ture of cereal beverages while awaiting the future of the Vol- stead Act. It would have been easy to go through the form of a sale, and thus do indirectly what the law allows as a direct deduction. Taxpayers cannot be penalized for an at- tempt to secure a temporary use of property, the effect of which is beneficial both to taxpayers and the government. Vineyards. — Ruling. No deduction representing extraordinary loss due to prohibition legislation is allowable in the case of vineyards unless such legislation necessitates the abandonment of the vineyard. If the vineyard is abandoned, the amount deductible as a loss is the cost of the vineyard, or its fair market value as at March i, 1913, if acquired prior to that date, plus cost of subsequent improvements, less any depreciation previously charged off and any salvage value. No deduction is permitted on account of land. If, by reason of legis- lation passed in 1918, the abandonment of the vineyard occurs in 1919, the loss deduction may be equally divided between 1918 and 1919, since the law prohibits the utilization of the 1919 crop, and 1919 income is to be attributed to the manufacture and sale of vintage of 1918 and earlier years. (C. B. i, page 125; O. D. 102.) GOODW^ILL. Ruling. Where a corporation engaged in the wholesale liquor business continued to make sales in 1918 it will not be permitted to deduct in its 1917 return an amount representing the entire value of its good will since it did not actually sustain a determinable loss of such amount in the year 191 7. (C. B. 3, page 156; A. R. R. 185.) The comments made above on the Treasury's ruling that \vhere a related business is continued no deduction for obso- lescence is permitted, also apply as to the following: Ruling. Liquor dealers who continued in a similar trade or busi- ness after prohibition legislation became effective are not entitled to a FOR OBSOLESCENCE AND AMORTIZATION 1147 deduction for obsolescence of llicir intangibles such as good will, trade-marks, and trade brands. (C. B. 4, i)age I7037.96. Th'e present value of $100 per annum computed on the basis of an annual return of 5 per cent, with reinvestment earnings of 4 per cent per annum, is only $1,000.58. When factors are uncertain. — Regulation (c) Mineral deposits for which these fac- tors may not be determined with reasonable accuracy from past operating experience may, with the approval of the Commissioner, be valued in a similar manner; but the factors must be deduced from concurrent evidence such as the general type of the deposit, the characteristics of the district in which it occurs, the habit of the mineral deposits in the property itself, the intensity of mineralization, the rate at which additional mineral has been disclosed by exploita- tion, the stage of the operating life of the property, and other evi- dence tending to establish a reasonable estimate of the required factors (Art. 206.) It is recognized that in many cases the factors ideally nec- essary for a scientific a])plication of the present value method will not be found. In such instances it may become necessary to consider the operating history of the property after March I, 191 3, to determine average assays, gross values, costs, pro- duction, etc. These can be checked with the operating results obtained by other mines in the district. It is well to supple- Il82 DEDUCTIONS ment such data with comprehensive maps, showing the geology and workings. There readily comes to mind the case of many ore deposits in limestone where, because of the commonly irregular distribution of the orebodies and the heavy character of the ground when the altered rock is exposed to the air, it is customary to carry develop- ment work not far ahead of current extraction. In the matter of valuation on the basis of exposed or proved ore such mines are clearly at a disadvantage with extensively developed mines like the porphyry coppers.^- Method of determining factors. — Regulation (d) Mineral deposits of different grades, lo- cations, and probable dates of extraction in a mineral property shall be valued separately. The mineral content of a deposit shall be deter- mined in accordance with article 208. In estimating the average grade of the developed and prospective mineral, account should be taken of probable increases or decreases as indicated by the operating history. The rate of exhaustion of a mineral deposit should be de- termined with due regard to the limitations imposed by plant capacity, by the character of the deposit, by the ability to market the mineral product, by labor conditions, and by the operating program in force or definitely adopted at the basic date for future operations. The operat- ing life of a mineral deposit is that number of years necessary for the exhaustion of both the developed and prospective mineral con- tent at the rate determined as above. The operating cost includes all current expense of producing, preparing, and marketing the mineral product sold (due consideration being given to taxes) ex- clusive of allowable capital additions as defined in article 222, and deductions for depreciation and depletion, but including cost of re- pairs and replacements necessary to maintain the plant and equip- ment at its rated capacity and efficiency. This cost of repairs and replacements is not to be confused with the depreciation deduction by which the cost or value of plant and equipment is returned to the taxpayer free from tax. In general no estimates of these factors will be approved by the Commissioner which are not supported by the operating experience of the property or which are derived from dif^ ferent and arbitrarily selected periods (Art. 206.) The foregoing regulation indicates some of the practical problems encountered. If the deposits vary considerably as to grade, it would be manifestly unfair to the taxpayer to allow only a rate of depletion based on high and low grade ores, L. C. Gratoii, Federal Taxation of Mines, page 28. FOR DEPLETION X183 when the high grade only is being mined. On the other hand. in a case where the assays wxre high at March i, 19 13, but in later years declined, the Treasury does not confine itself to what was known at March i, 191 3, but has been known to take the average of a period of years thereafter which was supposed to be representative. Care must be taken, however, to see that the period selected is really representative and not prejudicial to the taxpayer. The life of the mine affects the value through the discount factor applied — a long life giving a low value, and a short life a high value. Some of the factors which would determine the life are indicated in the regulation and require detailed evidence to support them. An operating program as at the date of valuation, even if not fully carried out subsequently, would be admissible. Intensive production means that the units of mineral will be taken out sooner, and as appears from the table on page 1181, the annual income in the earlier years contains a greater ele- ment of profit, and thus affords the basis for an increased value of the mine. The earlier the mineral is removed and converted into cash, the less is the amount of discount that needs to be deducted from the expected gross realization to reduce to pres- ent value at March i, 1913. The costs need particularly to be analyzed and any ab- normal items not indicative of probable future costs excluded. The selling price of the product averaged over a period of years, in order to obtain a normal price, must be considered. Variations in the price, particularly under abnormal condi- tions, such as have affected silver under the Pittman Act, and copper during the past year with a very great decrease in pro- duction, must be fully weighed. Determination of quantity of ore in mine.^'' — REGiJLATibN. Every taxpayer claiming a deduction for depletion for a given year will be required to estimate or determine with respect "^For former procedure and comments thereon, sec Income Tax Pro- cedure, 1919, pages 598-602, 1148-1156 (Supp.). ii84 DEDUCTIONS to eacli separate jM-operty the total units (acres, tons, pounds, ounces, or other measure) of mineral products reasonably known or on good evi- dence believed to have existed in the ground on the basic date, ac- cording to the method current in the industry and in the light of the most accurate and reliable information obtainable. Preference shall be given in the selection of a unit of estimate to the principal unit (or units) paid for in the product marketed. The estimate of the recoverable units of the mineral products in the property for the purposes of valuation and depletion shall include as to both quantity and grade (a) the ores and minerals "in sight," "blocked out," "de- veloped," or "assured," in the usual or conventional meaning of these terms in respect to the type of the deposit, and (b) ""probable"" or ■'prospective" ores and minerals (in the corresponding sense) ; that is, ores and minerals that are believed to exist on the basis of good evi- dence although not actually known to occur on the basis of existing de- velopment ; but "probable" or "prospective" ores and minerals may be computed, for purposes of this valuation, (c) as to quantity, only in case they are extensions of known deposits or are new bodies or- masses whose existence is indicated by geological or other evidence to a high degree of probability, and (d) as to grade, of such richness only as accords with the best indications available. If information subsequently obtained clearly shows the estimate to have been mate- rially erroneous, it may be revised with the approval of the Com- missoner. (Art. 208.) Ill the foregoing instructions it is provided that the esti- mate must include minerals "assured" and may include pro- spective or probable quantities. In making this estimate due consideration should be given to the comments on pages 123 1 to 1233. In some cases estimates of possible future extraction have been so large (thus extending the prospective removal over an excessively long period) as to make the annual deple- tion allowance a negligible factor. Such a result proves the in- accuracy of the estimate, as purchases of mines are not made on such a basis. The substance of article 208 has been the subject of com- ment as follows :"* Quantities are required to be estimated as of March i, 1913. In making such an estimate any engineer would make his estimate up to the date of examination, and reduce to the basic date by adding the units produced between the basic date and the date of examination. °* R. V. Norris, The Taxation of Income from Wasting Assets. FOR DEPLETION 1 185 While perhaps technically no information not available March i, 1913, is supposed to be used in such estimates, in this case, as in the case of estimating profits, no engineer would or should be asked to stultify himself by using estimates based on what he may try to imagine he would have thought on March i, 1913, but which on in- formation available when his estimate was actually made he knows to be incorrect. The Department has repeatedly and very sensibly accepted estimates frankly made in this way. The necessity for a revision of original estimates is shown in the following : Ruling During the year 1917 in the development of the mining operations of the taxpayer, it was discovered that the com- pany's coal vein was lacking in approximately ^ acres and that there was hard black rock in its place. This so-called "rock fault" was actually determined by tests and statements to this effect are sup- ported by affidavit of engineers. On the basis of original cost of this vein of coal, the development of this large area of solid rock deter- mined a loss of x dollars. With respect to loss of this character, section 234(a) of the Revenue Act of 1918 does not materially differ from section I2(a)2 of the Revenue Act of 191 7. The examining revenue agent reports that the vein of coal pur- chased had an estimated recovery of y tons per acre. In the original acreage purchased there were 42 acres. The acreage loss by location of the rock fault was z acres, leaving actual coal acreage purchased 3^ acres. The en bloc tonnage on revised estimate was, therefore, 6^y tons which, at a cost of 3.1- dollars, gives the cost per unit for deple- tion charge on basis of 3,:; acres actually contained in this tract. It is contended by taxpayer that a loss of x dollars has been estab- lished during the year 1917 under article 143 of Regulations 45. The amount of alleged loss is based on cost at i/2-)X dollars per acre plus four years' interest charges. The Committee can not reach the conclusion that location of this rock fault determines a loss of useful value as contemplated by the regulations. The rock fault determined that a bad estimate had been made in fixing the consideration of purchase. This mistaken value for tax purposes affected the true measure of capital returnable by way of depletion. Article 208, Regulations 45, provides for the deter- mination of mineral contents of a mine. The last sentence of the article reads : If subsequent developments show a material error in the original estimate, a new estimate may be made and the capital remaining to be recovered distributed accordingly. Hence, if this mine was under production after discovery of the rock fault, the capital remaining to be recovered through depletion Ii86 DEDUCTIONS may be distributed pro rata over subsequent years. If the mining operation of this property was discontinued entirely in the taxable year, the deduction for depletion should be taken in that year so that the return of capital may be complete. No interest on the capi- tal sum should be considered in this computation. If an erroneous estimate is made and a large amount of tax is paid in the years of high rates (1917 to 1921) and the error is discovered in 1922, it would be equitable to permit the filing- of amended returns on the basis of a correct estimate." Calculation of Value. — Regulation (c) The number of units of mineral re- coverable in marketable form multiplied by the difference between the selling price and the operating cost per unit gives the total expected operating profit. The value of each mineral deposit is then the total expected operating profit from that deposit reduced to a present value as of the basic date at the rate of interest commensurate with the risk for the operating life, and further reduced by the value at the basic date of the depreciable assets and of the capital additions, if any, necessary to realize the profits. The degree of risk is generally lowest in cases where the factors of valuation are fully supported by the operating record of the mineral property prior to the basic date; relatively higher risks attach to appraisals upon any other basis. (Art. 206.) If the mine at date of valuation is not equipped, it is cus- tomary to discotmt further the operating profits, on a straight compound interest basis, for the number of years necessary to equip the mine. For example, if two years are necessary to equip the property, the value of the ore is still less, because of the further loss of interest in delay."*^ The following expression of opinion as to the best method of determining fair market value is also of interest: The valuation engineers of the Revenue Bureau, as I under- stand it, are to answer the question of valuation that is compre- hended in the imaginary situation of a prospective buyer, competent to measure mine values and actuated by the hope of profit to be de- rived from mine operation, making an offer for a mine to the owner who is likewise competent to measure mine values and who is under "" See page 601. ™H. C. Hoover, Frinciplcs of Mining, page 48. FOR DEPLETION 1 187 no obligation to sell except such obligation as arises from his belief that the offer made is advantageous to him In arriving at fair market value as of March i, 1913, one is sup- posed to take into consideration only the facts that were then known or that could have been then known had one endeavored to learn them at that time. The question may therefore arise as to whether it is fair to arrive at a 1913 valuation by applying to the standard present-value method of mine valuation modifications which have not been proposed until 1919. In my opinion, however, there is suffi- cient justification for using those modifications that are consequences of taking into account changing grade of ore and changing rate of production. The justification is this: In 1913 and since that time there was no actual method followed for valuing mines for purpose of sale, for the reason that mines of the size to which these newly proposed factors would apply are rarely, if ever, sold. In arriving at a market value as of 1913, therefore, we are dealing with a wholly hypothetical question. // there had been occasion to value such mines for sale in 1913, it is unbelievable that factors so impor- tant as the change in grade of ore and the likely change in rate of production would have been ignored. In other words, if a market value had been required at that time, it would have been reached in accordance with the methods now proposed.-" What is fair rate of interest? — There seems to be considerable difference of opinion as to what is the proper rate of interest to be used in determining the present value of future earnings, when arriving at the value of mining prop- erty as at a specified date. It is understood that the Treasury is using 8 per cent for bituminous and 6 per cent for anthracite coal properties. An eminent authority"^ points out that rates vary consider- ably with the risks involved and summarizes the various rates that have been used by other authorities, as follows : The proper rate of interest on mining investments has been and still remains the subject of much discussion among engineers. A rea- sonable solution of the problem has not been advanced and it is the belief of the author that it is not possible to determine a rate of in- terest that would apply equally well to all mining investments. The risk incurred by investing in a property that has been slightly devel- oped is much greater than the risk in the case of a well-prospected ore body even when the mines contain similar ores and will be operated " L. C. Graton, Federal Taxation of Mines. "C. E. Grunsky, Valuation, Depreciation and the Rate-Base, page 241. 1 188 DEDUCTIONS under similar conditions. Then again the average risks in copper mining differ from the average risks in gold mining and so on. Mr. H. C. Hoover has tabulated the risks of mining as follows (Principles of Mining, 1909) : "i. The risk of continuity in metal contents beyond the sample faces. 2. The risk of continuity in volume through the blocks estimated. 3. The risk of successful metallurgical treatment. 4. The risk of metal prices, in all but gold. 5. The risk of properly estimating costs. 6. The risk of extension of the ore beyond exposures. 7. The risk of management." Several of these risks are found in industrial enterprises (risks 4, 5 and 7). The risks of continuity of ore body and of ore values are peculiar to the mining industry. The limited market for the mineral products and the effect of the volume of the output on the prices that can be obtained increases the risk that capital must take. The problem of obtaining proper metallurgical treatment is an im- portant one, particularly when starting operations at new properties. The fact that the mineral constituents of the ore may change as greater depths are reached and that the previously satisfactory flow sheet may no longer realize the percentage of extraction on which the profits were based cannot be ignored by the investor. The interest return that might be attractive to an investor in a proven district might not be sufficient to attract capital in a district where the mines are still prospects and where the depth of the mineralization has not been tested. It is a fact that industrial enterprises because of additional risks demand greater interest returns than government bonds and it seems reasonable that mining investments taken as a class should call for a greater rate of interest than industrial enterprises. This claim for a higher rate of interest is opposed by such an authority on mine valuation as Mr. J. R. Finlay {Valuation of Iron Mines, Trans. A. I. M. E., Volume 45, page 295), who can be quoted, as follows: "I have generally assumed that 5 per cent was a normal interest — or discount rate. If that is so, it is a fair figure to use in a mine valuation, which should be nothing but a candid inquiry into the pres- ent value of expected profits." If Mr. Finlay's statement is correctly understood, he is willing to ignore the risk that these prospective profits may be diminished or may entirely be cut off before the estimated life of the property has been accomplished. If it is true that at any mining property risks exist over and above the risks existing in so-called "safe" investments, then a 5 per cent discount or interest rate is not sufficient to induce FOR DEPLETION 1 189 sane investment. Mr. Finlay's 5 per cent interest rate, as applied to the iron mines of Michigan in his appraisal made for the State Tax Commission in 191 1, was changed by that Commission to a 6 per cent basis in 1913. Other authorities have gone on record as advocating higher in- terest rates and in this connection the following will be found of interest : Mr. J. H. Curie (The Economist, London, September 15, 1903) states that a suitable mining investment must fulfil the following re- quirements : "i. The development in the bottom must be good. 2. The mine must pay 10 per cent per annum. 3. There must be 60 per cent of the price of the shares in sight." Mr. Hoover in his admirable work on mine valuation says (Prin- ciples of Mining, 1909) : "What rate of excess return the mine must yield is a matter of the risks in the venture and the demand of the investor. Mining busi- ness is one where 7 per cent above provision for capital return is an absolute minimum demanded by the risks inherent in mines, even where the profit in sight gives warranty to the return of capital." Mr. G. A. Denny (Mexican Mining Journal, July, 1910), an English engineer, says : "A normal mining risk stated in terms of interest may be taken at ID per cent per annum on the capital expended plus a rate for the redemption of capital." John Hays Hammond (Engineering and Mining Journal, Jan- uary I, 1910) expresses his views on this question as follows: "In many mines persistency of the ore deposits and, therefore, the reliability of the mines as dividend payers, justified the investment upon a basis in some instances as low as 8 per cent, dividends to which of course, must be added a certain percentage to provide for the amortization of the capital. Generally speaking, however, invest- ments in mining securities are not to be regarded as attractive unless they return from 10 per cent to 15 per cent in dividends, in addition to the profits to be set aside for amortization." The Treasury has, in some instances, adopted a higher rate of interest than taxpayers have felt to be warranted. It is noteworthy that an eminent authority in !iis latest work still maintains that 5 per cent is sufficiently high.^^ The author is of the opinion that it is impossible to fix a -*J. R. Finlay, Cost of Mining (1920 edition), page 66. iicp DEDUCTIONS rate of discount for an industry which should be appHed to all taxpayers in the same industry. Each case should be treated separately, and the rate fixed in accordance with the risks involved. In the case of a lessor the contention was advanced by a certain taxpayer that 6 per cent is an equitable rate because the risk is reduced to a minimum on account of a clause in the lease which provides that in case of the failure of the lessee to pay the royalties all rights under the lease will be forfeited together with all improvements made by the lessee. Since the risk to the lessor is never as great as that to the lessee, the rate of discount should be somewhat lower than that used for determining the value to the lessee. It must be remembered that the Treasury, in discounting the anticipated profits, uses a formula which provides for inter- est on the principal sum at one rate, say lo per cent, and also provides for an annual contribution to a sinking fund, w'hich, accumulated at 4 per cent interest compounded annually, will equal the principal sum at the end of the term. The actual return on the capital sum, however, is greater than 10 per cent due to the introduction of the sinking fund provision.^" The increase in interest rate has been w'orked out as follows : On the assumption that money in an ordinary, good investment is entitled to 6 per cent, it is found that in the case of a property of 10 year Hfe, valued to give 10 per cent on initial sum and amortized at 4 per cent compounded annually, the ratio of total profit assignable to amount remaining at risk in the property, divided by the total of the amounts at risk during each of the 10 years, works out to be not 10 per cent but 13.25 per cent. Similarly, for a 10 year life, an apparent 8 per cent return is found to give an average of 9.71 per cent; and a 12 per cent return to ayerage in reality 16.79 per cent on the money at risk. In the three cases, 8 per cent, 10 per cent, and 12 per cent, these actual average returns are re- spectively 21.4 per cent, 32.5 per cent, and 40 per cent higher than the flat rate to which they are related. The question now arises whether this greater interest return, concealed in the apparent flat rate of 10 per cent, is actually required ^" Sec page 11 77. FOR DEPLETION II91 to offset hazard, or whether on the other hand, an even 10 per cent on the decreasing sum actually at risk is enough, in which case the present value of the mine would increase. '^^ Attention has already been called (page 11 79) to the fact stated by one of the most eminent authorities, Mr. Herbert C. Hoover, that sinking funds for the reinvestment in conserva- tive securities of the annual depletion allowances are in the practical conduct of mines and mining companies never es- tablished. The Treasury in using the present value of anti- cipated earnings for determining the value of oil and gas wells^' does not use the 4 per cent reinvestment factor which it insists shall be used in valuing mines. The author knows of no reason why mines should be thus discriminated against. Since the depletion deductions return to the mine owner annually a part of his capital, leaving a decreasing sum at risk, it would seem to be sufficient to require interest i.e., a return each year, only on the decreasing sum and not on the entire capital originally invested. Illustration of present value method. — An illustra- tion showing the computation of the value of a mine as of March i, 191 3, appears on pages 601. The computations will be varied by whatever necessities arise which require treatment of the various factors employed in a manner to reflect properly normal conditions and the elimination of abnormal items. Evidence required to support depletion charges. — The law permits a reasonable allowance for depletion and no more. It is proper and necessary that taxpayers should comply with all reasonable Treasury requirements and furnish detailed evidence bearing on the propriety of the deductions claimed. In addition to the regulations reproduced in full in this "L. C. Graton, I'edcnil Taxation of M{)ics, page 33. "The Manual for the Oil and Gas Industry, published liy the Treasury Department, contains on page 57, a disconnl table for computing present values. This tabic includes no reinvestment feature. 1 192 DEDUCTIONS book, the Treasury has prepared comprehensive "schedules of depletion. ''^^ The information which taxpayers are re- quired to submit in these schedules or questionnaires includes maps of the property ; full particulars of contents and produc- tion at March i, 19 13, and subsequently; kinds of ore or min- eral produced; manner of acquisition and, when cash was not paid for property, cash value of securities issued; details of appraisals, if any; details of sales of similar properties; esti- mates of deposits made by engineers or others; assessments for local taxation ; sales of securities on exchanges or at private sale ; partnership or estate accountings, if any, about March i , 1913 ; various other details are required, all of which are pertin- ent and proper. It should be noted, however, that the so-called market value of the securities of a corporation frequently is not a true indi- cation of the fair market value of any particular asset. The courts have so decided many times. It is understood, however, that the Treasury is most rea- sonable and does not require or expect special research to answer these questionnaires. Information not affecting the taxpayer's claims is not needed and blanks for this may be ignored. Revaluation after March i, 1913, not permitted except in case of discoveries. — At the time the value is being determined, it is important to present all the pertinent data to the Treasury in order to secure the maximum valuation to which the tax- payer is entitled, because after the value is once determined, the regulations provide that a revaluation will not be permitted. It must be remembered that the depletion allowance for all sub- sequent years is based on such valuation. It is well settled practice (although disputed by many per- sons) that appreciation since March i, 19 13, cannot be con- sidered in increasing depletion allowances or reducing the "Form D (minerals), form E (coal), form F (miscellaneous non- metals), form O (oil and gas), form T (timber). FOR DEPLETION 1 193 taxable profit arising from sales, except in the case of dis- coveries.^* Regulation. No revaluation of a property whose value as of the basic date has been determined and approved will be allowed during the continuance of the ownership under which the value was so de- termined and approved except in the case of discovery as defined in articles 219 and 220 or of misrepresentation or fraud or gross error as to any facts determinable on the basic date. Revaluation on account of misrepresentation or fraud or such gross error will only be made upon written application to the Commissioner and approval thereof by him. The value as of the basic date may, however, be corrected when a virtual change of ownership of part of the property results as the outcome of litigation, and may be redistributed (a) when a revision of the number of imits of mineral in the property has been made in accordance with articles 208, 209, or 211, and (b) in case of the sale of a part of the property, between the part sold and part retained. (Art. 207.) In a case where the "probable or prospective" ores had not been included in the original valuation, a revaluation was per- mitted, as shown by the following: Ruling. While article 207 does not permit of a revaluation of property whose value as of the basic date has been determined, it is clear that only a valuation based upon an estimate of the recover- able units including not only ores and minerals in sight, blocked out, developed or assured, but also probable or prospective ores, is con- templated by this article. The meaning of this article is that once the property has been valued in accordance with the Regulations as they now stand, it can not be revalued because it subsequently de- velops that the taxpayer has in his mine more ore than could rea- sonably have been included in the original estimate of recoverable units when the estimate was properly made. If, as is now contended by the M Company the original valuations were based upon estimates of recoverable units which included only ores in sight, blocked out, developed or assured, the properties should be revalued as of the basic date in accordance with the present regu- lations and the rate of depletion determined accordingly. If it should subsequently develop that a material error in the original estimate of the recoverable units was made, the properties may not be re- valued but a redistribution of the depletion may then be made as provided in articles 207 and 208.^^ (Extract from memorandum of the Solicitor; C. B. 4, page 190; A. R. M. 124.) "* See page 1196. " See page 1184. 110)^^ DEDUCTIONS The Treasury does not have the power to foreclose a taxpayer's right to review in case of error, except in cases when the right to claim a refund for prior years is barred by statute. Discovery of mines. ^'^ — Fair market value disproportionate to cost. — Regulation, (a) The discovery must add a new mine to those previously known to exist and can not be made within a proven tract or lease as defined in paragraph (g) infra, (b) To entitle a tax- payer to a vahiation of his property, for the purpose of depletion allowances, by reason of the discovery of a mine on or after March I, 1913, the discovery must be made by the taxpayer after that date, and must resuh in the fair market value of the property becoming disproportionate to the cost. The fair market value of the property will be deemed to have become disproportionate to the cost when the newly discovered mine contains mineral in such quantity and of such quality as to afford a reasonable expectation of return to the tax- payer of an amount materially in excess of the capital expended in making such discovery plus the cost of future development, equip- ment, and exploitation. Definition of discovery. — (c) For the purpose of these sections of the Act a mine may be said to be discovered when (i) there is found a natural deposit of mineral, or (2) there is disclosed by drilling or exploration, con- ducted above or below ground, a mineral deposit not previously known to exist and so improbable that it had not been, and could not have been, included in any previous valuation for the purpose of depletion, and which in either case exists in quantity and grade sufficient to justify commercial exploitation. (d) In determining whether a discovery entitling the taxpayer to a valuation has been made, the Commissioner will take into account the peculiar conditions of each case ; but no discovery, for the pur- poses of valuation, can be allowed, as to ores or minerals, such as extensions of known ore bodies, that have been or should have been included in ''probable"' or '"prospective" ore or mineral,"' or in any other way comprehended in a prior valuation, nor as of a date subse- quent to that when, in fact, discovery was evident, when delay by the taxpayer in making claim therefor has resulted or will result in ex- cessive allowances for depletion (Art. 219.) °°For discovery of oil and gas wells, see page 1205. " See page 1184. FOR DErLETION "95 "VVheii iniprovcnicnts in pnKXSscs of treatment make valu- able certain ores previously of no value the Treasury recog- nizes that exploration for such ores will be stimulated, hence "discovery" is made; but it is unwilling to allow a discovery value of the same kind of ores known to exist in the mine before the improvement in process made the ores valuable. Ruling. Advice is requested as to whether certain known bodies of zinc and copper ores owned by the M Company could be revalued on account of improvements in certain metallurgical processes which made valuable ores which theretofore had no commercial value. This inquiry raised a point of law and inasmuch as the amendment of the regulations with respect to discovery was under consideration the matter was referred to the Solicitor for consideration and an opinion. The Committee is in receipt of a memorandum from the Solicitor dated March 9, 1921, which reads, in part, as follows: As the question is presented in the memorandum the claims of dis- coveries in the case of zinc ore were based upon improvements in metallurgical processes, making valuable ores which had theretofore had no commercial value. It now appears that, while these processes first made commercially valuable zinc ores which before that time were valueless, by reason of this very fact the indications of zinc ore which had originally been found in these mines, were not fol- lowed up, and the presence of the zinc ores which were commercially valuable by any process of treatment was not actually discovered until the dates claimed for discoveries. The claims for discoveries in the case of zinc ores, therefore, have no different basis than the claims for discovery of copper ores. At the time this memorandum was received in this office, regu- lations dealing with the question of discovery were in process of preparation, and it was not deemed advisable to anticipate those regulations. The regulations have now been prepared and appear as articles under the appropriate heading, in Regulations 45 (1920 edition). Articles 219, 207, and 208 of those Regulations appear to answer the question presented. Under this article''^ a discovery for the purpose of a new valua- tion for depletion can not be made in a "known mine," nor can a discovery be made of any "probable" or "prospective" ores which had been or could have been included in the previous valuation. This appears to exclude most, if not all, of the alleged discoveries of cop- per ores. It will be noted that this article does not recognize a dis- covery for the purpose of depletion as the result of improved processes of treatment of ores, making commercially valuable ores which were theretofore valueless. This omission was intentional and made only 'Referring to Art. 219 (b) and (f). 1 196 DEDUCTIONS after mature consideration. If, however, bodies of zinc ore, not theretofore known to exist, were discovered within the meaning of the Regulations, the fact that the explorations were stimulated by recent improvements in metallurgy which made them commercially valuable for the first time would not bar a claim for discovery (C. B. 4, page 190; A. R. M. 124.) The foregoing definition of the word "discovery" may not be upheld by the courts. If a purchaser of low grade ore finds a body of high grade ore, surely it is a discovery. It may be, however, that the term will be strictly interpreted in view of the intention of Congress to extend what may be characterized as a tax privilege. Value 30 days after "discovery" must be reasonably CERTAIN.^® Regulation (e) The value of the property claimed as a result of a discovery must be the fair market value, as defined in article 206, based on what is evident within thirty days after the com- mercially valuable character and extent of the discovered deposits of ore or mineral have with reasonable certainty been established, de- termined or proved. Capital account to be adjusted. — (/) After a bona fide discovery the taxpayer shall adjust his cap- ital and depletion accounts in accordance with article 206, 208, and 210, and shall submit such evidence as to establish his right to a re- valuation, covering the conditions and circumstances of the discovery and the size, character, and location of the discovered deposit of m.ineral, the value of the property at the prior basic date, the cost of discovery, and its development, equipment, and exploitation, its value and the particular method used in the determination. Proven tract or lease. — (g) In the case of a mine, a "proven tract or lease" includes, but is not necessarily limited to, the mineral deposits known to exist in any known mine at the date as of which such mine was valued for purposes of depletion, and all extensions thereof, including "probable" and "prospective" ores considered as a factor in the determination of the value or cost. (Art. 219.) "" See page 1205. FOR DEPLETION 1 197 Valuation of Oil and Gas Wells" In the foregoing pages dealing with the valuation of mines, the general principles underlying the valuation of mineral properties for purposes of depletion have been explained. The following discussion refers to some of the particular prob- lems found in the valuation of oil and gas wells. In view of the highly technical regulations relative to the gas and oil industries the Treasury has prepared an exhaustive treatise which should be consulted by all interested.*^ There- fore articles 209, 21 1-2 14, 220, 220 (a), 223 and 226 are omitted from this chapter. Among petroleum engineers the recognized method of ap- praising an oil or gas property for tax purposes is on the basis of past production of similar properties in the same sand and pool or geographical district. The authority for this method is the law of equal expectations, which is as follows : "If two wells under similar conditions produce equal amounts during any given year, the amounts they will produce thereafter, on the average, will be approximately equal, regardless of their relative ages."" Production decline curves. — The past production of individ- ual wells may be graphically represented by production decline curves which depict the decline in the production of a well over the period of its existence. Such curves are constructed on co-ordinate paper with evenly spaced divisions, the vertical scale indicating units of production, the horizontal scale rep- resenting years. The curve for an oil well is symmetrical. The decline of production in the first year of the well's exist- ence is very rapid but the slope gradually subsides until it ap- proaches the horizontal. All oil curves are of this type. Wells *° For former procedure and comments thereon, see Income Tax Pro- cedure, 1919, pages 602-609, 1156-1164 (Supp.). " The book contains 245 pages and is entitled Manual for the Oil and Gas Industry. Copies may be obtained from the Superintendent of Docu- ments, Washington, D. C, for 25 cents each. *' Manual for the Oil and Gas Industry (1921), page 72)', and Bureau of Mines Bulletin 177, by Carl H. Beal (1919), page 36. ti98 ^EDUCTIONS with a large first year production decline more rapidly than wells with a small initial production. The curve for a gas well approximates that of an oil curve, but it is less likely to be symmetrical. The unit of production in the case of oil is the barrel. There is little difficulty in obtaining the records of the produc- tion for this unit as the production of a lease is generally measured on the lease by the flow of oil into tanks. Royalties, the equivalent of rents, on oil leases are almost universally based on production, the lessor usually receiving the value of one-eighth of the production. There is a different situation with gas. The production unit is a thousand cubic feet. Royalties consist of fixed pay- ments each year or payments based on pressures taken at the well. There are numerous instances where producers do not meter their gas at the lease and it is not metered until it reaches the consumer. This is not fatal if the producer has accurate pressure records from which the production of a well for the year may be calculated. Where there are not accurate pressure records the appraiser should check his esti- mate of production in the field by adding to the total volume of metered gas the line losses, or leaks from the pipe fines car- rying the gas, and such other losses between the wells and the meters, as free gas to the lessor and gas used by the lessee for drilling purposes. Line losses are difficult to estimate when the production in the field is not known. They vary according to the weather, condition of the pipe line, and the type of pipe line. Line losses in a city are apt to be large because of the frequent connections made for each house or factory. Welded lines show less loss than other types. Leaks are more frequent in the winter than in the summer. It is obvious that with such difficulties at the outset the estimation of the gas which a well will produce is subject to a large percentage of error. Having constructed decline curves for the individual wells, the next step is to construct a composite production decline FOR DEPLETION 1199 curve for a given sand in a given pool or district. The Manual for the Oil and- Gas Indiistry^^ recommends that the family curve be used. The family curve is constructed by se- lecting the largest producing well in the pool, and, using that as a basis, putting the production of the second largest well with its first year's production on the curve of the first well, the third in the same way, and so on. An average curve is constructed giving due weight to the variations of each well. There is a considerable personal equation with the consequent danger of error involved in this method. It is laborious and difficult to accomplish neatly. Some engineers have found that the segmental method is a short and fairly accurate method of constructing a composite decline curve. Thisi consists of averaging the periods of time for declines between selected points of production. The months or years required by all the wells to decline from a production of, let us say, lOO to 90, 90 to 80, 80 to 70, etc., are read from the individual well curves and averaged by dividing the total amount of time by the number of producing wells. Great care must be exercised in selecting the wells to be used in the composite production decline curve. All aberrant or erratic wells such as those which show the effects of water, which are aljandoned after short periods, and which are drilled too closely to one another, should be excluded. In making in- dividual curves for gas wells the appraiser should exercise caution in selecting pressures upon which to calculate yearly production. The majority of Appalachian producers .who sup- ply domestic consumers shut in some of their wells during the summer months as the demand for gas is low, practically none being required for heating purposes. The effect of shut- ting in the wells is to increase the pressures. In the winter pressures are low, due to the cold weather and the heavy drain on the fields made necessary to supply the consumers with gas for fuel. In general the pressures at the end of September are Manual for Oil and Gas Induslry, page 86. I200 DEDUCTIONS representative pressures upon which to base a calculation of the year's volume. Abnormally low pressures due to the pres- ence of water in a well or sudden high pressures due to the abandonment of nearby wells should be disregarded. The composite production decline curve represents the decline in production of the average well in a given sand, or stratum, and geographical district. To obtain the estimated future production of a well, the point on the composite decline curve corresponding to the yearly rate of production as of the date of valuation of the well is located and the future production is read off, year by year, to the economic limit. The economic limit is that point where the production is so small that the producer makes no profit by operating the well. The economic limit varies according to the profit on the com- modity. The sum of the future production, year by year, equals the estimated recoverable reserves, or the amount of oil or gas which the taxpayer expects to produce. Field prices and costs. — Prices are estimated for the oil or gas unit of production on the lease. The taxpayer places a value on his well or lease, taking into consideration the trans- portation facilities available. It is essential in predicting fu- ture prices, especially in the case of oil, that the engineer be acquainted with the supply of and demand for the com- modity. In recent years price curves depicting the rise in price of oil since the year 1900 extrapolated, or extended, into the future with the same percentage of increase, have been unsatisfactory because of the sudden drop in the price of oil at the beginning of 192 1. This type of prediction has been successful for the prices of gas in the Appalachian region. In this section the gas reserves seem to be steadily declining with no new pools being discovered. One company had one- third less production in 1920 than in 1916, although it had about 30 per cent more wells producing in 1920. The pro- ducers are educating the people in methods of conservation and at the same time gradually increasing the prices against FOR DEPLETION I20I the day when there will be no natural gas resources and the people must use artificial gas, which is more expensive. Some of the cities of Pennsylvania which formerly used natural gas for fuel have had to turn to coal within the last year. This situation indicates that the taxpayer in the Appalachian field is safe in assuming that the price of gas will rise steadily for the next few years. Where a producer does not sell his gas in the field to a pipe line company, and has only a consumer's price, there is the same difficulty in estimating a field price as there is in estimat- ing field production when there are no pressure records. Field prices must then be estimated by deducting from consumers' prices the value of line losses, free gas, and gas used for drill- ing or other purposes. Production costs include the cost of drilling, maintenance, and transmission of the product to the lease boundary. The appraiser should be cautious about estimating his future costs on the basis of the rise in the past because of the inflation of prices of materials during the period of the recent war. The field price per unit of production minus the production cost in any year, equals the future net revenue for the unit in that year. The future net revenue for the unit for a year times the estimated recoverable units of production for the year, equals the net revenue for the property in the year. Present value method. — To obtain the present worth of the property discount factors of from 8 to lo per cent are used. In addition to the discount to obtain the present value, a "discovery" well should be further discounted for the risk of abandonment, which is the risk that natural forces, such as water, will prevent the actual production equalling the anti- cipated production, and the risk of olTset wells, that is, the risk that rival producers will drill so close as to drain a por- tion of the resources of the well. The discount table published 1)y the Treasury"** is based ^Manual for lite Oil and Gas /mluslry, page 57. 1202 DEDUCTIONS on the present value of $i due a number of years hence, the present value being worked out for each year separately. The sum of the present worths for each year is the total value to be ascribed to the property. The necessity for discounting each year's income separately is that production in an oil prop- erty progressively declines, whereas in a mine it is assumed to be fairly constant year after year. The discount table contains no reinvestment feature as is the case in the tables used for mines ; that is, no provision is made for estab- lishing a theoretical sinking fund at 4 per cent compounded annually, as in the case of mines, which results, of course, in a greater present value being assigned to the property. As stated by the Treasury, "The rate of discount employed de- pends upon the judgment of the person making the valuation. ''*° Risks affecting rate of return. — Some of the ordinary risks to be considered in valuing oil and gas properties are : 1. For wells valued as of March i, 1913: (a) Risk of offset wells or the risk that rival pro- ducers will drill producing wells so close to the property as to drain a portion of the re- sources. (b) Risk of abandonment, or the risk that natural forces will prevent the actual production equalling the anticipated production. 2. For discovery wells : (a) Risk of dry holes, or the risk that there will be no production. (b) Risk of abandonment. (c) Risk of offset wells. 3. For undrilled locations : (a) Risk of dry holes. (b) Risk of abandonment. (c) Risk of offset wells. ''Manual for the Oil and Gas Indiislry, page 58. FOR DEPLETION 1203 (d) Risk of deferment in drilling, the risk that the rate of production in the field may be smaller at the time the proposed well is drilled. Perhaps in 191 3 it would have been absurd for engineers to attempt to estimate the present value of oil and gas wells by appraisals. During the last six years many improvements have ]:)een made in the methods of valuation so that at the pres- ent day with the law of equal expectations'*'' and the use of pro- duction decline curves as a basis for estimates, very fair values may be placed upon oil and gas properties. Valuation of undrilled acreage. — A fair method of valuing undrilled acreage surrounding a well is on the basis of the drilling program which any experienced producer would in- augurate. The drainage area of a wxll varies as to its locality and the porosity of the sand. In the Appalachian field an oil well drains about eight acres and a gas well approximately forty acres. Using the drainage area of the well as a basis, the appraiser indicates on a map the territory which he expects to be drilled, taking into account the geological conditions, the practical difficulties, and the neccbsity of placing the wells in such positions that they will drain the maximum amount from the taxpayer's territory at the least cost, and at the same time be as near the lease boundaries as possible in order to drain neighboring leases held by rival producers. The value of a location for a future well should be discounted for defer- ment, the risk of a dry hole, the risk of abandonment, and the risk of offset wells. The risk of deferment is the risk that the rate of production for the field will be smaller than its present rate at the time the proposed well is drilled. The risk of a dry hole is the risk that the proposed well will not produce any gas or oil at all. Gasoline. — In recent years producers have found that/ sometimes they can absorb gasoline from the gas as it comes 'Manual for the Oil and Gas Industry (iQJi), paj'c 7Z- I204 DEDUCTIONS from the well. Where the producer has indicated by the pres- ence of an absorbing plant his intention to take out the gasoline at the date of valuation, or shortly thereafter, he may claim depletion on the gasoline contents of the gas, as well as on the gas itself. A refiner may have a large number of contracts for the purchase of gasoline at the wells. It is understood that he is allowed to deplete the value of these contracts. Apparently the reason for this is that the refiner has a legal interest in the mineral content of the well similar to that of the lessee who is allowed to claim depletion for the value of his rights. De- pletion of such contracts, however, would be permissible only if they were held at March i, 1913, or were acquired since for a valuable consideration. Evidence required to support depletion charges. — Although the oil and gas taxpayer reaps many benefits under the income tax law as it now stands, he must also undergo considerable expense in meeting the requirements of form O to support his claims for depletion and depreciation. The information re- quired is not likely to be kept in such form by the taxpayer that he can readily produce it. Some companies require three years, with a staff of twenty men and girls working continu- ously, to complete amended returns from 191 3 to date. De- tailed information as to each lease is required. When a tax- payer has three or four thousand leases, this information is in itself a burden. The most unreasonable requirement is that a taxpayer show development in the neighborhood of his dis- covery. This is in effect compelling him to wrest information from his rivals. Probably the Treasury Department is not particular as to this feature today, as the government maps showing development are understood to be in good shape. In the case of discovery wells the Treasury Department asks for the true bearing and distance of all wells within 3,733.5 feet of the discovery. In thickly drilled fields this is almost impos- sible of accomplishment. Tlie information as to true bearing FOR DEPLETION • 1205 should be eliminated, since the Treasury holds under the law that ordinarily a discovery proves a maximum area of 160 acres. Revaluation after March i, 1913, not permitted except in case of discoveries. — The comments on page 1192 apply equally to oil and gas wells. Article 206a is therefore omitted. Discovery of oil and gas w^ells. — Fair market value disproportionate to cost. — In the case of oil and gas properties it is understood that the Treasury Department requires that the fair market value of the prop- erty must exceed the cost by at least 100 per cent. The law,*^ however, does not fix any definite percentage by which the fair market value must exceed the cost. It reads ''where the fair market value is materially disproportionate to the cost." Proven tracts in relation to discovery claim. — The Treasury interprets the law allowing revaluation on account of discovery as meaning that a discovery well ordinarily proves an area of 160 acres of a sand regardless of private boundaries, or in other words, a producing well indicates that there is a reasonable certainty that the area of 160 acres around the well contains oil and gas in sufficient quantities to justify its exploitation.^^ The discovery law was originally enacted to protect the ad- venturous oil men who drilled wild-cat wells, or who drilled and opened up undeveloped territory. As such producers take large risks their returns should be large. The original inter- pretation of the law was that a discovery well proved a pool or geographical district. The more recent rulings of the Treasury indicate that a proven area is limited to 160 acres. The following are some of the ordinary cases which arise "Sections 214 (a-io) and 234 (a-9). ** Manual, page 44, first paragraph. i2o6 DEDUCTIONS under the first three paragraphs on page 44 of the Manual for the Oil and Gas Industry (1921). 1. The Sniitli lease is taken in 1916. The Jones Xo. i is drilled in 191S and produces from the Big Injun sand. The Smith No. i is drilled to the Big Injun in 1919 within the area proved by the Jones No. i. A discovery may be claimed since the Smith lease was acquired before the Jones well was drilled. 2. The Smith lease is taken in 1918 and No. i well is drilled to the Big Injun sand in the same year. Although the well itself is not on proven territory it is compactly surrounded by the proven areas of other wells drilled to the Big Injun sand in previous years. No discovery may be claimed. This is a case where the present in- terpretation of the Treasury contains the spirit of the old interpreta- tion that a well may prove more than 160 acres. 3. The Jones No. i is drilled to the Big Injun sand in 1917. The Smith lease is taken in 1918 and the No. i well is drilled to the Speechly sand in 1918 within the 160 acres surrounding Jones No. I. Smith No. i may be claimed as a discovery since its production comes from a different sand. The Jones No. i proves 160 acres of Big Injun sand but does not prove the Speechly sand. 4. Smith No. i is drilled to the Big Injun sand in 191 7 and valued as a discovery. In 1918 it is drilled deeper to the Speechly sand. It may be revalued as a discovery in the Speechly sand, since that sand was not proved by the discovery in the Big Injun sand. 5. Smith No. I is drilled in undeveloped territory. It produces oil from the Berea sand and gas from the Big Injun. It should be valued as an oil discovery and a gas discovery. 6. Where the Wildcat Oil Company owns the Smith lease but not the Jones lease and part of the proven area of Smith No. i lies on the Jones lease, that portion of the acreage may not be valued by the company. Nor may the owner of the Jones lease value it, since he has not made the discovery. 7. The Jones lease lies east of the Smith lease. The Smith No. i is a discovery in the Gantz sand. The Smith No. 2 is drilled to the same sand easterly and within the proven area of the Smith No. i and proves a small strip A-A on the Jones lease beyond the area proven by Smith No. i but it is not a discovery. Jones No. i is drilled outside of either area and is claimed for discovery in the Gantz sand. Query whether the strip A-A may be revalued by the Jones lessee. It is understood that the Treasury Department has ruled in such a case that the strip A-A may not be revalued by the Jones lessee since the Smith No. 2 extended the proven acreage of the discovery. Ruling. Where a partnership incorporated in 1917 and at the date of incorporation the property transferred was '"proven terri- FOR DEPLETION 1207 tory,'' depletion was allowed the corporation on the basis of the cost to the corporation, i.e., the appreciated "discovery" value at which taken over, even though under Section 331*'' the corporation, for in- vested capital, could not include any such appreciation. (I-i-io; A. R. R. 712.) Comment on the regulations. — The expressed purpose of the law is to permit annual allowances for depletion, based on output, up to the cost of the wells, and the intention of the numerous rulings and regulations has been to carry out the provisions of the law. The most that any owner can desire to charge off against income is the fair value of the property March i, 19 13, or the entire cost of property acquired or the fair value of discoveries since that date. He recognizes that any net income realized in excess of such amount is profit and should be taxable. In some cases owners desire to charge off too much annu- ally and in other cases they do not charge off enough. Those who charged off too much prior to January i, 191 7, regret their action because there is now so much less left to claim as allowable deductions under laws levying higher taxes. On the other hand, conservative financing and accounting require liberal reserves for depreciation and depletion, and the con- cern which has followed this policy should continue it and make such adjustments between the books and the tax returns as will reflect the true state of affairs. An oil company with a large cash investment cannot afford to ignore depletion or exhaustion. Aside from new purchases, it is obvious that at the end of any period the product remaining in the ground is less than at the beginning of the period by exactly the amount which has been extracted. New wells brought in may increase flow and there may be an apparent appreciation in values rather than depreciation, but when such hazardous properties as oil wells are under con- sideration the tendency of good managers is to be pessimistic about the future and to be liljeral in setting up depletion re- " 1918 law. T2o8 DEDUCTIONS serves. This policy prevents the overstatement of assets and the payment of excessive dividends. It may save a company from bankruptcy. The government will not lose anything in taxes in the long run by permitting liberal depletion deductions. It will probably gain, because the instant the entire investment is written off the books no further deductions for depletion can be claimed and under graduated income and excess profits tax laws the aggregate tax is increased. From, the taxpayer's point of view, it is better to pay too much tax in the long run and have a conservative balance sheet, than to ignore deple- tion or provide insufficient reserves and publish misleading balance sheets. Determination of the Depletion Allowance Having determined the value of the property as at the date of valuation (the ''basic date"), the next step is to determine the depletion unit, which is ascertained by dividing the value of the property by the number of units of mineral estimated to be in the property. The unit value multiplied by the numbers of units sold during the year gives the depletion allowance. Regulation, (a) Depletion attaches to the annual production "according to the peculiar conditions of each case"' and when the depletion actually sustained, whether legally allowable or not, from the basic date, equals the cost or value on the basic date plus subse- quent allowable capital additions, no further deduction for depletion will be allowed except in consequence of added value arising through discovery or purchase (&) When the value of the property at the basic date has been determined, depletion sustained for the taxable year shall be computed by dividing the value remaining for depletion by the number of units of mineral to which this value is applicable, and by multiplying the unit value for depletion, so determined, by the number of units sold or produced within the taxable year. The depletion deduction for the taxable year is subject, however, to the limitation contained in article 201 (h).^*^ In the selection of a unit for depletion preference shall be given to the principal or customary unit or units paid for in the product sold.°^ (Art. 210.) ™ See page 121 i. °' [Former Procedure] Before the revision of December 29, 1920, FOR DEPLETION 1209 In (a) "production" is mentioned, but in (b) reference is made to the "units sold or produced." It is obvious that the quantity extracted represents actual depletion, because coal and other natural resources are frequently consumed by the tax- payer and not sold. Depletion of mines. — In copper mines the practice is to multiply the depletion factor by the number of net tons of ore smelted or by the number of pounds of metal recovered or produced from ore smelted. ^^ In establishing the depletion rate care must be taken to use a rate that will provide for the proper deduction based on the grade extracted. If high grade ore is extracted during the early years, and low grade in the latter years, an average rate might fail to recover the full capital because in the later years the income might be insufficient. The effect of improperly using an average rate may be seen from the following : Assume that the copper in this mine is 1,000,000,000 lb. of which the high-grade ore averages two-thirds, or 666,000,000 lb., and the low-grade ore amounts to, approximately, 333,000,000 lb. The profit on the high-grade ore is 10 cents, or $66,000,000 in round figures, and the profit on the low-grade is 5 cents, or $16,000,000. Adding these figures together gives a total value of $82,000,000. As- sume a life of 10 years; this gives an expected annual income of $8,200,000. The present value of that income would be in round figures $66,500,000. Applying the Treasury rufe to those figures for depletion, you must divide the $66,500,000 by the total number of pounds of copper, or 1,000,000,000, and be allowed a depletion of 6.65 cents per pound. In the first years when we get a 10 cent profit, all is well, we readily obtain the depletion of 6.65 cents, but in the latter years of that mine's life, when we only have a 5 cent profit on that ore, how can we take 7 cents out?-""'^ The point is that the extraction of 100 pounds of copper Art. 210 provided for computing the depletion allowance based on the num- ber of units extracted during the year. See Income Tax Procedure, 1920, page 770. Reg. 45 (1920 edition), Art. 210, based the allowance on number of units sold. See Income Tax Procedure, 1921, pages 936-937. " T. O. McGrath, Mine Accounting, page 72. " L. C. Graton, Federal Taxation of Mines, page 57. I2I0 DEDUCTIONS contained in rich ore results in a greater impairment of the mine, because of the greater profit in the high grade ore than does lOO pounds of copper in low grade ore in which there was little profit. The problem may be solved in some cases by separate valuations of the various blocks of ore, where it is feasible to do so, as provided in article 206,^* and the es- tablishment of separate depletion rates applicable to each.^^ In the case of a silver mine, this situation was recognized by basing the depletion, not on the tons of ore contained in the mine, but on the metal content of the ore. The unit of deple- tion was, therefore, the ounce of silver instead of the ton of ore containing silver. Each year's depletion allowance is based on the silver recovered (allowance having been made in the basic valuation for expected loss in extraction), which naturally varies as between different grades of ore. Note particularly the last sentence of article 210. The unit paid for in the product sold by a silver mine is not ore but silver, by a copper mine, copper not ore, etc. Depletion of gas wells. — When gas wells have been valued on the basis of production, it is more practicable to use the production for calculating depletion for any given year than the pressure units suggested by the Treasury Department. ^^ Depletion on the basis of production is the depletable capital sum divided by the estimated recoverable reserves (which equals the unit cost), times the number of cubic feet of gas produced during the year. Depletion of oil wells. — Each barrel of oil or unit extracted and marketed must, before a profit can be realized, pay not only its proportionate share of the operating expense and deductions for depreciation and obsolescence of physical property, but also must pay its proportionate share of capital sum returnable through depletion ' allowances. " See page 11 76. "^ Recovery of the cost or Alarch i, 1913, value of tlie physical property may also be obtained through a depreciation deduction, based on the rate of current exhaustion of the mineral. See page 1105. ''"Manual for the Oil and Gas Industry (1921), page 32. FOR DEPLETION I2ll This proportionate^ sliare of capital sum returnable through depletion allowances, which each unit of oil must pay, is unit cost. Unit cost is obtained by dividing the capital sum returnable through depletion by the "estimated recoverable reserves" at the be- ginning of the taxable year. * * * * The depletion deduction is computed by multiplying the unit cost by the number of units produced during the taxable year."'" While the Treasury refers to units produced, as above, it also provides, in article 210, that depletion shall be computed on the number of units sold or produced during the year. In a year like 192 1 when, with falling prices, prodticers were obliged to accumulate storage oil instead of selling all of their production to the pipe line companies, a considerable reduc- tion in the total depletion would result if the basis of sales were adopted. Limitation on depletion deduction based on discovery value. — The 192 1 law^^ does not permit any part of the deple- tion deduction based on discovery value to be used in the com- putation of a net loss. This prevents the loss from being de- ducted from the income of a succeeding year, due probably to the "discovery" provision (which is first found in the 19 18 law) being considered to be in the nature of a gift; and if the net income in any one year is not sufficient to take care of the full depletion charge based on discovery, there is no good reason for extending the terms of the gift to another period. Regulation (/i) Depletion allowance in case of dis- covery : The deduction for depletion in case of a discovery can not ex- ceed the net income computed without allowance for depletion, from the property upon which the discovery is made, except where and to the extent that such net income so computed is less than the depletion allowance based on cost or fair market value as of March i, 1913. Net income is the gross income from the sale of all mineral products and any other income incidental to the operation of the property for the production of the mineral products, less operating expenses, includ- ing depreciation on equipment, and taxes, but excluding any allowance for depletion. If the mineral products are not sold as raw material " Ibid., page 30. ■'''Section 204; see page 1023. I2I2 DEDUCTIONS but are manufactured or converted into a refined product, then the gross income shall be assumed to be equivalent to the market or field price of the raw material before conversion. Operating expenses, depreciation, and taxes on the property upon which the discovery is made, should be applied against the gross income from the same property on the basis of actual expenditures, but if the records for the year 1921 are in any case inadequate, allocation of such expendi- tures for that year may be made on the basis of the ratio of (i) the number of wells operated on the property on which the discov- ery is made to (2) the total number of wells operated in the operating division in which the discovery is included. (Art. 201.) The following illustrations show how the limitation oper- ates: I Net income from investments $10,000 Net income from mineral property before depletion 50,000 Total $60,000 Depletion charge based on cost or March i, 1913, value.. $40,000 Depletion charge based on discovery value $80,000 Depletion allowable (amount of depletion charge based on dis- covery value, but not to exceed the net income from the property) 50,000 Taxable income $10,000 11 Net income from investments $10,000 Net income from mineral property before depletion 50,000 Total $60,000 Depletion charge based on cost or Alarcli i, 1913, value.. $60,000 Depletion charge based on discovery value $80,000 Depletion allowable (amount of depletion charge based on discov- ery value, which, if it exceeds net income from the property, is allowed up to the amount of depletion based on cost or March i, 1913, value) 60,000 Taxable income None III Net income from mineral property before depletion (no income from other sources) $50,000 Depletion charge based on cost or March i, 1913, value.. $60,000 Depletion charge based on discovery value $80,000 FOR DEPLETION 1213 Depletion allowable (as above) 60,000 Net loss (which may be applied against net income of succeeding year — section 204) $10,000 IV Net income from investments $ 5,000 Net income from mineral property before depletion 50,000 Total $55>ooo Depletion charge based on cost or March i, 1913, value.. $60,000 Depletion charge based on discovery value $80,000 Depletion allowable (as above) 60,000 Net loss (which may be carried forward — section 204) ... $ 5,000 The point is that the taxpayer may get depletion based on discovery value, if the net income is sufficient, but always gets depletion based on cost or March i, 1913, value even if it re- sults in a net loss, which net loss may be applied against the net income of a succeeding year under section 204. Inventory to be market even though higher than cost. — If raw products are inventoried at the market price, as per- mitted by article 201, the latter may include a considerable element of profit. In so far as this may be a method recog- nized as representing the best accounting practice in the in- dustry, it will be recognized by the Treasury. It is a good illus- tration of one of the five departures from the rule of cost or market, which ever is lower.^° Depletion accounts on books. — Regulation. Every taxpayer claiming- and making a deduction for depletion and depreciation"" of mineral property shall keep accu- rate ledger accounts in which shall be charged the fair market value as of March i, 1913, or within thirty days after the date of discovery, or the cost, as the case may be, (a) of the mineral deposit, and (b) of the plant and equipment, together with subsequent allowable capital additions to each account. These accounts shall thereafter be credited "" See Auditing, Theory and Practice, by R. R. Monegomcry (1921 edition), page 122. °" See pages I104-T108 for articles 222, 224 and 225 which refer to depre- ciation as well as depletion in connection with equipment. J2I4 DEDUCTIONS annually with the amounts, whether legally allowable or not, of the depletion and depreciation sustained; or the amounts of the deple- tion and depreciation sustained shall be credited to depletion and de- preciation reserve accounts, to the end that when the sum of the credits for depletion and depreciation equals the value or cost of the property, plus subsequent allowable capital additions, no further de- duction for depletion and depreciation with respect to the property shall be allowed. (Art. 216.)''^ Statement to be attached to returns. — Regulation, (a) To the return of every taxpayer claiming a deduction for depletion or depreciation there shall be attached a state- ment setting" forth with respect to each mineral property: (i) Whether taxpayer is a fee owner, lessor or lessee, (2) the date of acquisition and if under lease, its exact terms and date of expiration, (3) the cost of the property ; stating the amount paid to each vendor, with his name and address, (4) the basic date at which the property is valued, (5) the value of the property on the basic date with a statement of the precise method by which it was determined, (6) the value of the surface of the land for purposes other than mineral production, (7) the estimated number of units of mineral at the basic date with an explanation of the method used in the estimation, and an average analysis which will indicate the quality of the mineral valued, (8) the number of units sold during the year for which the return is made, (9) the gross and net income derived from the sale of mineral, and in case of discovery the net income from the property upon which the discovery was made; (10) the amounts deducted for depletion, (11) the amounts sustained on account of depletion or on account of de- preciation stated separately from the basic date to the taxable year, and (12) any other data which will be helpful in determining the reasonableness of the deductions claimed in the return. Additional information in cases of fractional in- terests AND leaseholds. (b) To the return of every taxpayer claiming a deduction for depletion in respect of (i) property in which he owns a fractional interest only, or (2) a leasehold, or (3) property subject to lease, there shall also be attached a statement setting forth the name and address and the precise nature of the holding of each person inter- ested in the property, and every lessor shall attach to his return an affidavit stating, as of the date of filing the return, whether the lease involved is still in effect during the year covered by the return, and, if not still in effect, when it was terminated and for what reason and whether the lessor has repossessed the property. " Sec A. R. M. 124, page 1195. FOR DEPLETION 1215 (c) All statements required to be furnished in connection with the returns of taxpayers claiming depletion or depreciation must be under oath and may be included in a single affidavit. (Art. 217.) Depletion may be deductible even if not on books. — As with depreciation, depletion charges should appear on the books and the book figures should conform exactly with those given in the returns. If it has not been the practice to record depletion, no time should be lost in making the proper book entries. However, the courts thus far have taken the posi- tion that the taxpayer cannot be deprived of the right to de- duct depletion because of a failure properly to record the charges. Decision. The United States District Court has held that a coal company was entitled to a deduction of 15 cents for each ton mined as an allowance for depletion. The fact that this amount was in- correctly carried on the books of the company in surplus account instead of as depletion reserve did not justify the Government in disallowing the deduction."" Under the 192 1 law the Commissioner is authorized to re- quire taxpayers to adhere to good accounting practice." The courts may and should interpret this to mean that if depletion is not set up on the books the claim will not be allowed for income tax purposes. Moreover, the deduction claimed in the return should agree exactly with the books. Depletion allowance to operating owner. — Regulation. In the case of an operating owner in fee, the amount remaining in any year returnable through depletion and de- preciation deductions is (o) the cost or value of the property at the basic date plus (b) subsequent allowable capital additions and minus (c) depletion and depreciation sustained, whether legally allowable or not, from the basic date to the taxable year, and minus (d) the value of the land at the basic date for other purposes than mineral production and the residual value of other property at tlic end of operations. The amount returnable through depletion is the total '"Forty Fori Coal Co. z'. Kirkcndall, Collector, 233 Fed. 704. " [Former Procedure] The 1918 law had a similar provision [section 212 (b)]. j2i6 DEDUCTIONS capital remaining less the sum recoverable through depreciation. (Art. 202.) Stockholder may not claim depletion. — It will be noted that a stockholder in a mining or oil or gas corporation is not en- titled to any allowance for depletion, because the depletion claimed by and allowed to the corporation exhausts the allow- able deduction. Regulation Operating owners, lessors and lessees, whether corporations or individuals are entitled to deduct an allow- ance for depletion and depreciation, but a stockholder in a mining or oil or gas corporation is not allowed such deductions (Art. 201.) Depletion allowance to lessor. — The 192 1 law**^ provides that "in the case of leases the deductions allowed by this para- graph shall be equitably apportioned between the lessor and lessee." The depletion allowance to lessors is fully discussed in the text following. If the lessor is entitled to a sliding scale of royalties or if, as in the case of oil wells, he receives in addition to a bonus a specific part of the whole product (one-eighth of the product being a widely used figure), he will follow the same proce- dure as an owner who is also an operator. Revaluations as of March i, 191 3, may be placed on the books. When leases are for a fixed royalty per unit, appreciation in value between the making of the lease and March i, 191 3, usually accrues solely to the lessee. Appreciation which ac- crued prior to the making of the lease which was in effect at March i, 1913, inures to the benefit of the lessor in appor- tioning the depletion allowance between lessor and lessee. The lessor having divested himself of any return beyond the royalties, cannot participate in appreciation as such. If interest rates were lower at March i, 191 3, than when the leases were made, the lessor might claim an increased value for the property, subject to the lease. "Sections 214 (a-io) and 234 (a-9). The igi8 law included the same provision. FOR DEPLETION 1217 In all cases the lessor merely gets back through depletion his capital investment or value at March i, 19 13, and the lessee through depletion charges gets back his investment or value at March i, 191 3; and in no case must the aggregate depletion charges allowed to lessor and lessee exceed the aggregate capital investment. Regulation, (a) In the case of a lessor, the amount remaining in any year returnable through depletion and depreciation deduc- tions is (i) the value of his equity in the property at the basic date minus (2) depletion and depreciation sustained, whether legally al- lowable or not, from the basic date to the taxable year, plus (3) subsequent allowable capital additions, and minus (4) the value of the land at the basic date for other purposes than mineral production and the residual value of other property at the end of operations. The amount returnable through depletion is the total capital remaining less the sum recoverable through depreciation. (b) The value of the equities of lessor and lessee shall be com- puted separately, but, when determined as of the same basic date, shall together never exceed the value at that date of the property in fee simple. (c) The value of the lessor's equity in the case of a mineral property not under lease on March i, 1913, but subsequently leased, is the en bloc value of the mineral in the ground on March i, 1913, and will, in the absence of satisfactory evidence to the contrary, be presumed not to exceed the value as of March i, 1913, of the royal- ties to be expected under the lease. (d) The value of a lessor's equity in a mineral property under lease March i, 1913, for the entire operating life of the mineral de- posits is the value as of March i, 1913, of the royalties and other payments to be expected under the terms of the lease in effect on that date. (e) The value of a lessor's equity in a mineral property under lease for a portion of its operating life is the value as of March i, 1913, of the royalties expected from the mineral to be extracted during the life of the existing lease plus the estimated en bloc value of the mineral remaining at its expiration, which, in the absence of satisfactory evidence to the contrary, will be presumed not to exceed the value as of March i, 1913, of royalties which could have been expected as at that date from the remaining mineral. (/) The value of a lessor's equity in a mineral property when acquired on or after March i, 1913. is its cost. (g) The value of a lessor's equity in a discovery on or after March i, 1913, is the fair market value at the date of discovery, or I2i8 DEDUCTIONS within thirty days thereafter, of his equity in the mineral discovered.'* (Art. 204.) The application of the principle laid down in paragraph (e) in the foregoing regulation, as affected by the 1916 law, is stated in the following: Ruling. The question is raised as to the proper construction to be placed upon Solicitor's Memorandum 1365 in so far as it relates to the computation of deductions for depletion of a mine allowed to a lessor. The inquiry is made in connection with the following statement of facts: A leases a property to B in 1910 at 20 cents a ton for the period of 10 years. In 1913 it is determined that the property is very valuable, and has a large tonnage of ore which will extend its life, at the probable rate of extraction, until 1940. In 1920 A renews the lease to B for the life of the mine at a royalty of $1.00 per ton. In Solicitor's Memorandum 1365 it is held that the allowable deduction for depletion m that case under the Act of September 8, 1916, i.e., the maximum amount that could be deducted, was to be determined by dividing the fair market value of the entire body of coal in place on March i, 1913, by the estimated content of the mine in tons and multiplying the result so obtained by the number of tons of coal taken out each year, in accordance with article 172, Regula- tion 33 (revised). The lease there considered was entered into June 12, 1914. There was no evidence in the case that the value of the coal in place had increased between March i, 1913, and the date of the making of the lease, and it was stated that the lease, which was for the term of 10 years, was coterminous with the life of the mine. The decision was based upon these facts and was clearly correct. Section 12(a) Second (b) of the Revenue Act of 1916 provides '° [Former Procedure] Article 202 before amendment in 1920 erro- neously provided that a lessor could not claim any part of discovery value. See Income Tax Procedure, 1920, pages 771-772. In an opinion of the Attorney General, dated October 29, 1920, it was held: Ruling, (i) The deduction for depletion in the case of mines, oil and gas wells, as the result of discovery on or after March i, 1913, is allowed only to the party or parties in possession at the time of the discovery, and not to subsequent purchasers. (2) The value which may be set up in the case of the discovery of mines, oil and gas wells, pursuant to the second proviso of section 234 (a) (9), Revenue Act of 1918, to be depleted in accordance with such reason- able rules and regulations as the Commissioner of Internal Revenue and the Secretary of the Treasury may prescribe according to the peculiar conditions in each case, is, in the case of a lease, to be equitably apportioned between the lessor and the lessee. (C. B. 3, page 175; T. D. 3089.) FOR DEPLETION I2ig for a deduction in the case of mines of a "reasonable allozvance for depletion .... not to exceed the market value in the mine." It is clear from this language that it was not the intent of Congress that an owner of a mine who had leased it for a fixed royalty, thus putting a limit upon the amount which he could receive in any event, should recover all the value of the ore in place as of the basic date, but only that he should be allowed a deduction for depletion to the amount of his interest in the ore extracted, not in excess of the cost of the mine or its fair market value as of March i, 1913. In the case now presented the value of A's interest as of March I, 1913, in the ore in the mine was the present worth as of that date of his royalties of 20 cents per ton, obtained by multiplying the roy- alty per ton by the number of tons probable extraction by the lessee and discounting the product for the remaining life of the lease, plus the value of the ore which would be left in the mine at the termination of the lease. T.he fair market value of the ore in the mine as of March l, 1913, having been determined, "a. reasonable allowance" to the lessor for depletion under such lease was the then present worth of his royalties, provided this did not exceed such fair market value. Upon the renewal of the lease in 1920 for the remaining life of the mine the lessor's interest in the capital sum will again be represented by the royalties stipulated to be paid, capitalized and discounted as above, and this present worth divided by the estimated mineral content of the mine at the date of the lease will equal the unit of depletion which, multiplied by the number of tons extracted in any year, will give the allowable deduction for depletion for such year, provided always that such deduction does not exceed the value as of March i, 1913, of the ore extracted during such year. The above ruling is not understood to modify the conclusion reached in Solicitor's Memorandum 1365, but only to apply the principle therein laid down to the different facts here presented. (C. B, 4, page 195; Sol. Op. 80.) Assume that the mine leased in 19 10 contained at March I, 1913, 2,700,000 tons, annual production 100,000 tons, so that when the lease terminated in 1920, at the end of seven years, 2,000,000 tons would be left. The lessor then renews the lease at $1 royalty per ton. The Treasury says, in effect, that, since under the 1916 law the depletion deduction in any one year is limited to the "market value in the mine" of the ore removed, such market value was the present worth in 1913 of the 20-cent royalty fixed in 19 10. Permission to recover any additional part of the value of the mine at March i, 1913, I220 DEDUCTIONS (under the 191 6 law) would not be granted until the termina- tion of the lease in 1920, under which stipulated royalties of 20 cents were paid. The following illustration will help to make this clear.*'*^ Number of tons in mine at Alarch i, 1913 2.700,000 Number of tons lessee would extract between March i, 1913, and termination of lease in 1920 (say 7 years) 700.000 Number of tons remaining in mine at 1920 (which would be ex- tracted by 1940) 2,000,000 Production per annum, estimated at 100.000 tons Value of A's interest at 1913 : Present worth of royalties to be received from 191310 1920: 100,000 tons X 20 cents ^= an annuity of $20,000, dis- counted at 6% for 7 years $ 111,647.62 Add: Value of ore remaining at end of lease in 1920: Estimated profit per ton of ore remaining at 1920 $ .25 Operating profit from 1920 on, of ore then remaining, 2,000,000 tons at 25 cents . . $ 500,000.00 $500,000 -^ 20 ^ $25,000, or annual profits 1920 to 1940. Present worth of an annuity of $25,000 for 20 years at 6% $ 286.748.03 Since the realization of the value of the ore in 1920 ($286,748.03) is deferred for another 7 years (1913- 1920), such value must be further discounted. Therefore, present worth of the entire $286,748.03 at 6 % is 190,703.78 Total value of A's interest at March i, 1913 $ 302.351.40 Depiction allowed A from March i, 1913, to end of lease in 1920 is the present value of his royalties under the lease, or, as stated above, $ 111,647.62 "'' In a case with which the author is familiar, the problem was to determine the value as at March i, 19 13, of the royalties to be received by the lessor. At that date it was estimated that the mine would be worked out in nineteen years. The lessor sold its interest in 1917, taking in pay- ment non-interest bearing notes maturing semi-annually, running to 1951, and through the acceptance of those notes the life of the mine, so far as the lessor was concerned, was in effect extended to 1951. The Treasury related this after-discovered factor of longer life back to 1913, when as a matter of fact it had no bearing on the estimate of nineteen years' life made in 1913, which was based on the rate at which the mine was being exhausted. FOR DEPLETION I22I Upon removal of the lease in 1920 the capital value at that date °' would be 2,000,000 tons X $1 (the new royalty rate) $2,000,000.00 Present worth of an annuity of $100,000 ($2,000,000 -^ 20) for 20 years at 6% =^ vafue of A's interest in 1920, or $1,146,992.10 But, for purposes of depletion deductions allowable to A in the years 1920-1940 for the 2,000,000 tons, the value would be re- stricted to the March i, 1913, value thereof, determined as above to be $ 190,703.78 In valuing his equity at March i, 191 3, the lessor is justi- fied in assuming that at the end of the lease not then terminated new rates will be effective and that the new rates will be as much higher relatively as the March i, 191 3, rates exceed the rates in existing leases. As stated by an authority : In the case of term leases, .... the value of the property should be calculated, taking into consideration the probable going royalty of the region at the time of release or renewal, rather than calculating for the entire life of the property, at the royalty of the lease, which will probably be far lower than the new royalty ob- tainable.®^ Bonus in addition to royalties. — Regulation, (a) Where a lessor receives a bonus or other sum in addition to royalties, such bonus or other sum shall be re- garded as a return of capital to the lessor, but only to the extent of the amount remaining to be recovered through depletion by tlie lessor at the date of lease. If the bonus exceeds the amount remaining to be recovered, the excess and all the royalties thereafter received will be income and not depletablc. If the bonus is less than the amount re- maining to be recovered by the lessor through depletion, the differ- ence may be recovered through depletion deductions based on the royalties thereafter received to the extent that such deductions are legally allowable. The bonus or other sum paid by the lessee for a lease made on or after March i, 1913, will be his value for depletion as of date of acquisition (Art. 215.) " Calculated solely for the purpose of corroborating tlie conservative estimate of 25 cents per ton as of March i, 1913. "'R. V. Norris, discussion of L. C. Graton s paper, lu-deral 1 axaiion of Mines, page 43. 1222 DEDUCTIONS In a recent case one of the questions as to bonuses was : Where annual payments of large amounts in addition to stipulated royalties were made, could the receipt of such pay- ments be considered by the lessor as bonuses? Ruling Upon first reading, it would appear that the above-quoted article^'-' is controlling of the questions presented by this case. A careful examination discloses, however, that the term ''other sum" means a sum of money in the nature of a bonus which is paid for the delivery or assignment of a lease and does not relate to rental payments which are made for the purpose of continuing the occupa- tion and use of property. The annual cash payments in this case are not bonuses, or in the nature of bonuses, and therefore not within the meaning and spirit of said article 215(a). It is to be observed that throughout the lease instrument the an- nual cash payments are described and referred to as rentals and not as bonuses. It is to be further observed that the obligation on the part of the lessee to make these payments is independent of any mineral production. If no development work is done or operations performed, the obligation to pay these fixed amounts remains as long as the lease continues in force. Where no mineral is produced upon the premises it follows that the interest of the taxpayer in the mineral reserves is not affected and that no allowance can be made for de- pletion. Under such conditions to treat the annual payments of 50;?; dollars each as a return of capital would be the equivalent of making an allowance for depletion when no depletion has been sustained. In the same ruling the other cjuestion involved was whether the property leased, and for which bonus was received by the lessor, had value at March i, 1913, against which to apply the bonus payment. The payments under the aforesaid leases are unquestionably in the nature of bonuses, but before they can be treated as returns of capi- tal under article 215 it must be shown that the leased lands had a value for mineral purposes on March i, 1913. If the lands had no value for such purposes on that date, then there would be no capital remaining to be recovered through allowances for depletion. There would be nothing against which a depletion deduction could be taken. The ascertainment of values is a function of the Natural Resources subdivision of the Income Tax Unit and it has already determined that this property had no value for mineral purposes on that date and as far as it appears it has no such value today. The land lies "Art. 215 (a). FOR DEPLETION 1223 outside of the producing area and no evidence has been submitted which indicates any mineral vakie. It is, therefore, the opinion of this office that the 18 i/^-v dollars paid by the aforesaid lessees upon the execution and delivery of the leases should be treated as income .... (I-5-56; A. R. M. 148.) The ruling states that the property "has no value today." The lessees paid a considerable sum, apparently for the oppor- tunity to explore the property, which must have seemed valu- able to them. Similarly, at March i, 191 3, other persons may have considered the property to have prospective value. One of the tests is what a prospective lessee would pay. Restoration of bonus written off. — Regulation ((/) Upon the expiration, termination or al'andonment of a lease, without the removal of any or all of the min- eral contemplated by the lease, the lessor shall be required to restore to capital account so much of the bonus received and deducted from the amount returnable through depletion as is in excess of the actual de- pletion or loss in value sustained as a result of the operations under the lease and the corresponding amount will be income for the year in which the lease expires, terminates, or is abandoned. (Art. 215.) Apportionment of depletion between lessor and LESSEE. — The following comment on the allocation of deple- tion between lessor and lessee is of interest.^" The clause requiring the lessor and lessee "to equitably appor- tion the allowances on the basis of their respective interests," is per- fectly just, but quite impracticable in application. From long experi- ence in the relations of lessor and lessee it seems most improbable that such apportionment could be made except through the action of the courts, or of some commission having the necessary authority. It seems wise not to attempt the apportionment required but to value the interests of lessor and lessee separately, using recognized methods of valuation. The two estates of lessor and lessee in the case of royalty "leases" of natural resources are essentially separate. That such a "lease" is a sale of mineral in place has been repeatedly decided by the Supreme Court of Pennsylvania— 31 Pa. 475; 105 Pa. 469-472; 94 Pa. 15; 109 Pa. 583; 123 Pa. 240; 144 Pa. 613; 143 Pa. 293; 240 Pa. 234; etc. "R. V. Norris, The Taxdlion of Income front IVastinn .Issels. 1224 DEDUCTIONS Depletion allowance to lessee. — The 192 1 and 1918 laws fully recognize that leases are property and may be revalued as of March i, 19 13, such value to be returned to the lessee through depletion charges without any tax being levied. This point is settled by the specific provision that "the taxpayer's in- terest" in *'the fair market value of the property" acquired prior to March i, 1913, is the basis of the deductions per- mitted. In the opinion of the author lessees have always had the same rights and privileges, in regard to depletion, as were accorded to owners under the 191 3 and 191 6 laws.^^ Regulation, (a) In the case of a lessee, the amount remaining in any year returnable through depletion and depreciation deductions is (i) the value as of the basic date of the lessee's equity in the property plus (2) subsequent allowable capital additions but minus (3) depletion and depreciation sustained, whether legally allowable or not, from the basic date to the taxable year and the residual value of other property at the end of operations. The amount returnable through depletion is the total capital remaining less the sum recov- erable through depreciation. (b) The value of the equities of lessor and lessee shall be com- puted separately, but, when determined as of the same basic date, shall together never exceed the value at that date of the property in fee simple. (c) The value of a lessee's equity, if acquired prior to March i, 1913, is the value of his interest in the mineral as of that date. (d) The value of a lessee's equity in a proven mineral property acquired on or after March i, 19 13, is its cost. (e) The value of a lessee's equity in a discovery on or after ''For former procedure and criticism of regulations and rulings, see In- come Tax Procedure, 1918, pages 409-410, and Income Tax Procedure, 1919, pages 611-613. The following ruling in 1920 is based upon Regulations 33, many articles of which have been overruled: Ruling Article 171 of Regulations 33, revised, provides that : "The deduction in the case of a lessee [of a mine] will be limited to an amount equal to the capital actually invested in the lease, without regard to value as of March i, 1913, or any other date." .... It is therefore held that where a corporation, organized for the purpose, takes over a mining lease, issuing its entire capital stock to the indi- vidual owners of the lease in the proportion of their respective interests therein the "capital actually invested in the lease," for the purpose of the deductions allowed by section 12 (a) of the Act of September 8, 1916, is the fair market value of the stock so issued. (C. B. 2, page 145; O. 1033.) FOR DEPLETION 1225 March i, 1913, is the fair market value at date of discovery or within thirty days thereafter, of his equity in the mineral discovered. (Art. 203.) In a recent decision'- the court held : Decision. The question of law presented for decision is whether or not the plaintiff is entitled to deduct a reasonable allowance for depletion of iron ore from the gross amount of its receipts from all sources in order to determine the net income subject to tax. The answer to this question turns on the true meaning of section 12 of the Revenue Act of September 18, 1916. The government's conten- tion is that the deduction authorized by the second subdivision of this section is allowable only to an operating owner of an ore mine and not to an operating lessee under a lease of the character stated I have carefully examined all of the cases decided under the corporation tax act of 1909 and under the several income tax acts and have also carefully studied the several provisions of these sev- eral acts so far as they relate to this question. My conclusion is that the operating lessee is entitled to the deduction as claimed. Upon appeal to the Circuit Court of Appeals, Sixth Cir- cuit, the district court was reversed. A careful reading of the opinions of the two courts indicates that the district court decided the case on its merits, while the circuit court depended almost entirely on the decision in the Bi\val)ik case.'"' Not only did that case arise under the 1909 law (which did not provide specifically for depletion) but in referring to it the court said: Decision the nature of the interest held by the lessee was not such as to permit it to claim the allowance, but ... . the contingencies which attended the character of the lessee's interest barred it from claiming that its capital assets had been diminished. The circuit court also said : Decision In the Biwabik case, the lessee was not heard to say that his capital assets had been consumed by his mining opera- tions, and we interpret that decision as resting in an essential degree on the idea that the nature of the lessee's title forbade him to make this claim. We cannot read the decisions of the Supreme Court as "Mohazvk Mining Co. v. IVciss, Collector. U. S. Dist. Court, Nortlicrn District of Ohio, Eastern Division (November 3, 1919) ; rt.'vcrscd June 15, 1920 (264 Fed. 502). Writ of certiorari denied by Supreme Court, October 18, 1920 (254 U. S. 637)-. ,., ,,. . ^. „ „ , "United Stales v. Bmahik Mnnng Co., 247 U. b. iiO. 1226 DEDUCTIONS having determined that the exhaustion of ore reserves is so inherently a business loss, rather than an impairment of capital, that a statutory grant of the right to deduct for depletion on that account will reach a case which has been adjudged not to involve the diminution of capital assets. We think the substantial principles established by the decisions are that both the royalty received by the fee owner and the sums received by the operating lessee above the cost of operation are income; that the statutory reduction for "depletion" cannot be twice credited, once to the fee owner, and once to the lessee ; and that the exemption belongs of right to the fee owner. It is difficult to infer from the foregoing that a lessee is not entitled under the 1916 law to depletion of the March i, 19 1 3, value. The special circumstances of the case seem to have been a factor in the decision. The conclusion that an allowance for diminution of capital value after March i, 191 3, accrues solely to the owner or lessor, even though the royalties or rentals thereafter are fixed, is not logical. It would mean in many cases that the lessor could claim depletion equal to the gross royalties or rent collected. The synopsis of the decision appearing on page 208 of the report of the Commissioner of Internal Revenue for 1920 is not as complete as it should be. ]-50NU.S DEDUCTIBLE BY LESSEE THROUGH DEPLETION. Ruling. Under an option to purchase or so-called "bond and lease" agreement, providing for the payment of royalties on ore mined and for the payment at stated times of the amounts necessary to bring the total amounts paid to certain specified sums, and giving an option to the purchaser to take title to the property upon the pay- ment of a specified amount upon which the royalties and deficiency payments are credited as part of the purchase price, the amounts paid as royalties constitute operating expenses and are deductible as such in determining net income. The additional sums paid to make up the amounts of the several installments when due are capital investments in the nature of bonuses recoverable through deduction for depletion, computed upon the total sum of such additional payments to the end of the tax year. Where, as in this case, the option is forfeited, the capital sum re- maining to be recovered is deductible as depletion in the return for the vear in which the forfeiture occurs (C. B. 4, page 138; Sol.' Op. 86.) FOR DEPLETION 1227 Lease as distinguished from sale. — Mining "leases" some- times partake of the nature of a sale of the ore in place, and before a determination of the depletion deduction it may be necessary to ascertain whether or not the contract constitutes one a lessee. In the foregoing ruling (Sohcitor's Opinion 86) the Solicitor, referring to the option to purchase or so-called "bond and lease," quotes :^* It is often difficult in a given instance to find a technically correct legal name for the contract employed, for it may possess some of the characteristics of two or more well-defined classes. What is more important, however, from a practical standpoint is to ascertain from the contract what are the respective rights of the contracting parties. In another case involving the construction of timber con- tracts, the Treasury ruled that the contracts conveying title to timber cut and removed from the property constituted leases and not sales of the standing timber."'^ Depletion sustained but not allowed under previous laws. — As heretofore stated,'" the income tax laws of 1913 and 1916 imposed limitations upon the deduction for depletion. Ruling. The amount recoverable by a taxpayer without liability to tax under the War Revenue Act of 1918, either by way of deduction for depletion or of the return of capital upon the sale of the property, is the cost of the property, its fair market value at March i, 1913, or within 30 days after discovery, as the^case may be, minus the amount of depletion (based upon the same cost or value) actually sustained prior to January i, 1918, whether or not all of such amount has been allowed for the purpose of computing net income under earlier income tax laws. (C. B. i, page 141; T. B. R. 4.) The foregoing ruling has not been sustained by the courts and good authorities doubt if it will be sustained. It is argued that the 19 18 law requires that the capital to be returned free of tax is cost or value March i, 19 13, and that the depletion which was not deductible cannot be considered, otherwise part ""Lindlay on Mines, sections 859 fa) and 861. '"C. B. 4, page 201; A. R. M. iil. ''See page 1169. 1228 DEDUCTIONS of the cost or value March i, 191 3, will be taxed. The fol- lowing ruling is cited as a precedent : Ruling. Inasmuch as no deduction for depreciation of the per- sonal residence of a taxpayer is allowable in his income tax returns, a taxpayer in determining the gain or loss arising from the sale of his personal residence, continuously occupied by him as such, is not required to reduce the cost of the property or its fair market value as at March i, 1913, by the depreciation sustained. (C. B. 3, page 46; 0. D. 600.) Development costs. — Development costs, as heretofore, may be added to capital investment and charged off there- after as a part of depreciation or depletion, or if the items can be held to be proper operating costs they may be omitted from the annual deduction and charged direct to maintenance. To the cost of the fee or the lease for the purposes of depletion there may be added in the case of both owner and lessee, "the cost of subsequent improvements and develop- ment not charged to current operating expenses." Oil and gas operators (as distinguished from mines) have the option of charging as expense or of capitalizing major items, such as cost of drilling wells." Depletion basis for discoverers. — The 192 1 law continues the provision first found in the 19 18 law which, in effect, per- mits the original discoverer of a mine or an oil well to set up the market value of a new discovery as a basis for depletion charges, when the discovery is after March i, 19 13, and irre- spective of cost, provided the cost is materially disproportion- ate to the value.^® It has been assumed by some that the statement in the law, to the effect that as to all discoveries on and after March 1, 191 3, the discoverer shall get back the market value through depletion, justifies amended returns for prior years so that the depletion charge shall commence in the year of discovery. " See page 11 07. "Sections 214 (a-io) and 234 (a-9). For mines, see page 1194. For oil and gas wells, see page 1205. FOR DEPLETION 1 229 The author does not so interpret the law. There is no doubt about the right of a discoverer to charge depletion on the basis of value instead of on cost, but it was hardly the intention of Congress to permit the increased depletion charge before January i, 19 18. There is no doubt, however, of the right to revalue at any time after March i, 1913. If a discoverer paid $1,000 for unproven acreage in 191 5, and discovered oil thereon worth $1,000,000, he would be entitled to charge depletion up to January i, 19 18, on only the $1,000. Commencing January i, 19 18, he may charge depletion on the $1,000,000 revaluation. While depletion deductions from income for the years prior to 19.18 would be based on cost ($1,000), the depletion sustained from date of discovery (1915) would be computed on the basis of the discovery value ($1,000,000). The deple- tion not allowed as a deduction prior to 19 18 would represent realized appreciation. Not having been charged against in- come, it would be reflected in surplus. After January i, 19 18, the depletion based on the excess of discovery value over cost, representing appreciation realized, would be included in in- vested capital.'^® Discovery value under lea.se from government. — Ruling. Where a taxpayer made claim under the placer mining laws to public land, which was withdrawn by Executive order prior to completion of valid location (and prior to A'lar. i, 1913), and later (subsequent to Mar. i, 1913) operated the land under agreement with the Secretary of the Interior, or lease from the Government, he is not entitled to a depletion deduction based upon the value of his claim as of March i, 1913, but, under the provisions of the Revenue Act of 1918, he is entitled to a depletion deduction based upon the discovery value as to discoveries made subsequent to the acquisition of the lease or leases from the Government. (B. 36-21-1801 ; Sol. Op. 118.) Advance royalties — depletion basis. — Leases of mineral lands frequently provide that minimum royalties must be paid '" See Appendix A, Chapter X. 1230 DEDUCTIONS in advance, irrespective of mining operations. The question arises as to whether a lessor should be entitled to claim an allowance for depletion as directly chargeable against the royalty receipts, or whether he should be entitled to the de- duction only if and when it can be shown that the number of units for which a deduction is claimed have been removed from the ground. If the lessee fails to remove the stipulated quantity within the period mentioned in the lease or for other causes, the lessor may repossess the property. In such case he will find himself in the embarrassing position of having claimed a deduction covering the removal of a given number of units, whereas his property is intact or a less quantity has been extracted than has been claimed. So much for the gov- ernment's side. If the lessor receives advance royalty payments during one period, and cannot claim an allowance for depletion until some subsequent period when proof can be offered to support the claim, it may be that the tax on the royalties reported as gross income will be at a higher rate than when the deduction is permitted. Or it may be that in the subsequent period the re- ceipts will be small and the allowable deductions larger than the gross receipts. The matter is important if graduated tax rates are involved. So much for the taxpayer's side. In the regulations the Treasury takes a liberal attitude. Owners in receipt of royalties must report royalties as tax- able income but are permitted to deduct depletion even though there has been no extraction during the taxable year. It is, however, provided that if the deductions are found to be un- warranted because the minerals were not really taken out, upon repossession the amount theretofore claimed for de- pletion must be returned as income for the year when the property is repossessed. The actual effect of this might be the imposition of an extremely large tax for one year. It would be more equitable if amended returns were permitted. FOR DEPLETION 1231 Dividends declared out of depletion reserves. — Certain mining companies have paid dividends which have been de- clared to be out of depletion reserves instead of earned surplus. For a discussion of this practice, see page 743.^° Depletion basis when resources are unworkable within reasonable period. — The usual rule is that depletion charges represent the book value of the quantity mined at the per unit value, established by dividing the cost or the March i, 191 3, value, by the entire estimated contents of the mine. This rule works well in all cases when the life of a mine is short. In practice it works well also when the life of a mine is not short because it is not customary to include in the aggregate contents of a mine the ore or coal which cannot be mined with- in a reasonable time. Otherwise the owner of a mine would receive credit for an insufficient depletion charge during the early years of operation. The reason is that, in effect, nothing is paid for the ore or coal in the ground which cannot be reached by ordinary mining methods within a reasonable number of years. If the regulations were litPrally followed it Vvould result inequitably and would not return the capital of the owner or lessor as the law provides. A copper or anthracite mine might have an estimated life of 100 years, but no sane purchaser would tie up any of his capital for 100 years. The fair market value of mining prop- erty is based on the possible (or probable) extraction of the mineral content during, say, 20 or 30 years or more, depend- ing on the circumstances of each case; and this aggregate quantity if determined by careful estimates is the proper amount by which the cost or value of the mine should be divided to ascertain the per unit cost for depletion purposes. '" [Former Procedure] Regulation If dividends arc paid out of a depletion or depre- ciation reserve, the stockholders must be expressly notified that the dividend is a return of capital and not an ordinary dividend out of profits (Art. 216, prior to amendment by T. D. 3107, flattd December 29, ujM.) 1232 DEDUCTIONS Engineers who have given much thought to this subject sug- gest that the maximum be 45 years. Appraisals of oil and gas wells in the United States at the present time rarely show a maximum life of more than twenty years. If all future and prospective extraction were to be con- sidered as an element of the calculation it would be necessary to include as a factor the question of interest on capital. In other words, if the entire possible contents of a mine were to be used as a divisor it would be necessary to compute the depletion charge on a sliding scale. It might be that the total contents of a mine would be estimated at 1,000,000 tons. If the cost or value at March i, 191 3, were $100,000, the theo- retical depletion charge would be 10 cents a ton, but if part of the contents could not be extracted for 50 years it would be evident that the purchaser did not pay 10 cents a ton for that part of the contents which w'ould not be mined for 40 or 50 years. The capital invested was intended to cover only the extraction during a period which warranted an investment. If the capital were spread over a period longer than twenty or thirty years, the owner would expect in some way to be recompensed for the use of long time capital investment through the equivalent of an interest return. The simplest method of handling a case of this sort would be to segregate any part of the estimated contents not re- movable within a profitable period, and, if it represented any capital investment, such part of the asset should be carried to a separate account designated as investment not subject to depletion. If that part of the property were opened subse- quently, depletion charges would commence as if it were a new property. The investment in the mine which the owner knows will be operated and expects to have repaid through depletion charges would then appear at cost or March i, 1913, value; and the resulting book value of .the investment divided by the quantity removable within a reasonable time would give the unit value for depletion purposes. FOR DEPLETION 1233 It may be urged that at the end of each year a certain quantity of mineral has been extracted, but its place is taken, in effect, by an equal quantity which at the end of the year has in point of time been moved forward from just outside the period to just inside the period. So year by year the de- pletion is made good by other mineral covered by the original purchase. If this line of reasoning were sound no depletion should be allowed. But the reasoning is not sound. In most cases in which the extent of the deposits is known at the time of purchase there is a definite distinction drawn as to the value after a certain number of years, and there is the expectation that the cost of mining after a certain period will be too great to meet the competition of more fa- vorably situated deposits. Irl such cases the postponement of the depletion charge would be unfair. If the later costs of mining, due to the depth of the deposit, for instance, were far greater than the earlier costs, it is conceivable that there would be no margin to cover high enough depletion in the aggregate to return the entire capital invested. The court decisions establish the principle that the capital invested in specific property represents the amount which must be returned to the taxpayer free from the tax. Therefore, if it were shown that at the time of purchase there was a specific amount of capital invested in a specific tonnage, the purchaser would be entitled to a return of such investment in the way of depletion charges, irrespective of additional tonnage which at the beginning may have been undeveloped and in ef- fect is not reflected in any capital investment whatever. Furthermore the quantity of mineral to be extracted after, say, thirty to forty years is always uncertain. If additional quantity becomes valuable or realizable while the quantity workable within a reasonable period is being extracted it is in effect appreciation and is not taxable until actually realized. Then, too, when it is realized the entire net recovery will be taxable as the book investment will have been written off. Appreciation in land values is not allowed to offset depre- ciation in the value of Imildings. (Sec page 1050.) 1234 DEDUCTIONS Timber-Forest Industries While the principles underlying the valuation of the natural resource and the computation of the depletion allowance are in general the same for timber as for mines and for oil and gas wells, there is a very important difference in that the "dis- covery value" provision^^ of sections 214 (a-io) and 234 (a-9) does not apply to timber. There are, of course, other differences in the details of the computations because of the different physical characteristics of timber as compared with minerals. Regulations in regard to forest industries are comprehen- sive and are reproduced in full except when the provisions are the same as for mines, etc. The Treasury has issued a questionnaire (form T) con- sisting of 36 pages which should be in the hands of all who are interested in the valuation or taxation of forest industries." Depletion of timber. — Regulation. A reasonable deduction from gross income for the depletion of timber and for the depreciation of improvements is per- mitted, based (a) upon cost if acquired after February 28, 1913, or (b) upon the fair market value as of March i, 1913, if acquired prior thereto. The essence of this provision is that the owner of timber property, whether it be a leasehold or a freehold, shall secure through an aggregate of annual depletion and depreciation deductions a re- turn of the amount of capital invested by him in the property, or in lieu thereof an amount equal to its fair market value as of March i, 1913, plus in any case the subsequent cost of plant, equipment, and development which is not chargeable to current operating expenses, but not including cut-over land values. (Art. 227.) Computation of allowance for depletion of tim- ber. — Regulation. The allowance for depletion of timber in any taxable year shall be based upon the number of units of timber felled during the year and the unit value of the timber in the timber account or accounts, pertaining to the timber cut. The unit value of the " See pages 1228-1229. '■ Form T (Timber), 7 pages, is another schedule which must be filed with the return. FOR DEPLETION I235 timber for a given timber account in a given year shall be the quotient obtained by dividing (a) the total number of units of timber on hand in the given account at the beginning of the year plus the number of units acquired during the year plus (or minus) the number of units required to be added (or deducted) by way of correcting the estimate of the number of units remaining available in the account into (b) the total fair market value as of March i, 1913, and (or) cost of the timber on hand at the beginning of the year, plus the cost of the number of units acquired during the year, plus proper additions to capital. (See art. 231.) The amount of the deduction for depletion in any taxable year with respect to a given timber account shall be the product of (a) the number of units of timber cut from the given account during the year multiplied by (b) the unit value of the timber for the given account for the year. Those taxpayers who keep their accounts on a monthly basis may, at their option, keep their depletion accounts on a monthly basis, in which case the amount deductible on account of depletion for a given month will be determined in the manner outlined above for a given year. The total amount of the deduction for depletion in any taxable year shall be the sum of the amounts deductible for the several timber accounts. For description of timber accounts see articles 235 and 236. The depletion of timber takes place at the time the timber is felled.*^ Since, however, it is not ordinarily practicable to determine the quantity of timber immediately after felling, depletion for pur- poses of accounting will be treated as taking place at the time when, in the process of exploitation, the quantity of timber is first definitely determined. (Art. 229.) Revaluation of stumpage, after March i, 1913, not al- lowed. — Regulation. In the case of timber acquired prior to March i, 1913, the fair market value as of that date shall, when determined and approved by the Commissioner, be the basis for determining the depletion deduction for each year during the continuance of the ownership under which the fair market value of the timber was fixed, and during such ownership there shall be no redetermination of the fair market value of the timber for such purpose. However, the unit market (or cost) value of the timber will subsequently be changed if from any cause such unit market (or cost) value, if continued as a basis of depletion, shall upon evidence satisfactory to the Commis- sioner be found inadequate or excessive for the extinguishment of ^^ Computing depiction on the basis of timber felled may be compared with the requirement of Art. 210, in the case of mines, that it be calculated on the number of units sold or produced. 1236 DEDUCTIONS the cost, or fair market value as of March i, 1913, of the timber. (Art. 230.) Revaluations based on discoveries after March i, 19 13, are not permitted as in the case of mines and oil wells. Charges to capital and expense of timber proper- ties. — The subject of the proper division of expenditures as between capital and expense items is treated in the chapter on Depreciation, pages 1119-1121. Evidence required to support depletion charges. — Regulation. To the income tax return of the taxpayer claiming a deduction for depletion or depreciation or both there shall be attached a map and statement (Form T-Timber) for the taxable year covered by the income tax return. Form T-Timber requires the following: (a) Map showing timber and land acquired, timber cut, and timber and land sold; (b) description of, cost of, and terms of purchase or lease of, timber and land acquired; (c) proof of profit or loss from sale of capital assets; (d) description of timber with respect to which claim for loss, if any, is made; (e) record of timber cut; (f) changes in each timber account as the result of purchase, sale, cutting, reestimate, or loss; (g) changes in physical property accounts as the result of additions to or deductions from capital and depreciation; (h) operation data with respect to raw and finished material handled and inventoried; (i) unit production costs, and (j) any other data which will be helpful in determining the reasonable- ness of the depletion and (or) depreciation deductions claimed in the return. Similar information is required for certain years prior to the 1919 taxable year from those taxpayers who have not already fur- nished it. The specific nature of the information required for the earlier years is given in detail in Form T — General forest industries questionnaire for the years prior to 1919. (Art. 233.) Determination of interest of taxpayer. — The law^* provides that the depletion is to be based on the taxpayer's interest in the property. Therefore, it is necessary to deter- mine first what that interest is, as appears from the following : Ruling. Where a lumber company in good faith purchased lands from a railroad company in violation of the grant of the lands to the railroad under an Act of Congress and subsequently, under a subse- Sections 214 (a-io) and 234 (a-9). FOR DEPLETION 1237 quent Act of Congress, compromised the litigation wliich had been instituted by the United States to declare a forfeiture of said lands by reason of the violation of the provisos of the grant, it did not thereby purchase complete title from the Government but only such title or interest as remained in the United States, nor did it relinquish whatever right, title, or interest it had acquired from the railroad company. By proceeding under the Act of Congress the parties compromised and adjusted their differences and the title of the lumber company to the lands was perfected and confirmed. On March i, 1913, after proceedings had been instituted under the Act of Congress to compromise the litigation between the United States and the so-called innocent purchasers, but prior to the issuance of patents for the land involved and tlie making of final payments therefor, the said purchasers had such an interest in the lands as would entitle them to an allowance for depletion. The value of that interest on the basic date was the value of the land less the amount paid to the United States as provided by the Act. (B. 46-21-1921 ; Sol. Op. 124.) Determination of fair market value of timber. — Regulation. Where the fair market value of the property at a specified date, in lieu of the cost thereof, is the basis for depletion and depreciation deductions, such value shall be determined, subject to approval or revision by the Commissioner upon audit, by the owner of the property in the light of the most reliable and accurate informa- tion available with reference to the condition of the property as it existed at that date, regardless of all subsequent changes, such as changes in surrounding circumstances, in methods of exploitation, in degree of utilization, etc. The value sought will be the selling price, assuming a transfer between a willing seller and a willing buyer as of the particular date. Such factors as the following will be given due consideration: (a) Character and quality of the timber as deter- mined by species, age, size, condition, etc.; (b) the quantity of timber per acre, the total quantity under consideration, and the location of the timber in question with reference to other timber; (c) accessi- bility of the timber (location with reference to distance from a com- mon carrier, the topography and other features of the ground upon which the timber stands and over which it must be transported in process of exploitation, the probable cost of exploitation, and the cli- mate and the state of industrial development of the locality) ; and (d) the freight rates by common carrier to important markets. The timber in question will be valued on its own merits, and not on the basis of general averages for regions ; however, the value placed upon it, taking into consideration such factors as those mentioned above, will be consistent with that of the other timber in the region. The Com-' 1238 DEDUCTIONS missioner will give due weight and consideration to any and all facts and evidences, having a bearing on the market value, such as cost, actual sales and transfers of similar properties, the margin between the cost of production and the price realized for timber products, market value of stock or shares, royalties and rentals, value fixed by the owner for the purpose of the capital stock tax, valuation for local or State taxation, partnership accountings, records of litigation in which the value of the property has been involved, the amount at which the property may have been inventoried and (or) appraised in probate or similar proceedings, disinterested appraisals by approved methods, and other factors. For depletion purposes the fair market value at a specified date shall not include any part of the value of the land. (Art. 234.) The regulation states that the timber will be "valued on its own merits, and not on the basis of general averages for regions." In the case of some companies owning many tracts containing a variety of grades and species, and where it has been the well-settled practice for sales and purchases to be made on the basis of a general average for a particular section, the courts would probably sustain valuations made on such basis by those having experience enough to qualify as experts. Revaluation affecting lessee. — Ruling. A licensee of Crown Land Limits in the Province of Quebec, Canada, is to be regarded as a lessee for tax purposes and is not entitled to deduct depletion based upon the value of the timber as of March i, 1913 (C. B. 3, page 178; L. O. 1055.) The leases in question, however, were terminable in one year. For the distinction between a lease and a sale of timber, see Chapter XV. Determination of quantity of timber. — Regulation. Each taxpayer claiming or expecting to claim a deduction for depletion is required to estimate with respect to each separate timber account the total units (feet board-measure log scale, cords, or other units) of timber reasonably known or on good evi- dence believed to have existed on the ground on March i, 1913, or on the date of acquisition of the property, as the case may be. This estimate shall state as nearly as possible the number of units which would have been found present by a careful estimate made on the FOR DEPLETION 1239 specified date with the object of determining 100 per cent of the quantity of timber which the area would have produced on that date if all of the merchantable timber had been cut and utilized in accord- ance with the standards of utilization prevailing in that region at that time. If subsequently during the ownership of the taxpayer making the return, as the net result of the growth of the timber, of changes in standards of utilization, of losses not otherwise accounted for, of abandonment of timber, and/or of errors in the original esti- mates, there are found to remain on the ground, available for utiliza- tion, more or less units of timber than remain in the timber account or accounts, a new estimate of the recoverable units of timber (but not of the cost or the fair market value at a specified date) shall be made, and, when made, shall thereafter constitute a basis for deple- tion. (Art. 235.) Timber accounts. — Regulation. With a view to logical and reasonable valuation of timber, the taxpayer shall include his timber in one or more accounts. In general, each such account shall include all of the taxpayer's timber which is located in one '"block," a block being an operation unit which includes all of the taxpayer's timber which would logically go to a single given point of manufacture. In those cases in which the point of manufacture is at a considerable distance, or in which the logs or other products will probably be sold in a log or other market, the block may be a logging unit which includes all of the taxpayer's timber which would logically be removed by a single logging devel- opment. In exceptional cases, provided there are good and substan- tial reasons, and subject to approval or revision by the Commissioner on audit, the taxpayer may divide the timber in a given block into two or more accounts, e. g., timber owned on February 28, 1913, and that purchased subsequently may be kept in separate accounts, or timber owned on February 28, 1913, and the timber purchased since that date in several distinct transactions may be kept in several distinct accounts, or individual tree species or groups of tree species may be carried in distinct accounts, or special timber products may be carried in distinct accounts, or blocks may be divided into two or more accounts based on the character of the timber and (or) its accessi- bility, or scattered tracts may be included in separate accounts. When such a division is made, a proper portion of the total value, or cost, as the case may be, shall be allocated to each account. The timber accounts mentioned in the preceding paragraph shall not include any part of the value or cost, as the case may be, of the land. In a manner similar to that prescribed in the foregoing part of this article the land in a given "block" may be carried in a single land account or may be divided into two or more accounts 1240 DEDUCTIONS on the basis of its character and (or) accessibility. When such a division is made, a proper portion of the total value or cost, as the case may be, will be allocated to each account. The total value or total cost, as the case may be, of land and timber shall be equitably allocated to the timber and land accounts, respectively. Each of the several land and timber accounts carried on the books of the taxpayer shall be definitely described as to their location on the ground either by maps or by legal descriptions. For good and substantial reasons to be approved by the Com- missioner, or as required by the Commissioner, the timber or the land accounts may be readjusted by dividing individual accounts, by combining two or more accounts, or by dividing and recombining accounts. (Art. 236.) Depletion and depreciation accounts on books. — Since the requirements are practically the same as for mineral prop- erty,^^ the regulation for timber is omitted. ^"^ "Art. 216; see page 214. *'Art. 237. CHAPTER XXXIV DEDUCTIONS FOR CONTRIBUTIONS, DONATIONS, GIFTS AND SUBSCRIPTIONS The 1 92 1 law substantially re-enacts the provisions of the 1918 law regarding gifts and contributions. Individuals are permitted to deduct contributions made to certain classes of organizations up to 15 per cent of their net income. The scope of the new law has been widened to in- clude organizations not included in the 19 18 law. Partnerships may deduct from gross income such dona- tions as are in the nature of business expenses, any others being prorated among the members and deducted in their indi- vidual returns. Corporations have never been permitted to include gifts, as such, among their deductible expenses. There may be some merit in the argument which has been advanced that Congress did not give corporations the same status in respect to gifts which it has given to individuals because it felt it could not impliedly condone the wholesale giving away of stockholders' property by boards of directors; but the with- holding from corporations of the privilege of deducting gifts does not prevent the making of so-called gifts which are deemed to be for the benefit of the business and which con- stitute ordinary and necessary expenses. Gifts by individuals deductible within limitations. — Law. Section 214. (a) That in computing net income there shall be allowed as deductions: .... (11) Contributions or gifts made within the taxable year to or for the use of: (A) The United States, any State, Territory, or any political subdivision thereof, or the District of Columbia, for ex- clusively public purposes; (B) any corporation, or community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, including posts 1241 1242 DEDUCTIONS of the American Legion or the Women's Auxiliary units thereof, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual; or (C) the special fund for vocational rehabilitation authorized by section 7 of the Vocational Rehabilitation Act; to an amount which in all the above cases combined does not exceed 15 per centum of the taxpayer's net income as computed without the benefit of this paragraph. In case of a nonresident alien individual this de- duction shall be allowed only as to contributions or gifts made to do- mestic corporations, or to community chests, funds, or foundations, created in the United States, or to such vocational rehabilitation fund. Such contributions or gifts shall be allowable as deductions only if verified under rules and regulations prescribed by the Commissioner, with the approval of the Secretary ;i .... Gifts to United States, states, municipalities, etc., deduc- tible. — The deduction of this type of gift is new. The pro- vision of the law is restrictive in the sense that contributions of such nature must be for exclusively public purposes. A taxpayer who makes a donation to the United States or a poli- tical subdivision thereof, which meets the test of being for the general good of the public, may deduct in his tax return such expenditures up to the 15 per cent limit. The policy of permitting deductions for gifts is sound and will be of benefit to the United States and political subdivi- sions thereof. Ordinarily when public improvements are made under the direction of public officials,, the cost thereof is as- sessed to taxpayers in the form of municipal taxes. Such '^ [Former Procedure]. The 1917 law included the words "associa- tions" and "societies" as recipients. No mention of the rehabilitation act nor of non-resident aliens was made. No deductions for gifts were permitted before the passage of the 1917 law. Form 1040 (revised, 1918) erroneously limited the base upon which the allowance could be computed by eliminating the amount of dividends received in 1917, applicable to earnings of prior years. Subsequently the error was discovered and corrected. (Telegram to A. Iselin & Co., from Commissioner Roper, February 27, 1918.) The author's attention has been called to the fact that many taxpayers followed the original form and failed to obtain the credit to which they were en- titled. If the correction of the error has not been called to the atten- tion of taxpayers who erroneously failed to add to the total income shown on line M of the return the dividends applicable to prior years, claim can be made for the amount of tax overpaid and refund se- cured. FOR GIFTS AND DONATIONS 1243 taxes are deductible in an individual's return. If public im- provements are the gift of an individual citizen they are similar in some respects to taxes, in that the public receives benefit therefrom, and it is only reasonable that a limited de- duction should be permitted, as is now provided in the present tax law. The rules for valuing and reporting such gifts as pre- scribed by the Treasury must be adhered to." Gift to city for park purposes. — Regulation A gift of real estate to a city to be main- tained perpetually as a public park is an allowable deduction under the present statute, but was not an allowable deduction under tlie Revenue Act of 1918 (Art. 251.) Gifts to be deductible must be made to public association. — The law is not designed to cover private charity, such as assistance afforded to a needy relative or dependent; but the wording of the law is broad enough to include all contribu- tions to churches and other recognized agencies, which in turn dispense aid to the needy. Ruling. Contributions which may be deducted in computing the net income of an individual taxpayer include not only donations to incorporated institutions, but those given to similar associations which are not incorporated. Contributions to war chest funds, war camp community funds, and similar funds which were raised solely for organizations supporting and furthering war rehef, are likewise de- ductible items on personal returns, within the limit named in tlie law. All gifts and donations to churches are deductible, it being held by the Bureau that every church constitutes a religious corporation or association for the purpose of this deduction. Donations to mis- sionary funds, church building funds, or for church activities, which are intended for the furtherance of church work, constitute deductible items (Statement by Bureau of Internal Revenue, February 28, 1919.) The 192 1 law specifically includes the terms "fund, or foundation," which broadens the class of organizations em- '" See page 1247. 1244 . DEDUCTIONS braced under this section of the law. Posts of the American Legion or Women's Auxiliary units thereof are now speci- fically included within this section. The deductibility of such gifts will depend largely on the taxable status of the recipient organization. If no part of the contributed receipts inures to the benefit of any particular individual or individuals and it can be shown that the organi- zation comes within the contemplation of the law, the amounts donated are deductible up to the limit specified. Many such organizations have realized that the tax laws have operated in a peculiar manner to their benefit. They are in a position to receive relatively larger amounts as gifts than the expenditure represents to the donor, the difference being the amount "saved" under this section of the law. In other words, the organization receives the tax which the govern- ment would have received had the donation not been made. This condition will continue as long as the high surtax rates are in force. Treasury's rulings holding gifts deductible. — The Treas- ury has passed upon a large number of cases involving gifts. Donations to the following organizations have been held to be gifts within the 15 per cent limitation provided by section 214 (a;-ii) : a memorial association which is organized for the purpose of erecting by public contributions a monu- ment and building within which will be established and main- tained a museum as a depository of the records, flags, litera- ture and trophies of the late war, as well as a forum to be utilized for educational lectures and meetings, and educational in its nature and purpose;^ an association incorporated under the laws of Porto Rico for the purpose of soliciting and obtaining donations to be used in reconstruction work and for charitable purposes in portions of Porto Rico devastated by ' C. B. 3, page 188; A. R. R. 301 ; overruling B. 35-20-1170; O. D. 649. While this ruling appears to conflict with an earlier opinion of the Solicitor appearing in C. B. 2, page 149; S. 1246, no specific reference is made to this opinion. FOR GIFTS AND DONATIONS 1245 earthquake and tidal wave;* a committee constituted by law which has control of funds to be used for the pensioning of members of a municipal police force ;^ an association organ- ized and operated exclusively for the purpose of giving musical concerts, the programs being of an educational character, and no part of the net earnings under its charter inuring to the benefit of any private stockholder or individual;*^ a board of education of a school district which has been incorporated by the laws of a state ;^ and the Council of National Defense which was established by the Army Appropriation Act of August 29, 1916.^ The Treasury has also held that pew rents and so-called assessments and dues paid to churches'' and a contribution of money toward the cost of an article presented by the con- tributors to a corporation organized exclusively for educa- tional purposes, are deductible.^" Treasury's rulings holding gifts not deductible. — Dona- tions, however, to the following! organizations have been held not to be deductible within the 15 per cent limitation provided by section 214 (a-il) : a family cemetery corpora- tion organized under the laws of the state of New York;^^ a public high school, if the funds were to be used for athletic purposes ;^^ a memorial fund established, not to engage in a charitable undertaking itself, but which distributes its income to charitable institutions and to worthy individuals];^^ and contributions to make good the deficit of a club engaged in recreational as well as educational activities ;^'* the National Dry ' C. B. I, page 151 'C. B. I, page 148 'C. B. I, page 147 ' C. B. I, page 146 *C. B. I, page 145 ° C. B. I, page 150 '" C. B. 2, page 152 " C. B. I, page 151 '-'C. B. I, page 151 " C. B. 4, page 264 "C. B. 4, page 203 O. D. 345. S. 1202. S. I 176. S. 1052. S. 992. A. R. M. 2. O. D. 46s. O. D. 217. O. D. 126. O. D. 872. A. R. R. ZT). 1246 DEDUCTIONS Federation ;^'' an association engaged in disseminating propa- ganda to encourage the passage of labor legislation.^^ The Treasury has also held that contributions by citizens of a city to a fund raised for the purpose of inducing an industrial plant to establish itself in their city/' and contribu- tions to a trust company (a corporation) in trust to invest and disburse them for a charitable purpose are not allowable deductions under section 214 (a-i i ) ." Premiums on life insurance policy deductible as a gift — when? — Ruling. Premiums paid on a life insurance policy are allowable deductions from gross income when the beneficiary is a charitable corporation exempt from tax, provided the beneficiary named can not be changed at the option of the insured and the sum of the annual premium plus other allowable charitable contributions does not exceed 15 per cent of the taxpayer's net income. (C. B. i, page 151 ; O. D. 299.) Pledges — when deductible. — The deduction evidently is limited to contributions "made" and does not include sub- scriptions or promises to pay in the future. A subscription may constitute a legal liability and properly so appear among other accrued and unpaid liabilities; but a reasonable interpretation of the law seems to be that contributions which are "made" are strictly limited to those which have been paid in property, cash or notes, or other evidences of debt which the beneficiaries can reasonably convert into cash or hold as a suitable invest- ment. Procedure in reporting gifts. — Regulation In connection with claims for this deduc- tion there shall be stated on returns of income the name and address of each organization to which a gift was made and the approximate date and the amount of the gift in each case (Art. 251.) "C. B. I, page 150; O. D. 44. "C. B. 2, page 162; S. 1362. " C. B. I, page 150; O. D. 39. "C. B, I, page 187; O. D. 669. FOR GIFTS AND DONATIONS 1247 Under the law much is left to the good faith of the tax- payer. It is not enough, however, to make a wild guess at one's total contributions for the year. An accurate record must be kept to form a basis for the report required by the regulations. If this is done, such gifts as plate collections will be permitted. Rule for valuing gifts. — Regulation Where the gift is other than money the basis for calculation of the amount of the gift shall be the cost of the property, if acquired after February 28, 1913, or its fair market value as of March i, 1913, if acquired prior thereto, after deducting from such cost or value the amount of depreciation sustained and allowable as a deduction in computing net income ^^ (Art. 251-) The foregoing regulation places the valuation of gifts on a proper basis. The provision regarding depreciation would seem to mean that if a taxpayer donates an office building which cost $100,000 in 19 16 and no depreciation has subse- quently been claimed (as it could have been) and the depre- ciated value at date of gift is $80,000, the latter amount is to be used as a deduction. If a residence which cost $100,000 in 1916 is donated, credit may be taken for $100,000, because depreciation since 19 16 could not have been deducted. If the foregoing is a correct inference the author doubts the validity of permitting deductions exceeding in amount the value of the property donated at the date of gift. Individual credits for partnership gifts. — Gifts, such as contributions to the Red Cross, are not deductible by corpora- "• [Former Procedure] In an early edition of Regulations 45, this sentence of the article read as follows : "Where the gift is other than money, the basis for calculation of the amount of the gift shall be the fair market value of the property at the time given." As was pointed out in the 1920 edition of this book, the foregoing ruling permitted allowable deductions in excess of an equitable allowance. Ff)r a detailed criticism of this article as it originally appeared, see Income Tax Procedure, 1920, pages 560-562. 1248 DEDUCTIONS tions for either income or excess profits tax purposes.^" In the case of the partnership, however, donations not deductible as business expenses "may be prorated among the individual members of the partnership for the purpose of their individual income tax returns, as contributions or gifts," subject to the 15 per cent limitation. ^^ Article 251 specifically provides for deduction by partners: Regulation The proportionate share of contributions made by a partnership may be claimed as deductions in the personal returns of the partners to an amount which, added to the amount of such contributions made by the partner individually, is not in excess of i'5 per cent of the partner's net income computed without the benefit of the deduction for such contributions; but the contributions made by the partnership shall not be deducted from its gross income in ascertaining the amount of its net income to be reported on Form 1065 (Art. 251.) The distinction between gifts and business expenses. — So-called gifts often business expenses. — It has been pointed out that for the most part expenditures termed "Christ- mas gifts" are, as a matter of fact, merely remuneration to the employee and properly deductible as a business expense to the employer. The same thing may be said of many payments variously characterized as gifts, donations, gratuities,'^ sub- " [Former Procedure] The author has always contended that part- nerships were permitted under the 1917 law to deduct contributions, since section 206 of the 1917 law provided that "there shall be allowed (a) in the case of a domestic partnership the same deductions as allowed to indi- viduals in subdivision (a) of section 5." The deduction resulted in a con- siderable saving in excess profits tax. The Treasury formerly disallowed 1917 contributions by partnerships, but the author's contention has been upheld by the Committee on Appeals and Review in B. 45-21-1914. " Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated May 23, 1918. "A gratuity is a free gift, voluntarily given, for which the giver re- ceives no valuable or legal consideration It is not a charge against profits or surplus because it is not an expense or loss incurred in the opera- tions, transactions, management or administration of a business. The giver acquires absolutely nothing; he does not liquidate a liability. The giving of it merely causes a depletion of assets resulting from a withdrawal of undivided profits or surplus. "Possibly under peculiar conditions the giver receives consideration in the nature of advertising. In such a case it is correct to consider the disbursement a charge against advertising, but it should not be called a gratuity." (Joseph Robinson, Journal of Accountancy, November, 1918.) FOR GIFTS AND DONATIONS 1249 scriptions, contributions, etc. In the past little attempt has been made to distinguish one class of payment from another. Certainly most payments so designated have not been dis- tributions of profit in the usual and accepted meaning of that term. Almost without exception such itehis are charged to some expense account and are treated as ordinary and nec- essary expenses of doing business. The Treasury's attitude toward the question of the de- ductibility of such items is shown in the following regulation : Regulation. Corporations are not entitled to deduct from gross income charitable or other contributions which individuals may de- duct under paragraph (11) of section 214 (a). Donations made by a corporation for purposes connected with the operation of its busi- ness, however, when limited to charitable institutions, hospitals, or educational institutions conducted for the benefit of its employees or their dependents, are a proper deduction as ordinary and necessary expenses. Donations which legitimately represent a consideration for a benefit flowing directly to the corporation as an incident of its business are allowable deductions from gross income. For example, a street railway corporatio;i may donate a sum of money to an or- ganization intending to hold a convention in the city in which it operates, with the reasonable expectation that the holding of such convention will augment its income through a greater number of people using the cars. Sums of money expended for lobbying pur- poses, the promotion or defeat of legislation, the exploitation of propaganda, including advertising other than trade advertising, and contributions for campaign expenses, are not deductible from gross income. (Art. 562.) _3 The first sentence of the foregoing article is new. This regulation is in one particular even more rigid than those which were in force some time ago. Under it, donations to be deductible must legitimately represent expenditure for a benefit "flowing directly to the corporation." T. D. 2090, in force until 19 18, used the language "flowing directly or indirec- ly to the corporation." The example of the street railway dona- tion, however, indicates that the Treasury may be willing to allow deductions for expenditures made in the hope or ex- pectation that they will cause some benefit to flow "directly to the corporation." The attitude of the Treasury in the past 1250 DEDUCTIONS has seemed to exclude all expenditures which did not actually result in a "consideration moving in some form" to the cor- poration. ~^ The distinction between an expenditure which was allowable and one which was not turned apparently on the result of such payment rather than on the intention of the payer. Business, of course, could not be conducted on these principles, because vast expenditures must often be made in the expectation that due consideration will "move" to those who pay the money — but it does not always move. A "bank" donated a certain amount through a chamber of commerce for the purpose of inducing a railroad company to extend its tracks into the town in which it is located. It was held that the donation does not constitute an allowable deduc- tion because "donations of the character stated are not ordin- ary and necessary expenses incident to carrying on a banking business" and that there is no "consideration for a benefit flow- ing directly to the contributing banks.'"-* It is to be hoped that the courts will at an early date pass upon the distinction between expenses which taxpayers think are proper and those which are held by the Treasury to be gifts without consideration, llie Treasury in its attitude at- tacks the good faith and judgment of corporate directors. It is not likely that the courts will take a similar attitude. Let the taxpayer ask himself this question: "Was the ex- penditure made to further my business interests?" If it can be answered in the affirmative, it is an allowable deduction as intended by the law. This whole question is relatively unimportant, but the author has seen personally, and has heard of, so many cases where the only criticisms which have been made by income tax inspectors have concerned items of this nature that it seems desirable to dwell upon it at some length. Business men who are trying to be honest with the government do not like to be told that they erroneously included donations among their ex- T. D. 2090, December 14, 1914. ' 1-3-35 ; I- T. 1 169. FOR GIFTS AND DONATIONS 1251 penses, and that these donations were distributions of profit. The taxpayer knows that they were not. They are, he con- siders, properly to be classified as necessary expenses, and he is justly annoyed. The author suggests the abandonment of all these terms (gifts, donations, subscriptions, contributions, etc.) in books of account. Instead, open a new account, "Payments out of profits not deductible in income tax return." Charge to this account all items which are actually gifts, distributions of profit — that is, where there is no consideration moving in some form to the payer. Then in the regular expense accounts in- clude all payments which are made in the regular order of the business for the good of business, and do not call them gifts, but describe them properly. If this is done, it is not likely that any inspector will criticize the distribution so long as it is made in good faith and without intent to evade the just tax." Donations by corporations."*' — Article 562, which is largely a repetition of former regu- lations, states that "donations which legitimately represent " [British Practice] In Great Britain "donations," technically speaking, are not deductible. But payments in the nature of dona- tions are sometimes deductible. For instance, "where .... sub- scriptions are paid by a manufacturer to an infirmary — where any of his work people might be sent if injured — such subscriptions are allow- able as a deduction, the payment being looked upon as a trade expense." (Murray and Carter, A Guide to Income Tax Practice (8th edition), page 155)- When no direct benefit can be read into the subscriptions, they arc regarded as disposals of profit and are not deductible. "" [Former Procedure] Regulation Expenses incurred in advertising and promoting the sale of Liberty bonds and war savings stamps over the corporation's name are deductible (Reg. 45, Art. 562.) Ruling. Where a corporation in order to promote the sale of war sav- ings stamps to its employees donates a thrift stamp with each war savings stamp purchased, the amount expended by the corporation in purchasing the stamps so donated is an expense incurred in advertising and promoting the sale of war savings stamps over the name of the corporation and hence deductible from gross income under the provisions of article 562 of Regula- tions 45. (C. B. 3, page 266; O. D. 682.) The provision that the expenses for jiromoting the sale of Liberty bonds are deductible exix;nscs was hardly in line with the Treasury's atti- tude in the past. 1252 DEDUCTIONS a consideration for a benefit flowing directly to the corpora- tion as an incident of its business are allowable deductions from gross income." It must be assumed, therefore, that expenses incurred in advertising the sale of Liberty bonds heretofore permitted as a deduction entail some measure of benefit flowing to the corporation. At the same time the regulations do not permit as deductions gifts to the Red Cross, Y. M. C. A., or other similar purposes. Ruling. Donations made by a corporation to a Young Men's Christian Association located on its property and operated for the benefit of the employees of such corporation are not deductible as or- dinary and necessary business expenses. (B. Digest 31-21-1757; O. D. 986.) If benefits running to the corporation can be identified with gifts such as those mentioned in the foregoing ruling, the deductions should be allowed as "necessary" expenses. Ruling. Even though the entire stock of a corporation is owned within a single family, such corporation is not entitled under the provisions of the Revenue Act of 1918 to deduct from gross income donations made to the American Red Cross, United War Workers, Liberty loan drives, or the Salvation Army. (C. B. 4, page 291; A. R. R- 373-) It would seem that a corporation would reap quite as much benefit by making a contribution to the Red Cross as if it spent a large amount of money in advertising Liberty bonds. In the opinion of the author, Congress did not intend that a cor- poration should be permitted to deduct donations such as are mentioned above, and it cannot be expected that the law will be so administered. The allowance for Liberty bond expenses is probably a matter of expediency rather than a change in policy. It has been stated that when a taxpayer sent a cheque to federal reserve banks or elsewhere to pay part or all of a charge for advertising Liberty bonds and the advertisement failed to mention the donor's name, the amount expended has been disallowed. The author is of the opinion that, if there is any warrant at all in the law for the expense, the advertiser FOR GIFTS AND DONATIONS 1253 whose name did not appear can claim the deduction as a neces- sary business expense to the same extent as if the name ap- peared. Donations to Red Cross and other war activities. — The question as to the deductibiHty, by corporations, of dona- tions to the Red Cross has arisen so often that the Treasury in a lengthy decision reiterated its position that such con- tributions are not deductible." During 1921, reference has again been made to this sub- ject in the following: Ruling. In order to obviate the necessity of filing amended re- turns on the prescribed forms for the year 1918, corporations which, prior to the issuance of Treasury Decision 2847, filed their completed returns and erroneously claimed therein deductions on account of contributions to the Red Cross and other recognized war organizations, are required to file with the Collector of Internal Revenue within 30 days from the date of this decision a supplemental return in the form of a statement under oath showing the amount of such deductions claimed, the amount of net income as reported and as corrected, and the amount of additional tax due. Payment of the total amount of additional tax shown to be due by such supplemental return must also be made within 30 days. In cases where this procedure is followed, formal amended returns will not be required and the supplemental returns referred to when received by this office through the collector's office will be filed with the original returns. Where in connection with any return for the year 1918 an audit of the books of the corporation has been made by the Department and the amount of such contributions disclosed, the statement herein provided for need not be made. Failure by a corporation to file a supplemental return as required will subject it to the penalties provided by section 3176, United States Revised Statutes. (B. 36-21-1807; T. D. 3215.) Donations by agricultural corporations to fairs, ETC. Ruling. A corporation engaged in agricultural business cannot be allowed to make a deduction from gross income on account of donations to fairs, churches and associations, such donations being For te.xt of regulation, sec Income Tax Procedure, 1920, pages 566-567. 1254 DEDUCTIONS made for the purpose of obtaining and preserving the goodwill of the farmers who raise crops for it, since the amounts so expended are clearly in the nature of gratuities and are not necessary expenses of operation and maintenance, as there is no such consideration in this case as is contemplated in T. D. 2090. (Letter from Acting Commis- sioner of Internal Revenue, June 25, 1914.) If followed literally, this decision would deprive some corporations of the right to claim advertising as an allowable deduction. Many public service corporations advertise to re- tain customers' goodwill rather than to seek new business. Fortunately for corporations, questions as to what are and are not expenses necessary to obtain and retain the goodwill of customers will not be ultimately decided by the Commis- sioner of Internal Revenue but by the courts. Until such de- cision, corporations should continue to deduct all those ex- penses necessary properly to maintain their businesses. This, in the opinion of the author, is in accordance with the law and with common sense. "Treating money" an expense^ not a gift. — Regulation. So-called "spending or treating money" actually advanced by corporations to their traveling salesmen, to be used by them as a part of the expense incident to selling the product of such corporations, is an allowable deduction in a return of income by such corporation. The deduction of such expenditures is conditioned upon a satisfactory showing that all the allowance claimed as a deduction was actually expended for and was an ordinary and usual expense incurred in selling the product or merchandise of the corporation. (Reg. 33, 1918, Art. 133. )'« Gifts of merchandise. — Probably every retailer is re- quested to make gifts to charitable and religious organizations. Usually the solicitor is a good customer and the donation is made. The author has never heard it seriously contended that gifts of this nature w^ere other than expenses of doing business, as, of course, they are; and they should be so treated in preparing income tax returns. The Treasury in a certain T. D. 2090, December 14, 1914. FOR GIFTS AND DONATIONS 1255 case ruled that they are not allowable deductions. Corpora- tions, as a rule, do not make payments representing "mere gratuities," but expect and receive some consideration for expenditures of a quasi-charitable nature. As soon as the courts pass on the word "expenses" as used in the law, all items of this nature will no doubt loe found to be deductible. PART IV SPECIAL CLASSES OF TAXPAYERS CHAPTER XXXV TAX ON UNDISTRIBUTED PROFITS OF CORPORATIONS Congress has adopted two methods in the course of its attempts to prevent corporations from defeating the purpose of the income tax laws by the simple device of refraining from distributing their earnings. Until the earnings have been dis- tributed as dividends and, consequently, have become subject to the surtax rates in the hands of the individual stockholders the demands of the tax have not been fully met. The first method of forcing distributions in cases in which they are de- liberately withheld makes the entire profits "taxable to indi- vidual stockholders" and is directed at holding companies or "close" corporations which may refrain from distributing earnings because corporations are not subject to the surtax imposed upon individuals. An attempt is made to tax the indi- vidual stockholder as if the earnings were actually distributed, thus collecting the surtax. This method under the 1913, 1 9 16 and 191 8 laws failed in its object. It is rumored that the tax has been imposed in a few cases. The author has been unable to learn the details of a single case. The second method levies an additional tax on undistrib- uted earnings. It does not attempt to collect a surtax from stockholders, but imposes an additional flat rate tax on the corporation itself. The 191 7 law which imposed this tax may be said to have been a failure.^ The 1921 law may be more successful. ' [Former Procedure] Every time the question of a new tax on undis- tributed profits arises, apprehension is felt that prior or accumulated surplus is to be taxed. In the opinion of the author there is and has been no justi- fication for such apprehension. In 1917, when the 1916 law was being amended. Senator Jones proposed 1259 i26o SPECIAL CLASSES OF TAXPAYERS Evasion of surtaxes by incorporation. — Law. Section 220. That if any corporation, however created or organized, is formed or availed of for the purpose of preventing the im- position of the surtax upon its stockholders or members through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 25 per centum of the amount thereof, which shall be in addi- tion to the tax imposed by section 230 of this title and shall be com- puted, collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalities, as that tax: Provided, That if all the stockholders or members of such corpora- tion agree thereto, the Commissioner may, in lieu of all income, war- profits and excess-profits taxes imposed upon the corporation for the taxable year, tax the stockholders or members of such corporation upon their distributive shares in the net income of the corporation for an amendment imposing an additional tax of 15 per cent on all surplus of the taxable year undistributed sixty days after the end of the taxable year. There was no thought of retroactively taxing accumulated surplus of prior years. When the amendment was proposed every member of the Finance Committee, but one, voted for it. (Congressional Record, Septem- ber 10, 1917, page 7469.) Subsequently they voted against it and the amend- ment was not adopted. For text of previous laws and full discussion thereof, see Income Tax Procedure, 1919, pages 617-624; and 1920, pages 963-974. What has occurred in tlie past is only of academic interest. The Treasury admitted that section 220 of the 1918 law was difficult to administer. In Notes on the Revenue Act of 191S, the Secretary of the Treasury said : "The corporate form of organization is now used or abused by wealthy individuals who incorporate their personal business and investments and thus escape surtaxes upon that amount of their income which is reinvested or saved. Section 220 provides a remedy for this abuse, but it can be applied only by a troublesome special procedure which will necessarily restrict its use to a comparatively small proportion of cases." In the stock dividend case (Eisner v. Macombcr, 252 U. S. 189), the Supreme Court decided in effect that under an income tax law, stockholders could not be taxed unless they received or realized actual income. The 1918 law attempted to impose a tax upon individual stockholders, not upon corporations. The tax would be levied against stockholders on earnings not distributed and would therefore appear to be unconstitutional. The author does not know of any case in which such an assessment has been made, and as the Treasury since the stock dividend decision is in doubt about the legality of the section, the practical effect of the 1918 law docs not seem to be serious. UNDISTRIBUTED CORPORATE PROFITS 1261 the taxable year in the same manner as provided in subdivision (a) of section 218 in the case of members of a partnership. The fact that any corporation is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the busi- ness, shall be prima facie evidence of a purpose to escape the surtax; but the fact that the gains and profits are in any case permitted to ac- cumulate and become surplus shall not be construed as evidence of a purpose to escape the tax in such case unless the Commissioner cer- tifies that in his opinion such accumulation is unreasonable for the pur- poses of the business. When requested by the Commissioner, or any collector, every corporation shall forvirard to him a correct statement of such gains and profits and the names and addresses of the indi- viduals or shareholders who would be entitled to the same if divided or distributed, and of the amounts that would be payable to each. Regulation. Where a domestic or foreign corporation permits its gains and profits to accumulate for the purpose of preventing the imposition of the surtax upon such income if distributed to its stock- holders, it shall be subject to an income tax at 25 per cent in addition to the taxes imposed by section 230 of the statute. If, however, all the stockholders agree thereto, the Commissioner may, in lieu of all income, war-profits and excess-profits taxes imposed upon the cor- poration for the taxable year, tax them upon their distributive shares in the net income of the corporation for the taxable year as provided in subdivision (a) of section 218, in the case of members of a part- nership. In any case the Commissioner or a collector may require a corporation to furnish a statement of its gains and profits and of the names, addresses, and shareholding of the stockholders, and of the amounts that would be payable to each. (Art. 351.) Accumulation of earnings to be taxable must be with pur- pose of evasion. — Regulation. Section 220 of the statute applies where a cor- poration is formed or availed of for the purpose of preventing the im- position of the surtax upon its stockholders or members by permitting its gains and profits to accumulate instead of being divided or distri- buted. Prima facie evidence of a purpose to escape the surtax exists where a corporation has practically no business except holding stocks, securities or other property and collecting the income therefrom, or where a corporation other than a mere hold- ing company permits its gains and profits to accumulate beyond the reasonable needs of the business. The business of a corporation is not limited to that which it has previously carried on, but in general includes any line of business which it may legitimately undertake. However, a radical change of business when a considerable surplus has been accumulated may afford evidence of a purpose to escape 1262 SPECIAL CLASSES OF TAXPAYERS the surtax. When one corporation ovns the stock of another cor- poration in the same or a related line of business and in effect operates the other corporation, the business of the latter may be considered in substance the business of the first corporation. Gains and profits of the first corporation put into the second through the purchase of stock or otherwise may therefore, if a subsidiary relationship is es- tablished, constitute employment of the income in its own business. To establish that the business of one corporation can be regarded as including the business of another it is ordinarily essential that the first corporation own substantially all of the stock of the second. In- vestment by a corporation of its income in stock and securities of another corporation is not without anything further to be regarded as employment of the income in its business. (Art 352.) A corporation could pay ofif all its debts, add to its plant and inventories, expand in similar ways and retain substantial cash working capital without being subject to tax upon its undistributed earnings. Accumulation of earnings to be taxable must be unreason- able in amount. — Regulation. An accumulation of gains and profits is unreason- able if it is not required for the purposes of the business, considering all the circumstances of the case. No attempt can be made to enum- erate all the ways in which gains and profits of a corporation may be ■ accumulated for the reasonable needs of the business. Undistributed income is properly accumulated if invested in increased inventor- ies or additions to plant reasonably needed by the business. It is properly accumulated if retained for working capital required by the business or in accordance with contract obligations placed to the credit of a sinking fund for the purpose of retiring bonds issued by the corporation. In the case of a banking institution the business of which is to receive and loan money, using capital, surplus and de- posits for that purpose, undistributed income actually represented by loans or reasonably retained for future loans is not accumulated be- yond the reasonable needs of the business. The nature of the invest- ment of gains and profits is immaterial if they are not in fact needed in the business. (Art. 353.) When investment companies, such as those formed by in- dividuals and estates, invest their surplus funds in market- able securities, such as Liberty bonds, and do not pay reason- able cash dividends, an intention to relieve stockholders from surtax may be inferred. When the investments are in the UNDISTRIBUTED CORPORATE PROFITS 1263 securities of closely held corporations, in real estate or other property which is not readily marketable, and when it is nec- essary similarly to reinvest the accruing surplus in the same properties, the element of evasion is palpably absent. The section became effective November 23, 192 1, and does not affect surplus or earnings accumulated prior to that date. Pen- alty sections, unlike others, never take effect retroactively. If prior to November 23, 1921, surplus was available and was not distributed, the penalties for failure to distribute are found in the abortive provision of the 19 18 law. It can hardly be held that the 1921 law has any retroactive effect. Penalty sections cannot be enforced until after due notice has been given. In all cases where no good reason exists for the accumula- tion of earnings subsequent to November 23, 1921, dividends corresponding closely to the realized earnings should be de- clared. It is fortunate for corporations that the word "reason- able" is in the law. A corporation may refrain from distribut- ing its profits, even if it has no debts, if there is a reasonable present need for the profits in the business or a prospective need within the reasonably near future. Conservative cor- porations accumulate large cash surplus whenever a profit- able year enables them to do so. The courts will not hold that distributions should be made to stockholders, if the di- rectors in good faith and after due consideration decide that the present or prospective needs of the business itself (which must be paramount) do not justify larger cash dividends than are being paid. Stockholders of properly conducted corporations need not be any more disturbed over the new law than over the old. However, if accumulated earnings remain undistributed solely to permit stockholders to escape the surtax, that purpose should be frustrated. The continued attempts of Congress and of the Treasury to formulate means of forcing distributions indicate that an attempt will be made to enforce the present law. 1264 SPECIAL CLASSES OF TAXPAYERS Ruling. The question as to the unreasonable accumulation of undivided profits is one of fact to be decided upon a consideration of the volume of business done and the principles of sound business management. The fact that a corporation having capital stock of lox dollars and doing an annual business in excess of 150X dollars has an accumulation of 55X dollars in undivided profits is not suffi- cient basis for finding that there has been an unreasonable accu- mulation of profits. (C. B. I, page 182; S. 1117.) Investment of accumulation in obligations of the United States no bar to action. — The test of ability to distribute Hes in the form of tlie assets. Investments in Liberty bonds, when no habilities present or prospective exist, constitute prima facie evidence of ability to distribute. Retirement of preferred stock. — The retirement or pur- chase of preferred stock would be a proper use of surpkis earnings and would not be deemed to be a method of prevent- ing the imposition of the surtax.' Reduction of common stock. — The purchase of common stock for the treasury or the retirement of common stock, with a consequent reduction of the aggregate stock outstanding or a reduction of the par value of each share, cannot in itself be deemed to be a method of preventing the imposition of the surtax. But if the common stock were purchased pro rata from stockholders at a large premium, it might be held that such purchase is in effect a distribution of surplus. If the surplus earned since March i, 191 3, had not been distributed, it could hardly be claimed that the premiinn paid on the com- mon stock is a distribution of capital surplus or surplus ac- cumulated prior to March i, 19 13. There may be exceptional cases in which the retirement " [Former Procedure] A ruling which directly related to this point was rendered under the 1916 law : Regulation (a) The earnings of a corporation used to pur- chase preferred stock for cancellation are retained for employment in the reasonable requirements of the business, and are therefore not taxable. (T. D. 2570, November 6, 1917.) UNDISTRIBUTED CORPORATE PROFITS 1265 of common stock would be deemed to be prima facie evidence that earnings were unlawfully accumulating. Ruling Inasmuch as a retirement of capital stock would indicate that additional capital was not required, any retirement of common stock, leaving the surplus stand, would be regarded by this office as making the corporation one coming within the provisions of Section 220 of the Revenue Act of 1918. (C. B. 2, page 25; O. D. 360.) Can proceeds of sale of capital assets be reinvested with- out subjecting stockholders to surtax? — Article 352 states that "a radical change of business when a considerable surplus has been accumulated may afford evidence of a purpose to escape the surtax." Many corporations sell all or part of their capital assets and receive in payment cash or marketable securities. The question arises, whether or not a corporation may invest or reinvest the proceeds of sale without subjecting the cor- poration to the 25 per cent tax. If a corporation is in the auto- mobile manufacturing business or holds stocks in other corpor- ations which are in that i)usiness and sells its manufacturing business or capital stocks for cash, and soon thereafter reinvests the proceeds in other automobile stocks or resumes the manu- facture of automobiles, such transactions do not constitute a radical change of business and its stockholders could not be taxed. If the corporation sells its assets and purchases gen- eral investment securities with the proceeds, such procedure involves a radical change in the business and it could hardly be maintained that the accumulated surplus is held for the "reasonable needs of the business." On the contrary it would be difficult to argue that a former manufacturing corporation with a large surplus, no assets except marketable securities and no debts, requires any surplus whatever. It is contrary to ordinary commercial methods for a busi- ness corporation to transform itself into an investment corpora- tion. When stockholders invest in manufacturing or trading corporations they hazard their money and expect returns com- 1266 SPECIAL CLASSES OF TAXPAYERS mensurate with the risks of the business. Stock in a bank or trust company usually is looked upon as less of a risk. Pur- chases of one or the other are made, but the author has never heard of an original purchase of one class of stock by a pur- chaser who expected that the corporation would transform itself into a concern of an entirely different kind. When a corporation does transform itself, a prima facie case is made out for the imposition of the 25 per cent tax. If corporation sells capital assets or accumulates funds in excess of its needs, how much of surplus must be divided? — If it is obvious or if it is admitted by a corporation that cash or marketable securities in hand are in excess of the needs of the business, the question arises as to what part of the accumulated surplus must be distributed. Ordinarily it cannot be assumed that the earnings of a current fiscal period can be segregated to any part of the period. Surplus earnings accumulated during the taxable year 1922, which are known to be available as soon as realization takes place, fall within the purview of the law. But the 192 1 law can reach only unlawful accumulations. Surplus which originated prior to November 23, 1921, if lawfully accumulated, cannot be taxed at the 25 per cent penalty rate. If unlawfully accumulated it must be taxed; if at all, under the penalty clauses contained in the 1913-1918 laws. The Treasury held that the 19 18 law did not apply to sur- plus accumulated prior to January 1,1918; that if any sur- plus was improperly accumulated prior to that date, the laws in force during the prior period are applicable thereto. Prior to November 2^), 192 1, unlawful accumulations could be taxed only as if the stockholders were partners. The attitude of the Treasury in enforcing the penalty clauses in former laws is fully set forth in one case^ in which the Secretary of the Treasury had certified that the undis- •C B. 4, page 227; A. R. R. 475. UNDISTRIBUTED CORPORATE PROFITS 1267 tribtited accumulations of profits were unreasonable. Upon appeal the following opinion was handed down : Ruling. The taxpayer contends that this is not a case where section 2. (A) 2 of the 1913 Act, section (3) of the 1916 Act and sec- tion (3) of the 1916 Act as amended, and section 220 of the 1918 Act should be appHed, for the reason that the M Company was not a mere holding company and did not permit its gains and profits to ac- cumulate beyond the reasonable needs of the business. In the ordinary and accepted sense, the term "holding company" means one which is not actively engaged in business and which does nothing but hold stock of other corporations. The M Company has been actively engaged in business since its organization and has con- sistently paid capital stock taxes. It is noted that the 1913 Act, quoted above, requires that the corporation must be formed for the purpose of preventing the imposition of the tax through the medium of permitting its gains and profits to accumulate instead of being di- vided or distributed, or must have been fraudulently availed of for that purpose before the Secretary of the Treasury is authorized to make the certification which has been made in this case. An examination of the facts leading up to the organization of this corporation, the consideration of the rate of dividends paid, and the amounts carried to surplus from year to year do not indicate to the Committee that the corporation was frandidently availed of for the purpose of preventing the imposition of the tax through the medium of permitting the gains and profits to accumulate instead of dividing or distributing such gains and profits. Therefore the Committee recommends that the action of the In- come Tax Unit in assessing additional taxes for the years 1913 to 1917, inclusive, was in error and that such action be reversed and that the claim filed for the refunding of taxes paid on account of such assessment receive favorable consideration. The Committee has accepted the Bureau's position with respect to the reasonable requirements of a business as outlined in Treasury Decision 2736. Applying the principle therein laid down to the facts in the instant case, it would appear that all the capital of the M Company which is invested in the capital stock of the N Company or which is used in making loans and otherwise financing such sub- sidiary is needed in the business of such company. The facts now submitted are materially different from those submitted to the Secre- tary of the Treasury at the time the certification in question was made. Upon the basis of this additional evidence the present Secre- tary of the Treasury signed a resolution recalling the former certi- fication in this case. The Committee is in full accord with this action. The effect of this resolution is to remove the presumption of fraud heretofore existing against the corporation. 1268 SPECIAL CLASSES OF TAXPAYERS It is strongly urged that any taxes assessable under the provisions of the revenue Acts quoted above are in the nature of a penalty, and in order that such assessment may properly be made fraud or fraudu- lent intent must be established. It is submitted in the instant case that the corporation in carrying to surplus a considerable part of its earnings yearly is doing nothing more than was contemplated under the provisions of its charter. It is also submitted that this corporation could not have been created for the purpose of permitting its earn- ings to accumulate, thereby preventing the imposition of tax on such earnings, for the reason that the corporation was organized in 1898. The mere fact that the corporation carried to surplus these earnings is not to be considered as a fraud upon the Government, bearing in mind always that the corporation is not a mere holding company, that it has considerable income from operations, rents, royalties, and from interest on money loaned and investments in bonds. The corporation has been conservative in carrying a con- siderable portion of its earnings to surplus, and the mere fact that such earnings were carried to surplus and that the corporation now has a large accumulated surplus does not of itself authorize the Income Tax Unit to assess a tax against the stockholders on their pro rata share of such earnings. The fact that the corporation in- creased its dividends and, having increased the dividends, continued to pay same even though the earnings of the corporation fluctuated from year to year, substantiates the view of the Committee that the corporation was not fraudulently availed of for the purpose of pre- venting the imposition of the tax through the medium of permitting the gains and profits to accumulate instead of distributing such gains and profits Election to be taxed as individuals. — The 1921 law pro- vides that if all stockholders agree, the corporation may be relieved of "all income, war-profits and excess-profits taxes" and the stockholders as individuals shall be taxed upon their distributive shares. The only apparent excuse for such an agreement would be the definite knowledge that the 25 per cent penalty tax is to be enforced. In such cases stockholders should agree. But the contingency can hardly arise in a busi- ness corporation, and if it appears to arise in other cases the proper procedure is to distribute current earnings as they ac- cumulate. CHAPTER XXXVI NQN-RESIDENT ALIENS The 192 1 law^ deals at greater length than prior laws with the determination of the gross income of non-resident aliens which is to be considered as income from sources within the United States." What is so considered may be summarized as follows : 1. Interest on bonds, notes or other interest-bearing ob- ligations of residents, corporate or otherwise.""' 2. Dividends from certain domestic and foreign corpora- tions.* . 3. Compensation for labor or personal services performed in the United States. 4. Rentals and royalties from United States sources. 5. Gains from sale of real property located in the United States. While the foregoing represents what is generally taxable income to a non-resident alien, there are various items not subject to tax which are specifically dealt with hereafter in this chapter.^ Of these exempt items, interest on deposits in banks located in the United States paid to persons not engaged in business within the United States is for the first time in- cluded in the 192 1 law. Considerable objection has been raised heretofore concerning the taxation of this interest and its ex- emption now will be as popular as it is equitable. Another * Section 217 for individuals. Section 233 (b) makes the classification in section 217 also applicable to the gross income of foreign corporations, except foreign insurance companies subject to the tax imposed by sec- tions 243 and 246. ^ For former procedure, sec Income Tax Procedure, 1921, page 975 et seq. ^ For exception relative to interest, sec page 1278. ' See page 1279. ^ See page 1284. 1269 1270 SPECIAL CLASSES OF TAXPAYERS new feature of the present statute is the exemption from tax- ation of interest received from a resident ahen individual or foreign corporations where less than 20 per cent of the gross income of the payor has, for the preceding three years, been derived from sources within the United States. From the taxable items constituting the gross income there may be deducted items of expense properly allocated to such income. Where the segregation of expenses against particular gains cannot be made, a proportionate part of the total ex- penses must be so allocated. In drafting the new- law, it was proposed to tax citizens or residents of the United States, domestic partnerships or do- mestic corporations, 80 per cent of whose gross income for the past three years w^as from sources without the United States, and 50 per cent of whose gross income for the past three years was from the active conduct of a business outside the United States, only on the income arising from sources within the United States as defined in section 217. In place of this proposal, the new^ law limits the privilege to citizens of the United States and to domestic corpora- tions.*^ Method of collecting the tax. — The collection of the tax may be made through two channels : 1. Withholding of normal tax at source. 2. Requirement of returns direct from taxpayer. Only in case (2) is a non-resident alien able to get the benefit of such deductions and credits as are allowed him by law, except that benefit of the $1,000 credit allowed by section ^ [Former Procedure] Ruling. "A corporation organized in the United States is subject to the 4 per cent war income tax imposed by section 4 of Title I of the Revenue Act of 1917, even though it has 'its principal office, keeps its accounts, and does all of its business in Porto Rico and derives all of its income from sources therein. Such a corporation should file its return in the internal revenue district where its principal office in the United States is located. "Law Opinion 303 (not in bulletin service) revoked." (C. B. 4, page 272; L. O. 1066.) NON-RESIDENT ALIENS 1271 216 (e) may be obtained by filing claim with the withholding agent. Definitions. — It is very important that taxpayers and those responsible for withholding appreciate the real significance of the following definitions. Law. Section 2 (4) The term "foreign" when applied to a corporation or partnership means created or organized outside the United States; (5) The term "United States" when used in a geographical sense includes only the States, the Territories of Alaska and Hawaii, and the District of Columbia; .... Foreign partnerships and resident foreign corpora- tions. — Regulation The nationality or residence of members of a partnership does not affect its status. A partnership created by articles entered into in San Francisco between residents of the United States and residents of China is a domestic partnership. A foreign corporation engaged in trade or business within the United States or having an office or place of business therein is sometimes referred to in the regulations as a resident foreign corporation and a foreign corporation not engaged in trade or business within the United States and not having any office or place of business therein as a nonresident foreign corporation (Art. 1509.) Non-resident alien individual. — Regulation. A "nonresident alien individual" means an indi- vidual (a) whose residence is not within the United States and (b) who is not a citizen of the United States. An alien actually present in the United States who is not a mere transient or sojourner is a resident of the United States for purposes of the income tax. Whether he is a transient or not is determined by his intentions with regard to the length and nature of his stay. A mere floating intention, indefinite as to time, to return to another country is not sufficient to constitute him a transient. If he lives in the United States and has no definite intention as to his stay, he is a resident. One who comes to the United States for a definite purpose which in its nature may be promptly accomplished is a transient; but if his purpose is of such a nature that an extended stay may be necessary for its accomplishment, and to that end the alien makes his home temporarily in the United States, he becomes a resident, though it may be his intention at all times to return to his domicile abroad 1272 SPECIAL CLASSES OF TAXPAYERS when the purpose for which he came has been consummated or abandoned (Art. 311.) Proof of residence of alien. — Regulation. The following rules of evidence shall govern in determining whether or not an alien within the United States has acquired residence therein within the meaning of the Revenue Act. An alien, by reason of his alienage, is presumed to be a nonresident alien. Such presumption may be overthrown (i) in the case of an alien who presents himself for determination of tax Hability prior to departure for his native country, by (a) proof that the alien, at least six months prior to the date he so presents himself, has filed a declaration of his intention to become a citizen of the United States under the Naturalization Laws, (b) proof that the alien, at least six months prior to the date he so presents himself, has filed Form 1078 or its equivalent, or (c) proof of acts and statements of the alien showing a definite intention to acquire residence in the United States or showing that his stay in the United States had been of such an extended nature as to constitute him a resident; (2) in other cases by (a) proof that the alien has filed a declaration of his in- tention to become a citizen of the United States under the naturaliza- tion laws, (b) proof that the alien has filed Form 1078 or its equivalent, or (c) proof of acts and statements of an alien show- ing a definite intention to acquire residence in the United States or showing that his stay in the United States has been of such an ex- tended nature as to constitute him a resident. In any case in which an alien seeks to overcome the presumption of nonresidence under (i) (c) or (2) (c) above, if the officer who examines the alien is in doubt as to the facts, such officer may, to assist him in determining the facts, require an affidavit or affidavits setting forth the facts relied upon, executed by some credible person or persons, other than the alien and members of his family, who have known the alien at least six months prior to the date of execution of the affidavit or affidavits. (Art. 312; Reg. 45, Art. 313.) Loss of residence by alien. — Regulation. An alien who has acquired residence in the United States retains his status as a resident until he abandons the same and actually departs from the United States. An intention to change his residence does not change his status as a resident alien to that of a nonresident alien. Thus an alien who has acquired a residence in the United States is taxable as a resident for the remainder of his stay in the United States. The status of an alien on the last day of his taxable year or period determines his liability to tax for such NON RESIDENT ALIENS 1273 year or period as a resident or nonresident (Art. 313; Reg. 45, Art. 314.) Determination of status of alien leaving the United States. — The status of an alien leaving the United States during the taxable year is determined by his status on the last day of his taxable period. Ruling The taxable period is the interval between January i and the last day of the month preceding his departure. If the alien had formed no intention of leaving the United States by such date he will be taxed as a resident alien. If, however, his intention to depart was formed prior to the last day of the month preceding departure, he will be taxed as a nonresident alien for such period. In either case the alien is entitled to the full exemption and credit for dependents that he would have been entitled to had his re- turn been filed for the full taxable year. If the absence of a resident alien is to be only temporary, he will not lose his status as resident by reason of such absence. (C. B. 2, page 243 ; O. D. 468.) Alien seaman — when to be regarded as resident. — Regulation. In order to determine whether an alien seaman is a resident within the meaning of the income-tax law, it is necessary to decide whether the presumption of nonresidence is overcome by facts showing that he has established a residence in the territorial United States, which consists of the States, the District of Columbia, and the Territories of Hawaii and Alaska, and excludes other places. Residence may be established on a vessel regularly engaged in coast- wise trade, but the mere fact that a sailor makes his home on a vessel flying the United States flag and engaged in foreign trade is not sufficient to establish residence in the United States, even though the vessel, while carrying on foreign trade, touches at American ports. An alien seaman may acquire an actual residence in the ter- ritorial United States within the rules laid down in article 312, al- though the nature of his calling requires him to be absent from the place where his residence is established for a long period. An alien seaman may acquire such a residence at a sailor's boarding house or hotel, but such a claim should be carefully scrutinized in order to make sure that such residence is bona fide. The filing of Form 1078 or taking out first-citizenship papers, is proof of residence in the United States from the time the form is filed or the papers taken out, unless rebutted by other evidence showing an intention to be a transient. The fact tliat a head tax has been paid on behalf of an alien seaman entering the United States is no evidence that he has acquired residence because the head tax is payable unless the alien who is entering the country is merely in transit through the country. 12/4 SPECIAL CLASSES OF TAXPAYERS An alien may remain a nonresident although he is not in transit through the country [Art. 311 (a).] It is apparent from the foregoing regulations that resi- dence for income tax purposes is a question both of intent and of fact. If an ahen Hves as long as one year within the United States, such fact is presumptive but not conclusive evi- dence as to residence.'^ Nevertheless, the pay-rolls of an em- ployer may be accepted as written evidence of an employee's continuous residence in the United States, thereby establish- ing his status as a resident alien, unless the employer knows that the employee does not intend to remain here permanently.* A member of a foreign partnership who is within the territorial limits of the United States seven or eight months of the year does not become a resident if his presence here is to complete business for his firm and if when that is accomplished he returns abroad.^ A non-resident alien who has served at least one year in the United States Army has been considered a resident for income tax purposes.^" It is necessary for a widow who was a citizen before her marriage to a non-resident alien to register as an American citizen with a United States consul within one year after the death of her husband if she would become a citizen instead of a non-resident alien for tax pur- poses. ^^ Members of the families of foreign ambassadors and attaches, secretaries and servants included in their suites, are held to have the status of non-resident aliens for tax pur- poses and are subject to taxation only as income from any business conducted by them in the United States. ^^ Non-resi- dent naturalized citizens who expatriate themselves but sub- sequently apply to an American consul for registration as American citizens, do not thereby become repatriated though their registration is accepted by the Department of State.^' ' C. B. I, page 164; O. D. 197. "Treasury Bulletin "B," page 13. ° C. B. 3, page 128; O. D. S92. '"C. B. I, page 163; O. D.' 117. "C. B. 2, page 59; O. D. 533. " I-1-5 ; T. D. 3266. "C. B. 4, page 59; O. D. 861. NON-RESIDENT ALIENS 1275 Duty of employer to determine status of alien employee. — .Regulation. If wages are paid to aliens without withholding the tax, except as permitted in article 315, the employer should be pre- pared to prove the status of the alien as provided in the foregoing articles. An employer may rely upon the evidence of residence af- forded by the fact that an alien has filed Form 1078 or an equivalent certificate of the alien establishing residence. An employer need not secure Form 1078 from the alien if he is satisfied that the alien is a resident alien. An employer who seeks to account for failure to withhold in the past, if he had not at the time secured Form 1078 or its equivalent, is permitted to prove the former status of the alien by any competent evidence. The written statement of the alien employee jnay ordinarily be relied upon by the employer as proof that the alien is a resident of the United States. (Art. 314.) Form 1078 — "Certificate of alien claiming residence in the United States." — The presumption of non-residence is over- come by obtaining from the ahen form 1078 (revised) or an equivalent certificate of alien claiming residence. Ordinarily this form should be executed before any officer duly authorized to administer oaths. Ruling However, if such an officer is not reasonably accessible, it will be accepted if signed in the presence of an officer of the employer company under whose supervision the employee's duties are performed, and one other credible witness. If the with- holding agent did not procure this form or its equivalent, at the time of payment, he may prove the former status of the alien by any material evidence. Execution of this form does not bind the alien to become a citizen or to reside here permanently. Furthermore, it will not be necessary to procure this certificate every taxable year. It is applicable to the year during which filed and subsequent years. The employer should keep a record of each Form 1078 filed. The forms should be sent to the Commissioner of Internal Revenue, Sort- ing Division, Washington, D. C, not later than the 20th of the month succeeding that during which the certificate was received. (Treasury Bulletin "B," page 14.)^* If form 1078 (revised) was not secured from an alien and the employer is required to account for failure to with- hold tax in the past, the employer is permitted to submit pay- " Pending further revision of form 1078 (revised January, 1920) in- formation regarding length of employment and amnnnt paid need not he supplied on tliis form. (B. 37-20-1194; O. D. 660.) 1276 SPECIAL CLASSES OF TAXPAYERS roll records as written evidence or proof of the status of the alien/^ Gross income defined. — The gross income of non-resident alien individuals" and foreign corporations^' is covered by the following statutory provisions and regulations : Law. Section 213 (c) In the case of a nonresident alien individual, gross income means only the gross income from sources within the United States, determined under the provisions of section 217. Regulation. In the case of nonresident alien individuals ''gross income" means only the gross income from sources within the United States, determined under the provisions of section 217 As to the gross income of foreign corporations see section 233 (b) of the statute and article 550; also section 217 The items of gross income from sources without the United States and therefore not taxable to nonresident aliens or foreign corporations are described in section 217 (c) .... (Art. 92.) The essential differences between the 192 1 law and the statute of 1918^^ are contained in section 217 of the former, which is referred to in the foregoing regulation. In so far as income is concerned the material changes are the e.vchision under specific conditions, of "Treasury Bulletin "B," page 13; see also Income Tax Procedure, 1920, page 818. '* Members of foreign partnerships are taxed in their individual capacity upon their respective shares of income of the partnership from sources within the United States. However, withholding is now required. See page 1306. " Under the Revenue Act of 1916 the Treasury ruled that foreign corporations, of the nature specified as being exempt from taxation, are in the tax-exempt class. There has been no subsequent ruling on this point, but the wording of the law would imply that such organizations are exempt from tax. '* [Former Procedure] The following definition of "gross income" obtained under the 1918 law : Regulation. "In the case of nonresident alien individuals 'gross in- come' means only the gross income from sources within the United States. This includes interest on bonds, notes or other interest-bearing obligations of residents, corporate or otherwise, dividends from resident corporations, amounts received representing profits on the manufacture or disposition of goods within the United States, rentals and royalties from property and income from business carried on in the United States, interest on deposits in banks located within the United States, income from capital otherwise invested in the United States, and income from services rendered or labor performed within the United States " (Reg. 45, 1918, Art. 91.) NON-RESIDENT ALIENS 1277 1. Interest on deposits with persons carrying on the banking business. 2. Interest received from resident alien individuals or resident foreign corporations when less than 20 per cent of the gross income of the payor, for the three preceding years, has been derived from sources within the United States. 3. Dividends from corporations entitled to the benefits of section 262. 4. Earnings derived from the operation of ships under circumstances defined in section 213 (b-8). The changes in the nature of additional inclusions are: 1. Dividends from foreign corporations 50 per cent or more of whose gross income for the three years preceding the declaration of such dividend was de- rived from sources within the United States. 2. Gains, profits and income from the sale^® of real prop- erty located in the United States. 3. Rentals and royalties are extended to embrace the use of, or privilege of using, in the United States, patents, copyrights, formulas, trademarks and other like property. Ruling. The profit derived by a nonresident alien author from the sale of all rights of serial publication in the United States in certain stories is not considered as income from a source within the United States and accordingly is not subject to withholding. (B. 32-21-1759; O. D. 988.) Law. Section 233 (b) In the case of a foreign corpo- ration, gross income means only gross income from sources within the United States, determined (except in the case of insurance com- panies subject to the tax imposed by section 243 or 246) in the manner provided in section 217. There is no difference in the computation of the gross in- "' Law. Section 217. "... (f) As used in this section the words 'sale' or 'sold' include 'exchange' or 'exchanged' ; and the word 'produced' includes 'created,' 'fabricated,' 'manufactured,' 'extracted,' 'processed,' 'cured,' or aged,' . . . . " 1278 SPECIAL CLASSES OF TAXPAYERS come of foreign corporations and non-resident alien individ- uals. Both are governed by section 217 of the statute. Regulation. The gross income of a foreign corporation, includ- ing a mutual insurance company, means its gross income from sources within the United States, as defined and described in section 217 and articles 316-328 relating to nonresident alien individuals. .... (Art. 550.) Income of Non-resident Alien Individuals or of Citizens Entitled to Benefit of Section 262 Section 213 (c)"° defines gross income as that determin- able under section 217, which has two main divisions: 1. Income from sources within the United States, covered by subdivision (a). 2. Income from sources without the United States, cov- ered by subdivision (c). Income from sources within the United States. — Law. Section 217. (a) That in the case of a nonresident alien individual or of a citizen entitled to the benefits of section 262 the following items of gross income shall be treated as income from sources within the United States: .... Interest. — Law. Section 217. (a) .... (i) Interest on bonds, notes, or other interest-bearing obligations of residents, corporate or other- wise, not including (A) interest on deposits with persons carrying on the banking business paid to persons not engaged in business within the United States and not having an office or place of business therein, or (B) interest received from a resident alien individual or a resident foreign corporation v/hen it is shown to the satisfaction of the Com- missioner that less than 20 per centum of the gross income of such resident payor has been derived from sources within the United States, as determined under the provisions of this section, for the three-year period ending with the close of the taxable year of such payor, or for such part of such period immediately preceding the close of such taxable year as may be applicable; .... ^ See page 1276. NON-RESIDENT ALIENS 1279 Dividends. — Law. Section 217. (a) .... (2) The amount received as divi- dends (A) from a domestic corporation other than a corporation en- titled to the benefits of section 262, or (B) from a foreign corporation unless less than 50 per centum of the gross income of such foreign cor- poration for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such part of such period as the corporation has been in existence) was derived from sources within the United States as determined under the provisions of this section; .... Dividends paid by resident corporations are included in gross income, but as they are allowed as a deduction under section 234 (a-6), no tax is payable thereon. The following excerpt from the regulations covering the foregoing subsection of the law, calls attention to the necessity of the taxpayer proving that the income he reports hereunder falls within the meaning of the law'. Regulation. There shall be included in the gross income from sources within the United States, of nonresident alien individuals, foreign corporations and citizens of the United States or domestic corporations which are entitled to the benefits of section 262, all in- terest received or accrued, as the case may be, on bonds, notes, or other interest-bearing obligations of residents of the United States, whether corporate or otherwise, except : (a) Interest paid on deposits with persons, including individuals, partnerships, or corporations carrying on the banking business, to persons (nonresident alien individuals, foreign corporations and citi- zens of the United States, or domestic corporations entitled to tlie benefits of sec. 262) not engaged in business within the United States, and not having an oiifice or place of business therein; and (b) Interest received from a resident alien individual or a resi- dent foreign corporation when it is shown to the satisfaction of the Commissioner that less than 20 per cent of the gross income of such resident payor has been derived from sources within the United States for the three-year period ending with the close of the taxable year of such payor, or for such part of such period immediately preceding the close of such taxable year as may be applicable. Any taxpayer who excludes from gross income from sources with- in the United States income of the type specified in (a) or (b) above shall file with his return a statement setting forth the amount of such income and .such information as may be necessary to show that the income is of the type specified in those paragraphs. (Art. 317.) I28o SPECIAL CLASSES OF TAXPAYERS Compensation. — Law. Section 217. (a) . . . . (3) Compensation for labor or personal services performed in the United States; .... Regulation. Gross income from sources within the United States includes compensation for labor or personal services performed within the United States regardless of the residence of the payor, of the place in which the contract for services was made, or of the place of pay- ment. When a specific amount is paid for labor or personal services performed in the United States, such amount shall be included in the gross income. When 'no accurate allocation or segregation of com- pensation for labor or personal services performed in the United States can be made, or when such labor or service is performed partly within and partly without the United States, the amount to be in- cluded in the gross income shall be determined by an apportionment on the time basis, i. e., there shall be included in the gross income an amount which bears the same relation to the total compensation as the number of days of performance of the labor or services within the United States bears to the total number of days of performance of labor or services for which the payment is made. (Art. 319.) Rentals and royalties. — Law. Section 217. (a) . . . . (4) Rentals or royalties from property located in the United States or from any interest in such property, including rentals or royalties for the use of or for the privilege of using in the United States, patents, copyrights, secret pro- cesses and formulas, good will, trade-marks, trade brands, franchises, and other like property; .... Sale of real property. — Law, Section 217. (a) . . . . (5) Gains, profits, and income from the sale of real property located in the United States Regulation (c) A nonresident alien individual, or a citizen entitled to the benefits of section 262 may elect to be taxed under section 206 with respect to sales or exchanges of property located within the United States, subject to the limitation that his total tax may not be less than I2j^^ per cent of his total net income from sources within the United States. (Art. 165 1.) For the treatment of capital net gain, see full discussion of the subject in Chapter XVII. Only non-resident alien individuals are interested in whether or not profits from sale of property are to be taxed as a "capital gain," as the rate of tax on the income of cor- NON-RESIDENT ALIENS 1281 porations (both foreign and domestic) and the rate of tax on capital gains are identical, viz., 12J/I per cent. Other income from sources within the United States. — Regulation. Items of gross income other than those specified in section 217 (a) and (c) and articles 317-323 shall be allocated or ap- portioned to sources within or without the United States, as pro- vided in subdivision (e) of section 217. The income derived from the ownership or operation of any farm, mine, oil or gas well, other natural deposit, or timber, located within the United States, and from the sale by the producer of the products thereof within or without the United States, shall ordinarily be in- cluded in gross income from sources within the United States. If, however, it is shown to the satisfaction of the Commissioner that due to the peculiar conditions of production and sale in a specific case or for other reasons all of such gross income should not be allocated to sources within the United States, an apportionment thereof to sources within the United States and to sources without the United States shall be made as provided in article 327. Where items of gross income are separately allocated to sources within the United States, there shall be deducted therefrom, in com- puting net income, the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratal:)le part of other expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income. (Art. 326.) C Income from sources without the United States. — The law merely defines in section 217 (c) (1-5), income from sources without the United States as being income which is other than that provided for in the subsections (i) to (5) of section 217 (a) ([uoted above. Income from sources both within and without the United States. — Law. Section 217 (e) Items of gross income, expenses, losses and deductions, other than those specified in subdivisions (a) and (c), shall be allocated or apportioned to sources within or without the United States under rules and regulations prescribed by the Com- missioner with the approval of the Secretary. Where items of gross income are separately allocated to sources within the United States, there shall be deducted (for the purpose of computing the net income 1282 SPECIAL CLASSES OF TAXPAYERS therefrom) the expenses, losses and other deductions properly appor- tioned or allocated thereto and a ratable part of other expenses, losses or other deductions which can not definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as net income from sources within the United States. In the case of gross income derived from sources partly within and partly without the United States, the net income may first be computed by deducting the expenses, losses or other deductions apportioned or allocated thereto and a ratable part of any expenses, losses or other deductions which can not definitely be allocated to some item or class of gross income; and the portion of such net income attributable to sources within the United States may be determined by processes or formulas of general apportionment prescribed by the Commissioner with the approval of the Secretary. Gains, profits and income from (i) trans- portation or other services rendered partly within and partly without the United States, or (2) from the sale of personal property produced (in whole or in part) by the taxpayer within and sold without the United States, or produced (in whole or in part) by the taxpayer without and sold within the United States, shall be treated as derived partly from sources within and partly from sources without the United States. Gains, profits and income derived from the purchase of personal property within and its sale without the United States or from the purchase of personal property without and its sale within the United States, shall be treated as derived entirely from the coun- try in which sold Regulation. Income derived from the purchase and sale of personal property shall be treated as derived entirely from the country in which sold. The word "sold" includes "exchanged" and ordinarily means the place where marketed. This article does not apply to in- come from the sale of personal property produced (in whole or in part) by the taxpayer within and sold without the United States or produced (in whole or in part) by the taxpayer without and sold within the United States (Art. 323.) The following article of the new regulations gives certain rules for the allocation of income derived from sources partly within and partly without the United States by manufacturers and producers. Regulation Manufacturers and producers. — Gross income derived from the sale of personal property produced (in whole or in part) by the taxpayer within and sold without the United States, or produced in whole or in part by the taxpayer without and sold within the United States shall be treated as derived partly from sources within and partly from sources without the United States, under one of the cases named below. As used herein, the word "produced" includes NON-RESIDENT ALIENS 1283 created, fabricated, manufactured, extracted, processed, cured, or aged. Case I : Where the manufacturer or producer regularly sells part of his output to wholly independent distributors or other selling con- cerns in such a way as to establish fairly an independent factory or production price — or shows to the satisfaction of the Commissioner that such an independent factory or production price has been other- wise established — unaffected by considerations of tax liability, and the selling or distributing branch or department of the business is located in a different country than that in which the factory is located or the production carried on, the net income attributable to sources within the United States shall be computed by an accounting which treats the products as sold by the factory or productive de- partment of the business to the distributing or selling department at the independent factory price so established. In all such cases the basis of the accounting shall be fully explained in a statement at- tached to the return. Case 2 : Where an independent factory or production price has not been established as provided under case i, the net income shall first be computed by deducting from the gross income derived from sources partly within and partly without the United States the expenses, losses, or other deductions properly apportioned or allo- cated thereto and a ratable part of any expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income. Of the amount of net income so determined, one- half shall be apportioned in accordance with the value of the tax- payer's property within and without the United States, the por- tion attributable to sources within the United States being deter- mined by multiplying such one-half by a fraction the numerator of which consists of the value of the taxpayer's property within the United States and the denominator of which consists of the value of the taxpayer's property both within and without the United States. The remaining one-half of such net income shall be appor- tioned in accordance with the gross sales of the taxpayer within and without the United States, the portion attributable to sources within the United States being determined by multiplying such one-half by a fraction the numerator of which consists of the taxpayer's gross sales for the taxable year or period within the United States, and the denominator of which consists of the taxpayer's gross sales for the taxable year or period both within and without the United States. "Gross sales within the United States" means the aggregate arrtount of all sales made during the taxable year which were prin- cipally secured, negotiated or effected by employees, agents, offices, or branches of tlic taxpayer's business resident or located in the United States. The term "property'' as used in this article includes only the 1284 SPECIAL CLASSES OF TAXPAYERS property held or used to produce income which is derived from sources partly within and partly without the United States ^( exclud- ing all property held or used to produce income which is allocated or apportioned under other articles or paragraphs of these regula- tions). Such property should be taken at its actual value^ which in the case of property valued or appraised for purposes of inventory, depreciation, depletion, or other purposes of the Revenue Act of 1921 shall be the highest amount at which so valued or appraised, and which in other cases shall be deemed to be its book value in the absence of affirmative evidence showing such value to be greater or less than the actual value. The average value during the taxable year or period shall be employed. The average value of property as above prescribed at the beginning and end of the taxable year or period ordinarily may be used, unless by reason of material changes during the taxable year or period, such average does not fairly represent the average for such year or period, in which event the average shall be determined upon a monthly or daily basis. Bills and accounts receivable shall (unless satisfactory reason for a different treatment is shown) be assigned or allocated to the United States when the debtor resides in the United States, unless the taxpayer has no office, branch or agent in the LTnited States. Case 3 : Application for permission to base the return upon the taxpayer's books of account will be considered by the Commissioner in the case of any taxpayer who, in good faith and unaffected by con- siderations of tax liability, regularly employs in his books of account a detailed allocation of receipts and expenditures which reflects more clearly than the processes or formulas prescribed under cases I and 2, the income derived from sources within the United States. (Art. Computation of tax where income is from sources within and without the United States. — Regulation. Where a taxpayer has gross income from sources within or without the LTnited .States as defined by section 217 (a) or (c) together with gross income derived partly from sources within and partly from sources without the United States, the amounts thereof, together with the expenses and investment applicable thereto shall be segregated, and the net income from sources within the L'nited States shall be separately computed therefrom. (Art. 328.) What is excluded from gross income? — The general priji- ci])le underlying section 217 uf the 1921 law is that income which non-resident aliens (whether individuals or corpora- tions) derive from sources within the United States shall be NON-RESIDENT ALIENS 1285 subjected to the same income taxes which have to be paid on similar income received by residents or domestic corporations in the United States. There is, however, certain income which is exempt wdien received by non-resident ahens, some of it because it is exempt regardless of by whom received and some of it because of specific provisions of law applicable only to non-resident aliens or foreign governments. Income generally exempt. — Interest from state and municipal bonds, farm loan bonds, property acquired by gift,"^ devise, bequest or descent, proceeds of life insurance paid to an individual upon death of the insured, and similar items ex- pressly stated by law to be exempt from tax when received by a resident, are also exempt when paid to a non-resident alien. Income from United States bonds tax exempt" after March 3, 19 19. — - Regulation. By virtue of section 4 of the Victory Liberty Loan Act of March 3, 1919, amending section 3 of the Fourth Lib- erty Bond Act of July 9, 1918, the interest received on and after March 3, 1919, on bonds, notes and certificates of indebtedness of the United States and bonds of the War P'inance Corporation, while beneficially owned by a nonresident alien individual, or a foreign corporation, partnership, or association, not engaged in business in the United States, is , exempt from all income and war-profits and excess-profits taxes. (Art. 94.) This regulation was numbered 93 in the 1918 regulations. Income of foreign governments. — Regulation. The exemption of income of foreign Govern- ments applies also to their political subdivisions. Any income col- lected by foreign Governments from investments in the United States in stocks, bonds, or other domestic securities, which are not actually owned by but are loaned to such foreign Governments, is subject to tax. The income from investments in the United States in bonds and stocks and from interest on bank lialances received by ambassadors and ministers accredited to the United States and the fees of foreipn " Subject to limitation of section 202 (a-2). See page 6iy. ~ See Chapter XX. 1286 SPECIAL CLASSES OF TAXPAYERS consuls are exempt from tax, but income of such foreign officials from any business carried on by them in the United States would be taxable.-' .... (Art. 86.) Operation of ships^ when earnings are not included IN GROSS income. — Under section 213 (b-8) non-resident alien or foreign corporations are not called upon to include in their gross income earnings derived from the operation of ships under conditions specified in the following regulation. Regulation. The following additional exclusions from gross in- come not provided by the Revenue Act of 1918 are allowed by the Revenue Act of 1921 : (i) Income of a nonresident alien or foreign corporation consist- ing exclusively of earnings derived from the operation of a ship or ships documented under the laws of a foreign country which grants an equivalent exemption to citizens of the United States and corpo- rations organized in the United States. Any taxpayer claiming this exemption must file, under oath, a statement citing the foreign statute which grants the equivalent exemption and stating fully the facts upon which he relies to establish his claim; .... (Art. 89.) Rulings regarding income from sources within the United States. — While it is difficult to determine from the law and regulations exactly what constitutes income from sources within the United States, certain items of income have been expressly construed by the Treasury as taxable or non-taxable. Ruling. Where bonds, notes, or other obligations of a foreign Government are underwritten by a United States banking establish- ment and are by their terms payable at an office of such banking establishment in the United States, interest paid from the United States office to nonresident alien individuals or foreign corporations who are holders of such securities is not to be regarded as income received from a source within the United States. (C. B. i, page 99; O. 786.) Profits' on exchange realized on such payments are held to be non-taxable because not realized from sources within the ^ "Income from sources within the United States received by a foreign ruler in his individual capacity is subject to income tax. Income received by him from property belonging to the Crown is not." C. B. 2, page 96; O. D. 483.) NON-RESIDENT ALIENS 1287 United States.^* The identity of interest on such securities is lost if the amount collected is credited to an account in a domestic bank and interest is allowed on such balances. Under this condition the interest becomes subject to tax.^^ The fol- lowing ruling regarding discount on British treasury bills is of interest : Ruling. Where foreign corporations or nonresident alien in- dividuals purchase British Government treasury bills at a discount in United States markets and collect the same at maturity either in the foreign country or from the paying agent of that Government in the United States, such discount is not income from sources within the United States and is not subject to tax. Where foreign corporations or nonresident alien individuals pur- chase British Government treasury bills at a discount in United States markets and sell the same at a profit in the United States, such profit is income from sources within the United States and as such is sub- ject to tax. (C. B. 2, page 103; O. D. 534.)^*' It has been held that income derived by a foreign partner- ship from goods purchased in the United States through a purchasing agent in this country and sold in foreign coun- tries is not income from sources within the United States and hence is non-taxable.^^ Salary paid to a non-resident alien employee during a temporary visit to this country on business has been held not to be income from sources within the United States.^® If an alien comes to this country with merchandise and sells it at a profit, he receives taxable income, irrespective of the time necessary to complete his sales. ^^ Interest on tax- free covenant bonds of corporations organized in the United States doing no business and owning no property therein is ■' C. B. I, page loi ; O. D. 35. "C. B. I, page 183; O. D. 269. '° A similar ruling, making a distinction between profit on resale in the United States of foreign government or corporation bonds, which would be taxable, and profit realized at maturity of the bonds, which would not be taxable even though the bonds were paid off in the United States, was contained in a letter from Commissioner Wm. M. Williams to Morris F. Frey. dated March 21. 1921. "C. B. 3, page 128; O. D. ^92. ■"C. B. 3, page 128; O. D. 578. -"C. B. I, page 98; O. D. 291. 1288 SPECIAL CLASSES OF TAXPAYERS non-taxable when paid to non-resident aliens. ^° A non-resident alien corporation deriving profit from purchase or sale in this country of bank acceptances is taxable on such income, even though the corporation has no office or place of business in the United States.^^ Further information regarding "trans- acting business within the United States" and income from such sources is afforded by the following rulings : Rulings. In construing the provision of article 66 of Regulations ^T,, revised, that a foreign corporation is liable to tax with respect to income, the source of which is in the United States, and that the "source" as used therein means the place of origin, it is held that the place of origin thus referred to, is not restricted to the place where payment is made, since the place of payment may be ar- bitrarily selected without relation to the nature of the transaction and is not indicative of the source. Where the income grows out of a business activity in the United States it is immaterial where actual payment is made. The provision of article 92 of Regulations 45, exempting from tax the charter money on freight shipments received by a foreign owner in regard to a vessel operated between the United States and a foreign port, is limited to foreign steamship companies having no office, con- nections or agency in the United States, whose vessels only occasion- ally touch at ports in the United States and who can not otherwise be regarded as doing business therein. ( C. B. 3, page 265; O. D. 651.) Amounts paid to a nonresident alien corporation not having an office or place of business in the United States as compensation for orders secured by it from foreign customers for export booked through such nonresident alien corporation are held not to be income from sources within the United States and not subject to with- holding. (C. B. I, page 232; O. D. 112.) Profits derived by a foreign corporation having no office or place of business in the United States from a sale of goods to the United States Government are not subject to any income or profits taxes provided for by the Revenue Act of 1918, where the contract for sale was executed, the goods manufactured and delivered, and payment therefor received by the foreign corporation outside the United States (C. B. 4, page 114; A. R. M. 113.) Certain foreign corporations were organized for the purpose of manufacturing certain products. The entire capital stock of these companies is owned by a domestic corporation. The companies have ^^ C. B. I. page 100; O. 908. " C. B. I, page 232; O. D. 221. NON-RESIDENT ALIENS 1289 executive and administrative offices in the United States, maintained merely for the convenience of the domestic company which owns their stock, the offices which they maintain for business activities being located in the foreign country. The companies' products are sold in the open market by the foreign organization. Any products sold to citizens of the United States or to domestic corporations are sold f. o. b. shipping point in the foreign country. The merchandise thus sold is invoiced by the United States office, but this is merely a part of the clerical detail. The sales are made by mail or through United States representatives visiting the plants in the foreign country, payments on the con- tracts being made through the office of the domestic corporation. Held, that the sales are consummated and the title to the property passes in the foreign country. Any profit derived by the foreign corporations from such sales is not subject to tax under the provi- sions of the Revenue Act of 1918 as income from sources within the United States. (B. 46-20-1920; O. D. iioo.) Regulation. While resident alien seamen are taxable like citi- zens on their entire income from whatever sources derived, non- resident alien seamen are taxable only on income from sources within the United States. Wages received for services rendered inside the territorial United States are to be regarded as from sources within the United States. The wages of an alien seaman earned on a coast- wise vessel are from sources within the United States There is no withholding from the wages of alien seamen unless they are nonresidents within the rules laid down in articles 311 to 315. Even in the case of a nonresident alien seaman, the employer is not obliged to withhold from wages unless those wages are from sources within the United States as defined above (Art. 93.) Ruling. The wages of nonresident alien seamen received for services rendered on vessels sailing from a United States port on the Pacific coast to a United States port on the Atlantic coast, or vice versa, via the Panama Canal, are subject to withholding. (C. B. 4. page 116; O. D. 784.) Wages earned 1))- non-resident aliens on vessels plying be- tween continental United States and Porto Rico do not con- stitute income from sources within the United States. (C. B., 2, page 162; O. D. 536.) Wages earned by a non-resident alien on occasional coastwise voyages on a vessel regularly making foreign voyages have a taxable status. ^- C. B. I, page 183; O. D. 245. 1290 SPECIAL CLASSES OF TAXPAYERS Ruling. An annuity paid by a domestic corporation to a non- resident alien individual is not subject to withholding except to the extent that the aggregate amount of the payments to the annuitant exceeds the amount paid to purchase the annuity. (B. 44-21-1898; O. D. 1086.) Ruling. A foreign corporation derives income from sources within the United States in the form of dividends, received from stock owned by it in taxable subsidiary corporations organized and doing business in the United States. A portion of the stock of the foreign corporation is deposited with an American agent, who issues certificates of participation in such stock and the dividends thereon. Held, that since the foreign corporation derives income from sources within the United States, any dividends received by indi- vidual holders of such certificates of participation may be claimed as a credit for the purpose of the normal tax as a deduction from gross income in the case of corporate holders of such certificates subject in the. case of foreign corporation holders to the provisions of section 234 (b) of the statute. (I-2-22; L T. 1160.) The fact that foreign steamship companies having agents in the United States, receive income from sources within the United States to the extent of freight charges paid by domestic corporations, does not thereby make them receive income "from sources within the United States" under section 217 of the law.^^ Such instances are purely cases of domicile. To have taxable income, foreign corporations must be domiciled within the jurisdiction imposing the tax, or their property or business must be situated within such jurisdiction so that the income may be said to have a situs therein.^* Ruling, (i) There is no income from sources within the United States from goods manufactured there unless there is, in the language of section 233 (b),^^ both "manufacture and disposition of goods within the United States." The Act taxes only income that accrues within the United States. (2) The mere buying of goods within the United States, with capi- tal furnished from abroad, to be sold abroad, is not a trade or busi- ness exercised in the United States so as to subject the purchaser of "Bulletin 36-21-1806; O. D. 1024. ^* C. B. 3, page 21 ; T. D. 311 1. " [Former Procedure] According to section 233 (b) of the 1918 law, gross income included "all amounts received (although paid under a con- tract for sale of goods or otherwise) representing profits on the manufac- ture and disposition of goods within the United States." NON-RESIDENT ALIENS 1291 the goods to income tax. A merchant exercises his trade where he has his principal place of business, viz., where his profits come home to him. If income be taxed the recipient thereof must have a domicile within the jurisdiction imposing the tax, or the property or business out of which the income issues must be situate within such jurisdic- tion so that the income may be said to have a situs therein. (4) Where a corporation purchases goods abroad and sells them within the United States, the profits accruing from such transactions are profits derived from business carried on within the United States and the gross income from such business is income from sources within the United States. (5) In the case of a partnership organized abroad, one of whose members is a resident citizen of the United States, and whose busi- ness consists in selling abroad goods consigned to it from various parts of the world, including the United States, upon commission, title to the goods never vesting in the firm, but passing directly from the consignors to the purchasers, the business of the United States member consisting of soliciting consignments of goods, disbursing proceeds of sales made abroad in payment to consignors in the United States, attending to the shipment of goods, and making advances to consignors on security of bills of lading and express receipts; the funds for the use of the branch office in the United States being obtained by selling drafts on a foreign city, only the income of the partner resident within the United States is income from sources within the United States and subject to income tax. (6) A foreign corporation, having its home ofiice abroad, which operates a line of steamships between the United States and foreign ports, consigns its steamships to an American firm, which handles them as agents and brokers, seeing to the entry and clearance of each steamer, the discharge and loading of cargo and supplies, collecting such part of the freight as is prepayable in this country, deducting the amount of its disbursements and charges and remitting the bal- ance to the foreign corporation, derives income from sources within the United States to the extent that it derives income from traffic originating within the United States and is taxable upon such income. (C. B. 4, page 280; T. D. 3111.) The place where property may he purchased does not affect the determination of the source from which any profit arising from its disposition within the United States is derived.^" Income from property purchased within the United States but sold without is not taxable ; income from property purchased C. B. 4, page 114; O. D. 1292 SPECIAL CLASSES OF TAXPAYERS without the United States but sold within is taxable. The deciding factor is where the property may be sold.^'' In connection with the foregoing rulings concerning steam- ship companies and foreign merchants, it is to be borne in mind that the 1921 law contains in section 217 (e) specific pro- visions providing for the allocation to United States sources of a portion of transportation or other services rendered partly within and partly without the United States and of a portion of the income derived from manufacture and sale when cither of these operations occurred in the United States. Under the 19 18 law profits from manufacturing operations w^ere deemed to have been earned within the United States only when the goods were sold in this country. W'here foreign merchants merely purchase goods in the United States, as distinguished from producing them (in whole or in part) here, and sell them abroad, neither the 192 1 nor the 191 8 law deems any part of the profit to have arisen within the United States. Allowable deductions. — The deductions of non-resident alien individuals are restricted by statute as follows : Law. Section 214. [Xon-resident alien individuals] .... (b) In the case of a nonresident alien individual, the deductions al- lowed in subdivision (a), except those allowed in paragraphs (5), (6), and (11), shall be allowed only if and to the extent that they are connected with income from sources within the United States; and the proper apportionment and allocation of the deductions with respect to sources of income within and without the United States shall be de- termined as provided in section 217 under rules and regulations pre- scribed by the Commissioner with the approval of the Secretary. In the case of a citizen entitled to the benefits of section 262 the de- ductions shall be the same and shall be determined in the same manner as in the case of a nonresident alien individual. L.wv. Section 234. [Foreign corporations] .... (b) In the case of a foreign corporation or of a corporation entitled to the benefits of section 262 the deductions allowed in subdivision (a) shall be al- lowed only if and to the extent that they are connected with income from sources within the United States; and the proper apportionment The law, section 217 (e-2). NON-RESIDENT ALIENS 1293 and allocation of the deductions with respect to sources within and without the United States shall be determined as provided in section 217 under rules and regulations prescribed by the Commissioner with the approval of the Secretary. Regulations. Foreign corporations are allowed the same de- ductions from their gross income arising from sources within the United States as are allowed to domestic corporations,^^ to the extent that such deductions are connected with such gross income. The proper apportionment and allocation of the deductions with respect to sources within and without the United States shall be determined as provided in Section 217 (Art. 573.) The deductions provided for in section 214 shall be allowed to nonresident alien individuals and to citizens of the United States en- titled to the benefits of section 262, and the deductions provided for in section 234 shall be allowed to foreign corporations and to domestic corporations entitled to the benefits of section 262, only if and to the extent that they are connected with income from sources within the United States. In the case of nonresident alien individuals, however, (i) losses sustained during the taxable year and not com- pensated for by insurance or otherwise, if incurred in any transaction entered into for profit, though not connected with the trade or busi- ness, are deductible only if and to the extent that the profit, if such transaction had resulted in a profit, would have been taxable as in- come from sources within the United States; (2) losses sustained during the taxable year of property not connected with the trade or business if arising from fires, storms, shipwreck, or other casualty, or from theft, and if not compensated for by insurance or otherwise are deductible only if the property was located within the United States; and (3) contributions or gifts made within the taxable year are deductible only if made to domestic corporations or to com- munity chests, funds, or foundations created in the United States of the type specified in section 214 (a) (11) and article 251, or to the vo- cational rehabilitation fund. Losses embraced under clauses (2) and (3) above are deductible in full from items of gross income specified as being derived in full from sources within the United States, but if greater than the sum of such items, the excess of unabsorbed loss may be deducted from the income apportioned to sources within the United States under the provisions of article 327. Losses embraced under clause (i) are de- ductible in full ("as provided in article 325 or article 326) when the profit from the transaction, if it had resulted in a profit, would have been taxable in full as income from sources within the United States, but should be deducted under the provisions of article 327 when the profit from the transaction, if it Iiad resulted in profit, would have See Chapters XXV-XXXIV. 1294 SPECIAL CLASSES OF TAXPAYERS been taxable only in part. The amount of dividends included in the gross income may be deducted or credited, but in the case of a non- resident alien individual, for the purpose of the normal tax only. (Art. 324.) Apportionment of deductions. — Regulation. Froni the items specified in articles 317-323 as being derived specifically from sources within and vi^ithout the United States there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any other expenses, losses, or deductions which can not definitely be allocated to some item or class of gross income. The remainder shall be included in full as income from sources within the United States. The ratable part is based upon the ratio of gross income from sources within the United States to the total gross income. Example. — A nonresident alien individual derived gross income from all sources for 1921 of $180,000. There was included therein: $9,000 interest on bonds of a domestic corporation. 4,000 dividends on stock of a domestic corporation. 12,000 royalty for the use of patents within the United States. 11,000 gain from the sale of real property located within the United States. $36,000 total. That is, one-fifth of the total gross income was from sources within the United States. The remainder of the gross income was from sources without the United States, determined under article 322 above. The expenses of the taxpayer for the year amounted to $78,000. Of these expenses the amount of $8,000, including such items as com- mission paid for the sale of the real property located within the United States and interest on indebtedness incurred to purchase the stock of a domestic corporation, is properly allocated to income from sources within the United States and the amount of $40,000 is prop- erly allocated to income from sources without the United States. The remainder of the expenses, $30,000, can not be definitely allocated to any class of income. A ratable part thereof, based upon the relation of gross income from sources within the United States to the total gross income, shall be deducted in computing net income from sources within the United States. Thus, there is de- ducted from the $36,000 of gross income from sources within the United States, expenses amounting to $14,000 (representing $8,000 properly apportioned to the income from sources within the United States and $6,000, a ratable part (one-fifth) of the expenses which could not be allocated to any item or class of gross income). The NON-RESIDENT ALIENS 1295 remainder, $22,000, is the net income from sources within the United States. (Art. 325.) Filing of returns necessary to secure deductions AND credits. Regulation. Unless a nonresident alien individual, a foreign corporation, or a citizen of the United States or domestic corporation entitled to the benefits of section 262, shall file, or cause to be filed with the collector, a true and accurate return of income from sources within the United States, regardless of amount, the tax shall be collected on the basis of the gross income (not the net income) from sources within the United States. Where a nonresident alien has various sources of income within the United States, so that from any one source or from all sources combined the amount of income shall call for the assessment of a surtax, and a return of income shall not be filed by him or on his behalf, the Commissioner will cause a return of income to be made and include therein the income of such non- resident alien from all sources concerning which he has information, and he will assess the tax and collect it from one or more of the sources of income within the United States of such nonresident alien, without allowance for deductions or credits.' .... (Art. 329.) Credits allowed to individuals.^^ — Non-resident alien indi- viduals are allowed a specific exemption of $1,000 whatever their status and without regard to the reciprocal provisions extended by the country of which they are nationals. No additional allowances are permitted for dependents. Law. Section 216 (e) In the case of a nonresident alien individual or of a citizen entitled to the benefits of section 262, the per- ^' [Former Procedure] Under the 1918 law credits allowed non- resident alien individuals were the same as in the case of citizens or resi- dents, conditional upon the country of which they were citizens allowing similar credits to citizens of the United States. See' 1918 law, section 216 (e), and Income Tax Procedure, 1921, pages 992 and 993. To the countries named in Income Tax Procedure, 1921. must be added the fol- lowing: Under class (a) : Malta, Albania, Basutoland, Ceylon. Gambia, Grenada, Alauritius, N. Rhodesia, Sierra Leone, "Virgin Islands (British), Zanzibar, Bechuanaland, Cyprus, Gibraltar, Hongkong, Montscrrat, Nyasaland Pro- tectorate, Somaliland, Wcihaiwci, British Guiana, Falkland Islands, Gold Coast, Malay States, Nigeria, St. Helena, Swaziland, Uganda, Palestine, Armenia, Syria, Jamaica, Barbados, (jcrmany, Hungary, Fiji Islands, West- ern Pacific Islands, Kenya and St. Kitts-Ncvis, British Honduras. Under class (b) : Poland (formerly Prussian Poland). Not satisfying section 216 (e). Trinidad, Dutch Guiana, Straits Settlements. 1296 SPECIAL CLASSES OF TAXPAYERS sonal exemption shall be only $1,000, and he shall not be entitled to the credit provided in subdivision (d) .... Regulations. A citizen entitled to benefits of section 262 and a nonresident alien individual, similarly to a citizen or resident, are entitled for the purpose of the normal tax to the dividend credit described in article 301. They are also entitled in every case to a personal exemption of $1,000. but under no circumstances to any credit for dependents. Under the Revenue Act of 1921, the provisions of tax laws of the foreign country of which a nonresident is a citizen or subject are immaterial, the right to a personal exemption of $1,000 being" absolute. (Art. 306.) .... The benefit of the credits allowed against net income for the purpose of the normal tax may not be received by a nonresident alien by filing a claim with the withholding agent, but only by claiming it upon filing a return of income, except as permitted in articles 315 and 364 (Art. 329.) The specific exemption is dependent upon the status of the taxpayer on the last da}' of the period covered by his return. Credits allowed a foreign corporation. — A foreign corpora- tion is allowed the same credits as a dottiestic corporation, ex- cepting the specific exemption of $2,000 to corporations with income not exceeding $25,000, which is not allowed. *° A foreign corporation, like a non-resident alien individual, can ol^tain the full benefit of credits only by filing a complete re- turn of income from sources within the United States. Income of foreign corporations received on and after March 3. 19 19. from bonds, notes and certificates of indebted- ness of the United States and bonds of the War Finance Cor- poration, is exempt from income and profits taxes. Such in- come is not inchtded in gross income, and, of course, a credit cannot be taken therefor except for such income received prior to March 3, 19 19. As is the case of non-resident alien individuals, a for- eign corporatioit is permitted a credit against its taxes'*^ for any amounts withheld at the source. The gross income, in- '" Sec Art. 591. " This should not be confused with credits against income. NON-RESIDENT ALIENS 1297 eluding- income upon which any tax is withheld at source, must be inchided in the return. Rates of tax for non-resident alien individuals/^ — Law. Section 210 there shall be levied, collected, and for each taxable year upon the net income of every individual a normal tax of 8 per centum of the amount of the net income in excess of the credits provided in section 216: .... Rates of surtax. — Rates of surtax on the income of non- resident ahens are the same as in the case of citizens or resi- dents of the United States as given in section 211. (See Chapter VII, page 156.) Rates of tax for foreign corporations. — Law. Section 230. .... (a) For the calendar year 1921, 10 per centum of the amount of the net income in excess of the credits provided in section 236 ;^'' and (b) For each calendar year thereafter, 12^ per centum of such ex- cess amount. Returns of non-resident alien individuals. — Regulation, A nonresident alien individual shall make or have made a full and accurate return on form 1040B of his income received from sources within the United States, regardless of amount, unless the tax on such income has been fully paid at the source The responsible representatives of nonresident aliens in connection with any sources of income which such nonresident aliens may have within the United States shall make a return of such income, and shall pay any and all tax, normal and additional, assessed upon the income re- ceived by them in behalf of their nonresident alien principals, in all cases where the tax on income so in their receipt, custody or control shall not have been withheld at the source (Art. 404.) Returns required of aliens to secure sailing permits. — Sec- tion 250 (g) of the 1918 law has been amplified to include specific reference to the cases of departing aliens and imposing a penalty for any attempt to violate this section of the law. ''Normal tax on tlic first $4,000 of net income at the rate of 4 per cent applies only to citizens and residents. "See Chapter XII for credits enumerated under section 236. 1298 SPECIAL CLASSES OF TAXPAYERS Law. Section 250 (g) If the Commissioner finds that a taxpayer designs quickly to depart from the United States or to re- move his property therefrom or to conceal himself or his property there- in, or to do any other act tending to prejudice or to render wholly or partly ineffectual proceedings to collect the tax for the taxable year then last past or the taxable year then current unless such proceedings be brought without delay, the Commissioner shall declare the tax- able period for such taxpayer immediately terminated and shall cause notice of such finding and declaration to be given the taxpayer, to- gether with a demand for immediate payment of the tax for the tax- able period so declared terminated and of the tax for the pre- ceding taxable year or so much of said tax as is unpaid, whether or not the time otherwise allowed by law for filing return and paying the tax has expired; and such taxes shall thereupon become immediately due and payable.^* In any action or suit brought to enforce payment of taxes made due and payable by virtue of the provisions of this subdivision the finding of the Commissioner, made as herein pro- vided, whether made after notice to the taxpayer or not, shall be for all purposes presumptive evidence of the taxpayer's design. A taxpayer who is not in default in making any return or paying income, war- profits, or excess-profits tax under any act of Congress may furnish to the United States, under regulations to be prescribed by the Com- missioner with the approval of the Secretary, security approved by the Commissioner that he will duly make the return next thereafter required to be filed and pay the tax next thereafter required to be paid. The Commissioner m.ay approve and accept in like manner security for return and payment of taxes made due and payable by virtue of the provisions of this subdivision, provided the taxpayer has paid in full all other income, war-profits, or excess-profits taxes due from him under any act of Congress. If security is approved and ac- cepted pursuant to the provisions of this subdivision and such further or other security with respect to the tax or taxes covered thereby is given as the Commissioner shall from time to time find necessary and require, payment of such taxes shall not be enforced by any proceed- ings under the provisions of this subdivision prior to the expiration of the time otherwise allowed; or paying such respective taxes. In the case of a citizen of the United States about to depart from the United States the Commissioner may, at his discretion, waive any or all of the requirements placed on the taxpayer by this subdivision. No alien shall depart from the United States unless he first secures from the col- lector or agent in charge a certificate that he has complied with all the obligations imposed upon him by the income, war-profits, and excess- profits tax laws. If a taxpayer violates or attempts to violate this subdi- " The same personal exemption is allowed as if return were for a full taxable period. (Reg. 45, Art. 1013.) Credit should be taken for any taxes withheld at source. (C. B. i, page 253; Mim. 2195.) NON-RESIDENT ALIENS 1299 vision there shall, in addition to all other penalties, be added as part of the tax 25 per centum of the total amount of the tax or deficiency in the tax, together with interest at the rate of i per centum per month from the time the tax became due. (h) The provisions of subdivisions (e), (f) and (g) of this section shall apply to the assessment and collection of taxes vi^hich have accrued or may accrue under the Revenue Act of 1917, the Revenue Act of 1918 or this Act. The fact that a non-resident alien has executed a power of attorney authorizing a domestic bank to act as its agent in all income tax matters, does not relieve a domestic corporation paying royalties to such non-resident alien from the with- holding requirements of the law. The various instructions issued with respect to departing aliens are not applicable to representatives of foreign coun- tries bearing diplomatic passports. ^'^ Responsibility of agent for making return. — Regulation The agent of a nonresident alien is respon- sible for a correct return of all income accruing to his principal within the purview of the agency. The agency appointment will determine how completely the agent is substituted for the principal for tax pur- poses. Where upon filing a return of income it appears that a non- resident alien is not liable for tax, but nevertheless a tax shall have been withheld at the source, in order to obtain a refund on the basis of the showing made by the return there should be attached to it a statement showing accurately the amounts of tax withheld, with the names and post-office addresses of all withholding agents. . . . (Art. 404.) Domestic corporations handling specific transactions for foreign customers but not as agents are not required to file returns or withhold taxes for such customers. In the case of a commission house in the United States which bought and sold cotton for English mills, the Commis- sioner ruled as follows on the question of whether either the making of a return or the withholding of tax was required of the commission house. Bulletin 44-21-1899; O. D. 1087. I300 SPECIAL CLASSES OF TAXPAYERS Ruling Inasmuch as you state that you have not been designated to act as agent for the foreign corporations in question, to prepare their tax returns, or to otherwise assume general agency ob- ligations, and since you were instructed merely to handle specific transactions for such corporations, the same way that any customer might instruct a stock broker to buy or sell securities for his account, it is held that you were not agent for the foreign corporations in transactions of the character stated, within the meaning of the statute and regulations before mentioned, and, therefore, are not required to file a return for the foreign corporations for whom such purchases and sales were made You are not required to withhold the tax from the income accrued to foreign corporations in trans- actions such as those described, as the income arising therefrom is not deemed to be fixed or determinable annual or periodical income within the meaning of Section 221 of the Revenue Act of 1918 re- quiring withholding. (Letter of Commissioner D. H. Blair, dated June 8, 1921.) Return for non-resident alien beneficiary/'' — Regulation. Where a citizen or resident fiduciary has the dis- tribution of the income of a trust any beneficiary of which is a non- resident alien, the fiduciary shall make a return on Form 1040 B for such nonresident alien and pay any tax shown thereon to be due. Unless such return is a true and accurate return of the nonresident alien beneficiary's income from all sources within the United States the benefits of the credits and deductions to which the beneficiary is entitled can not be obtained in the return filed by the fiduciary. .... If the beneficiary appoints a person in the United States to act as his agent for the purpose of rendering income tax returns the fiduciary shall be relieved from the necessity of filing Form 1040 B in behalf of the beneficiary and from paying the tax. In such a case the fiduciary shall make a return on Form 1041 and attach thereto a copy of the notice of appointment. If there are two or more nonresident alien beneficiaries the fiduciary shall render a re- 'turn on Form 1041*' and also a return on Form 1040 B for each non- resident alien beneficiary (Art. 425.) Ruling. Where two separate trusts are created for the same nonresident alien beneficiary, each trustee is required to render a personal return on Form 1040 or 1040-A on behalf of the nonresident alien, and pay any and all normal tax found by such return to be due and any and all surtax, provided the income is not returned for the purpose of the tax by the beneficiary. *" See Chapter XXXVII for general discussion of fiduciaries. ^' See Appendix B. NON-RESIDENT ALIENS 1 301 If one of the trustees is the representative or authorized agent of the nonresident alien, he may render a complete return on Form 1040 or 1040-A, combining the entire net income from both trusts and take credit on the return for any tax paid by the other fiduciary in behalf of the nonresident alien. If the nonresident alien beneficiary of the two trusts should appoint a resident agent for the purpose of filing his return and pay- ing the tax in his behalf, it would not be necessary for the two trustees to file returns on Form 1040 or 1040-A, provided they have received notice of such appointment. The fiduciaries, however, would not be relieved from liability for rendering returns as such on Form 1041, as required by law. (C. B. 3, page 229; O. D. 572.) Returns on form 1040 are required even though the aHen's income consists entirely of dividends and is less than $5,000.** Record owner of stock is responsible for making return and payifig surtax due.*'' — Regulation. Dividends on stock of domestic corporations or resident foreign corporations are prima facie income of the record owner of the stock, and such record owner will be liable for any additional tax based thereon, unless a disclosure of the actual owner- ship is made to the Commissioner on Form 1087 which shall show that the record owner is not the actual owner and who the owner is and his address. In all cases where the actual owner is a nonresident alien individual and the record owner is a person in the United States, the record owner will be considered for tax purposes to have the receipt, custody, control and disposal of the dividend income and will be required to make return for the actual owner, regardless of the amount of the income, and to pay any surtax found by such return to be due. (Art. 405.) Forms for making individual returns. — Regulation. Nonresident alien individuals or their authorized agents should use form 1040 (revised) or 1040A (revised) in mak- ing returns of income derived from sources within the United States, regardless of amount, unless the tax on such income has been fully paid at the source. If a nonresident alien individual is not liable for any tax which has been withheld at the source, no refund of such tax will be permitted unless such a return is filed and a statement is attached thereto indicating the amounts of the tax withheld and the names and post office addresses of all with- Bulletin 1-19-79; O. D. 58. See also Chapter X, page 318, for use of form 1087. 1302 SPECIAL CLASSES OF TAXPAYERS holding agents. Unless a nonresident alien individual shall render a return of income, the tax will be collected on the basis of his gross income (not his net income) from sources within the United States. (Extract from T. D. 2815; dated April 2, 1919.) Form 1040C has been issued for the use of non-resident ahen individuals having net incomes of not more than $5,000 for the taxable period 1921. This form is largely used with sailing permits for aliens. In accounting for net incomes of over $5,000, form 1040 must be used, as stated above. Returns for foreign partnerships. — While foreign partner- ships as well as domestic partnerships are not taxed as busi- ness entities, returns on form 1065, regardless of the amount of income, are required to show the distributive shares of the partners, whether or not distributed. ^° Foreign partnerships account only for taxable income from sources within the United States on form 1065, and are required to file returns if they transact business within the United States. Law. ■ Section 224. That every partnership shall make a return for each taxable year, stating specifically the items of its gross income and the deductions allowed by this title, and chail include in the return the names and addresses of the individuals v/ho would be entitled to share in the net income if distributed and the amount of the distribu- tive share of each individual. The return shall be sworn to by any one of the partners. Regulation. Every partnership must make a return of income, regardless of the amount of its net income. The return shall be on Form 1065 and shall be sworn to by one of the partners. Such return shall be made for the taxable 3'ear of the partnership, that is, for its annual accounting period (fiscal year or calendar year as the case may be), irrespective of the taxable years of the partners (Art. 411.) Returns for foreign corporations. — Regulation. Every foreign corporation and corporation satis- fying the conditions set forth under section 262, having income from sources within the United States must make a return of income on Form 1 120. If such a corporation has no office or place of business ""See page 1308 for discussion of partnership income. NON-RESIDENT ALIENS 1303 here, but has a resident agent, he shall make the return. It is not necessary, however, for it to be required to make a return that the foreign corporation shall be engaged in business in this country or that it have any office, branch, or agency in the United States (Art. 625.) Consolidated returns." — Power is given to the Commis- sioner to consolidate the returns of foreign corporations when- ever he deems it proper to do so. Given this discretion, he should be asked to exercise it where circumstances justify the reqtiest and where it would prevent what would otherwise be an evident hardship on the corporations involved. Law. Section 240. .... (d) For the purposes of this section a corporation entitled to the benefits of section 262 shall be treated as a foreign corporation: Provided, That in any case of two or more related trades or businesses (whether unincorporated or incorporated and whether organized in the United States or not) owned or controlled directly or indirectly by the same interests, the Commissioner may consolidate the accounts of such related trades and businesses, in any proper case, for the purpose of making an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such related trades or businesses Return by agent.^'-' — Section 239 provides that "if any for- eign corporation has no office or place of business in the United States, but has an agent in the United States, the return shall be made by the agent." (See article 625, page 1302.) "' [Former Procedure] LTnder the 1918 law no provision was made for the consolidation of returns for foreign corporations. It was provided, however, that in case a domestic corporation controlled a foreign corpora- tion, a credit should be given for taxes paid by the foreign corporation. This provision [section 240 (c)] has been materially modified [it is section 238 (c) of the 1921] law. See Chapter XX VIII. °" Ruling. "An insurance broker in the United States who solicits and procures insurance for nonresident foreign corporations, collects the pre- miums thereon and credits the accounts of the respective corporations with the net proceeds after deductions are made, is considered the resident agent of such foreign corporations with respect to the business obtained through his efforts and is required to file returns for each nonresident foreign cor- poration covering the gross income received from sources within the United States within the purview of bis agency, claiming therein any deductions to which the corporations are entitled and to pay the total tax due thereon." (C. B. 3, page 284; O. D. 586.) 1304 SPECIAL CLASSES OF TAXPAYERS Time and place for filing non-resident individual re- turns.^^ — Law. Section 22-. (a) .... In the case of a nonresident alien individual returns shall be made on or before the fifteenth day of the sixth month following the close of the fiscal year, or, if the return is made on the basis of the calendar year, then the return shall be made on or before the 15th day of June. The Commissioner may grant a reasonable extension of time for filing returns whenever in his judg- ment good cause exists and shall keep a record of every such exten- sion and the reason therefor. Except in the case of taxpayers who are abroad, no such extension shall be for more than six months. (b) Returns shall be made to the collector for the district in which is located the legal residence or principal place of business ot the person making the return, or, if he has no legal residence or prin- cipal place of business in the United States, then to the collector at Baltimore, Maryland. Time and place for filing corporation returns. — Law. Section 241. (a) That returns of corporations shall be made at the same time as is provided in subdivision (a) of section 227, except that in the case of foreign corporations not having any office or place of bvsiness in the United States returns shall be made at the same time as provided in section 227 in the case of a nonresident alien individual. (b) Returns shall be made to the collector of the district in which is located the principal place of business or principal office or agency of the corporation, or, if it has no principal place of busi- ness or principal office or agency in the United States, then to the collector at Baltimore, Maryland. Returns in respect of money and other property sur- rendered to the Alien Property Custodian. — Ruling. Receipt is acknowledged of your letter dated October 30, 1919, stating that the .... Trust Company is attorney-in- fact for a non-resident alien client who is held to be an enemy by the Alien Property Custodian. On August 22, 1918^ the Trust Company surrendered to the Alien Property Custodian all money and securities in its possession belonging to its client. Your statement is noted, referring to article 446 of I'iegulations 45, that apparently the Trust Company was required to render a return at the time the money and securities were relinquished, .... In reply, you are advised that at the time the .... Trust "Form 1065 for foreign partnerships is filed under the same conditions as for individuals. NON-RESIDENT ALIENS 1305 Company turned over the money and securities of its enemy client to the AHen Property Custodian, the provisions of T. D. 2673, dated March 18, 1918, were in force. Under that decision it was required that "All persons who on October 6, 1917, had, or since have had, or may hereafter have, control of any money or other property for any enemy or ally of enemy, or who on October 6, 1917, were, or since have been, or may hereafter be, indebted to any enemy or ally of enemy, shall hold and deliver all said money and property in all respects subject to the provisions of the Trading with the Enemy Act and to the order of the President of the United States and of the Alien Property Custodian thereunder, and shall in due course file returns of income in respect of all said money and property for such periods as may elapse or have elapsed prior to the actual delivery of said money and property to the Alien Property Custodian." This decision was substantially repeated in article 446. Neither the language of the original ruling nor that of article 446 can be so construed as to require the filing of returns at the time of surrender- ing the money and property of enemies to the Alien Property Cus- todian. But as indicated in the last sentence of the decision given above, returns of income are to be filed in due course, which is held to mean by the next regular due date for the filing of returns of income. The following ruling of the Alien Property Custodian under T. D. 2673 is approved and quoted for your information, to wit : "Return of income is required to be filed in due course in respect of all money or other property for such part of the year 1918, or any subsequent year as may elapse prior to the actual delivery of the money or other property to the Alien Property Custodian, but no withholding or the payment of any taxes is required." (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated January 19, 1920.) When tax shown to be due by return is payable. — Pay- ment of tax shown to be due by returns as previously described shall be made when returns are filed or in instalments in ac- cordance with the provisions of section 250. (See Chapter VIII, page 217.) Extension of time for filing returns. — The 1921 law gives non-resident alien individuals and foreign corporations having no ]jlace of business in the United States three months longer for filing returns than is allowed residents of the United States.^* Consequently it should be possible for most foreign '^' See section 227 on page 1304. 1306 SPECIAL CLASSES OF TAXPAYERS taxpayers to file their returns within the required time without securing an extension. The Commissioner is authorized, however, to grant a reasonable extension of time when good cause therefore exists. Withholding from Non-Resident Aliens The tax is collected from non-resident aliens in two ways : (i) Payment by the aliens of the tax shown to be due by re- turns filed; (2) withholding of normal tax at the source in the case of all payments of fixed and determinable annual or other periodical income. In the case of income from w^hich tax is deducted at the source, non-resident aliens are required to include the gross payments in their returns, but a credit is allowed against tax for the amount which has been deducted at the source. There is withholding at the source only in the case of income described as "fixed and determinable, annual or periodical," and the withholding provisions of the law do not apply to foreign partnerships, except in the case of payment of interest on tax-free covenant bonds. Chapter X discusses in detail the use of various forms of ownership certificates and the use of withholding returns in lieu of information returns. Chapter XI explains the legal theory underlying tax-free covenants in bonds and withholding from citizens or resi- dents. Withholding of tax at the source. — Law. Section 221. (a) That all individuals, corporations, and partnerships, in whatever capacity acting, including lessees or mort- gagors of real or personal property, fiduciaries, employers, and all officers and employees of the United States having the control, re- ceipt, custody, disposal, or payment of interest (except interest on deposits with persons carrying on the banking business paid to persons not engaged in business in the United States, and not having an office or place of business therein), rent, salaries, wages, premiums, an- nuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical gains, profits, and income, of any nonresident alien individual or partnership composed in whole or in part of nonresident aliens (other than income received as dividends NON-RESIDENT ALIENS 1307 of the class allowed as a credit by subdivision (a) of section 216) shall (except in the cases provided for in subdivision (b) and except as otherwise provided in regulations prescribed by the Commissioner under section 217) deduct and withhold from such annual or periodical gains, profits, and income a tax equal to 8 per centum thereof: Provided, That the Commissioner may authorize such tax to be deducted and withheld from the interest upon any securities the owners of which are not known to the withholding agent. (b) In any case where bonds, mortgages, or deeds of trust, or other similar obligations of a corporation contain a contract or pro- vision by which the obligor agrees to pay any portion of the tax im- posed by this title upon the obligee, or to reimburse the obligee for any portion of the tax, or to pay the interest without deduction for any tax which the obhgcr may be required or permitted to pay thereon, or to retain therefrom under any law of the United States, the obligor shall deduct and withhold a tax equal to 2 per centum of the interest upon such bonds, mortgages, deeds of trust, or other obligations, whether such interest is payable annually or at shorter or longer periods and whether payable to a nonresident alien individual or to an individual citizen or resident of the United States or to a partnership: Provided, That the Commissioner may authorize such tax to be de- ducted and withheld in the case of interest upon any such bonds, mort- gages, deeds of trust, or other obligations, the owners of which are not known to the withholding agent. Such deduction and withholding shall not be required in the case of a citizen or resident entitled to re- ceive such interest, if he files with the withholding agent on or before February i, a signed notice in writing claiming the benefit of the credits provided in subdivisions (c) and (d) of section 216; nor in the case of a nonresident alien individual if so provided for in regulations prescribed by the Comm.issioner under subdivision (g) of section 217. '^s .... Law. Section 237. That in the case of foreign corporations sub- ject to taxation under this title not engaged in trade or business within the United States and not having any office or place of business therein, there shall be deducted and withheld at the source in the same man- ner and upon the same items of income as is provided in section 221 a tax equal to 12^/2 per centum thereof (but during the calendar year 1921 only 10 per centum), and such tax shall be returned and paid in the same manner and subject to the same conditions as provided in that section: Provided, That in the case of interest described in sub- "^ Withholding in the case of payments described in section 221 (a) (rent, salaries, etc.) is at the rate of 8 per cent, that being the normal tax rate prescribed by law for 1919 and subsequent years. Withholding of tax on interest on so-called tax-free bonds, however, is only at the rate of 2 per cent. 1308 SPECIAL CLASSES OF TAXPAYERS division (b) of that section the deduction and withholding shall be at the rate of 2 per centum. Regulation. With respect to, payments to foreign corporations not engaged in trade or business within the United States and not having any office or place of business therein, withholding is re- quired of a tax of 2 per cent in the case of interest payable upon corporate bonds or other obligations containing a tax-free covenant clause, and of a tax of 12J/' per cent (10 per cent during the calen- dar year 1921) in the case of other fixed or determinable annual or periodical income, other than corporate dividends To enable debtors in the L^nited States to distinguish between foreign corpora- tions which have and those which have not any office or place of busi- ness in the United States, and also to enable such corporations as have an office or place of business in the United States to claim exemption from withholding the tax on bond interest or other income, a certifi- cate, Form 108^, stating that any such corporation has an office or place of business in the L^nited States should be filed by it with the debtor. (Art. 6or.) Ruling. The obHgation of a person in the United States to pay to a foreign bank amounts representing drafts and interest thereon, drawn by him and accepted by the foreign bank, is such an "interest- bearing obligation" as is contemplated by section 233 (b), regard- less of the fact that tlie debt was incurred outside the United States and the interest was paid in a foreign country in foreign money. The interest is subject to withholding (B. 41-21-1863; O. D. 1062.) Withholding in case of partnerships. — A partnership composed in whole or in part of non-resident ahens, is subject to the withholding provisions of the statute. Ruling Withholding required from payments of in- come specified in Section 221 (a) Revenue Act of 1921 made to part- nerships composed in whole or in part of nonresident aliens. (Tele-, gram signed by Commissioner D. H. Blair, and dated December 8, 1921.) Nevertheless, the foregoing does not apply in the case of a partnership having an office or place of business in the United States. Ruling. Section 221 of the Revenue Act of 1921 provides for withholding of a tax equal to 8 per cent from the annual or periodi- cal gains, profits, or income of a partnership composed in whole or in part of nonresident aliens. (See sec. 221.) However, in the NON-RESIDENT ALIENS 1309 case of a partnership having an office or place of business in the United States, withholding will not be required, even though one or more of the members thereof is a nonresident alien; the partnership, however, as agent of the nonresident alien member or members, shall file a return of the income of such nonresident alien member or members in accordance with the provision of article 404 of Regula- tions 45, and the corresponding article of Regulations 62, to be promulgated under the Revenue Act of 1921. Approved January 5, 1922. (I-3-34; T. D. 3268.) Filing of return by foreign corporation does not relieve withholding.^*' — Ruling. A domestic corporation making payments of fixed or de- terminable annual or periodical income to a nonresident foreign corporation is not relieved from compliance with the withholding re- quirements of the income tax law on account of the fact that the nonresident foreign corporation has filed Federal income tax returns and claims for refund of excess taxes paid during prior years. (C. B. 4, page 302; O. D. 853.) Definition of withholding agent. — Regulation A withholding agent may be a corporation with bonds outstanding, a trustee under a corporate mortgage, or any corporation, partnership or private individual (Art. 1533.) Assignee must withhold. — Regulation Where in connection with the sale of its property payment of the bonds or other obligations of a corporation is assumed by the assignee, such assignee, whether an individual, part- nership, corporation, or a State or political subdivision thereof, must deduct and withhold such taxes as would have been required to be withheld by the assignor had no such sale and transfer been made. .... (Art. 365. Reg. 45, Art. 364.) '" [Former Procedure] Ruling. "A tax of 10 per cent is required to be withheld from the interest credited by a domestic bank to the account of a foreign corporation not having any office or place of business in the United States regardless of the fact that the foreign corporation intends to file an income tax return covering its income from all sources within the United States." (C. B. 4, page 302; O. D. 910.) As interest on deposits with domestic banks is no longer taxable to foreign corporations not doing business in the United States, the foregoing ruling is to that extent obsolete. I3I0 SPECIAL CLASSES OF TAXPAYERS What is fixed and determinable annual or periodical in- come ? — Regulation. Only (a) fixed or determinable (b) annual or periodical income is subject to withholding. Among such income, giving an idea of the general character of income intended, the statute specifies interest, rent, salaries, wages, premiums, annuities, com- pensations, remunerations, and emoluments. But other kinds of in- come may be included, (a) Income is fixed when it is to be paid in amounts definitely predetermined. On the other hand, it is deter- minable whenever there is a basis of calculation by which the amount to be paid may be ascertained, (b) The income need not be paid annually if it is paid periodically, that is to say, from time to time, whether or not at regular intervals. That the length of time during which the payments are to be made may be increased or diminished in accordance with someone's will or with the happening of an event does not make the payments any the less determinable or periodical. A salesman working by the month for a commission on sales which is paid or credited monthly receives determinable periodical income. (Art. 362.) Rulings. The excess of the face value of a so-called bank accept- ance as collected at its maturity, over the amount paid therefor by a person collecting the acceptance at maturity, is not interest within the meaning of sections 221 (a) and 237 of the Revenue Act of 1918. Gains and profits derived from the purchase and sale of so-called bank acceptances are not fixed and determinable annual or periodical income within the meaning of sections 221 (a) and 237, and are not subject to the withholding provisions of the act. (C. B. 2, page 189; O. 1024.) The tax should be withheld on payments by an American cor- poration to a nonresident foreign corporation having no office or place of business within the United States, representing royalties for the use of a patent, regardless of whether the amount paid is an agreed sum or is contingent on profits earned. The entire royalty, if not unreasonable, may be taken as a deduction by the American corporation. (C. B. i, page 230; T. B. R. 29.) Winnings of horses at a race track credited by the racing associa- tion to a nonresident alien owner and trainer of the horses winning such amounts are not fixed nor determinable annual or periodical gains, profits, and income within the meaning of section 221 (a), Revenue Act of 1918, and no withholding by the racing association is necessary. (B. 2-19-157; S. 975.) A firm of ship chandlers bills its sales to ships' captains at the list price of the goods but accepts a lesser sum in full settlement in order to secure their trade. No payments whatever were made by NON-RESIDENT ALIENS 1311 the firm to the ships' captains, who in this case were nonresident aliens. It is presumed that the captain of the ship in each case collected the face of the bill from the owner of the ship or his em- ployer. The mere fact that the firm billed the goods to the ships' captains at list price, entered such amounts on its books, but accepted in payment amounts less than list price, can not in the judgment of the Committee make the firm the payer of discount or commission to the ships' captains. Since the firm made no payments of fixed or determinable annual or periodical income to the nonresident alien ships' captains, there would be no amounts from which withholding is required. (C. B. i, page 184; A. R. R. 265.) While certain income payments do not require withhold- ing, such payments, nevertheless, have a taxable status. In other words, relief from withholding does not make income non-taxable.^^ No withholding from interest on bank balances in certain cases. — Under the 1921 law interest paid to non-resident aliens not having a place of business in the United States, on deposits in domestic banks, is specifically exempt from taxation.^* Regulation. Under the Revenue Act of 1921 persons carrying on the banking business within the United States are not required to withhold any tax from interest on bank deposits which is paid to (or credited to the accounts of) persons not engaged in business within the United States and not having an office or place of business therein. Any tax which, subsequent to December 31, 1920, and pursuant to the Revenue Act of 1918, had been withheld by persons carrying on the banking business within the United States from interest on bank deposits paid to (or credited to the accounts of) non-resident alien individuals not engaged in business within the United States and not having an office or place of business therein, or foreign corporations not engaged in business within the United States and not having an office or place of business therein, shall be released and paid over to such nonresident alien individual or foreign corporation, or his or its representative. (Art. 372.) " Section 217 (a). °' [Former Procedure] Under the 1918 law interest on bank balances paid or credited to non-resident ab'cn individuals or foreign corporations was subject to withholding. See Income Tax Procedure, 1921, pages lOio and ion. I3I2 SPECIAL CLASSES OF TAXPAYERS Withholding from bond interest and ownership certificates required. — I. Form iooo (revised). — This form must be used in col- lecting interest on bonds in all cases in which there is with- holding at the source. A tax of 2 per cent must be withheld on bonds of domestic or resident corporations containing a tax- free covenant clause if the owner is (a) a non-resident alien individual or fiduciary, (b) a foreign partnership, (c) a for- eign corporation not having an office or place of business within the United States. If such bonds do not contain a tax-free covenant clause, a tax of 8 per cent must be withheld in the case of non-resi- dent alien individuals or fiduciaries, and 10 per cent^^ in the case of corporations not having an office or place of business within the United States. A foreign corporation not engaged in trade or business within the United States but having a fiscal agent in this country is not a resident corporation''*' and should use form IOOO in collecting interest on tax-free covenant bonds of do- mestic or resident corporations. It is held,*'^ however, that a resident fiscal agent or a resident paying agent of a foreign corporation or country which has issued bonds containing a tax-free covenant clause is required to withhold a tax of 2 per cent from interest on such bonds, when form 1000 (re- vised) is used by (a) citizens or residents not claiming ex- emption, (b) domestic or resident partnerships or (c) ap- proved personal service corporations."- It will be noted that such a foreign debtor is not required to withhold against domestic or resident corporations owning its bonds. Citizens or residents may claim personal exemption on such interest payments by filing form looiA (revised). '° Increased to 12' j per cent from January i, 1922, by section 237 of the 1921 law. "'Bulletin 4-19-225; O. D. 144. "' Letter to The Equitable Trust Company of New York, N. Y.. signed by Paul F. Myers, Acting Commissioner and dated July 7, 1920. ""No corporations are classed as personal service corporations after December 31, 1921. NON-RESIDENT ALIENS 1313 2. Form iooi (revised). — This form should be used by foreign partnerships in collecting interest on bonds of domestic or resident corporations which do not contain a tax-free covenant clause and by foreign corporations having an office or place of business within the United States, foreign govern-: ments and exempt foreign corporations, regardless of whether the bonds contain a tax-free covenant clause or not. There is no withholding if this form is used. 3. Form iooi A (revised). — This form is used for inter- est payments on foreign bonds when no withholding is re- quired and for foreign dividend payments. Such income is not taxable in the case of non-resident aliens, although the funds pass through domestic banking channels for payment. ^^ The form may be executed on behalf of a non-resident alien individual, fiduciary, partnership or corporation by any re- sponsible foreign or domestic banker having knowledge of the ownership of such securities. The name of the foreign owner need not be supplied, but the due date and date paid must be given. The paying agent, if within the United States, is treated as the source of information; otherwise the last bank or collecting agent is so regarded. 4. Form iooiB. — This form is used by non-resident aliens when a personal exemption is claimed in collecting in- terest on tax-free covenant bonds."'* The use of substitute certificates is not permitted in case of foreign payments.*'^ Exemption claim of alien in collecting tax-free covenant bond interest — form looiB.'" — Exemption certificates of non-resident aliens. — Regulation, (a) When the g-ross income (inchiding bond in- terest) of a nonresident alien, which is derived from sonrces within *^ See page 309. '" See page 309. ""^Art. 368; see page 311. ""See page 331 for discussion of when citizens or residents should claim exemption on tax-free covenant bonds. I3I4 SPECIAL CLASSES OF TAXPAYERS the United States, does not exceed the personal exemption of $1,000, allowed by section 216 (e), an exemption certificate. Form looi B, should be executed and filed with the withholding agent, if any part of the gross income is derived from interest upon bonds or similar obligations of a domestic corporation which contain a tax-free covenant clause. The amount of tax due from the withholding agent, as shown by Form 1013, may be reduced by 2 per cent of the aggregate amount of interest payments made to such nonresident alien upon tax-free covenant bonds during the calendar year. (b) When the gross income of a nonresident alien, derived from sources within the United States, does not exceed $1,000, such per- son may file with the withholding agent an exemption certificate on Form lOOi C with respect to interest upon bonds or similar obligations of a domestic corporation not containing a tax-free covenant clause. The debtor organization or withholding agent, upon receipt of a properly excuted certificate showing that the individual's income does not exceed $1,000, shall release and pay over to such individual upon demand any tax withheld during the preceding calendar year. The tax assessed against the withholding agent and which has not been paid may be made the subject of a claim for abatement to the extent of the amount of excess tax withheld, and refunded to the alien on the basis of this certificate. In case the tax so withheld has been paid to the Government, refund of the tax withheld in the case of non tax-free bonds and similar obligations can only be made to the bond owner or his duly authorized representative. The exemption certificates, Forms lOOi B and looi C, properly executed, may be filed with the debtor organization or its duly au- thorized withholding agent at any time after the close of the calen- dar year, but not later than j\Iay i of the succeeding year. Owner- ship certificates, however, must be filed in connection with all in- terest payments upon bonds and similar obligations of domestic cor- porations in accordance with the regulations, notwithstanding the fact that Form lOOi B or Form looi C is filed. (Art. 364.) Ruling While form looiB was intended, primarily, for reporting 1919 income, it may be adopted for reporting any interest received in respect of the years 1916 and 1918, in which case a sepa- rate form should be filed for each of those years, in respect of which the nonresident alien has received interest during the calendar year. (Extract from letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated February 3, 1920.) Procedure when foreign item is presented without owner- ship certificate and owner is unknown. — Ruling. In case foreign item is unaccompanied by certificate and owner is unknown, affidavit and form looiA, revised, showing name NON-RESIDENT ALIENS 1315 and address of payee should be executed by first bank unless item represents interest on bonds containing tax free covenant issued by foreign country or corporation having paying agent in U. S. in which case affidavit and form 1000, revised, should be executed by first bank in accordance with article 368.'''^ For audit purposes payee will be considered actual owner. (Telegram to the Equitable Trust Company, New York, signed by Commissioner Daniel C. Roper, and dated January 20, 1920.) No withholding on bond interest due prior to March i, 1913.— Ruling. Coupons which became due June i, 1910, presented on behalf of non-resident alien individual owner. Should the federal income tax be withheld therefrom? Please wire reply. (Answer.) Bond interest represents income to taxpayer when due and payable in accordance with article 54, Regulations 45. No tax required to be withheld from interest upon bonds due prior to March i, 1913, but paid subsequent to that date. (Telegram from Chicago & Northwest- ern Railway Company and the answer thereto, signed by Acting Commissioner Callan and dated August 26, 1919.) Withholding is required at the rates for the year in which coupons are paid, but if they became due and payable in prior years, a claim for refund of excess tax withheld may be made. — Ruling. Income tax should be withheld from interest payments to nonresident aliens upon bonds at rates in force during year in which payments were actually made, although bond interest is held to repre- sent income for year during which coupons became due and payable. Any tax withheld and paid to Government in excess of taxpayer's liability may be adjusted through claim for refund. (C. B. i, page 182; O. D. 167.) Duties and obligations of employers, in connection with withholding, in the case of non-resident aliens employed in the United States. — Employers are held liable for deduction of income tax from salaries, wages, or other fixed and deter- minable annual or other periodical income paid to non-resident alien employees since September 17, 1915, the date of issuance " See page 310, 1316 SPECIAL CLASSES OF TAXPAYERS of T. D. 2242, which defined a non-resident ahen and pre- scribed the certificate of residence, form loyS.^^ If it can be estabHshed, as provided in articles 312 to 316 that the ahen employee had in fact acquired residence, the employer will not be liable for tax, because no withholding is required in case of resident aliens. *^° Allowance of personal exemption'" to non-resident alien employee. Regulation. A nonresident alien employee may claim the bene- fit of the credit for personal exemption by filing with his employer Form 1 1 15, duly filled out and executed under oath. On the filing of such a claim the employer shall examine it. If on such examination it appears that the claim is in due form, that it contains no statement which to the knowledge of the employer is untrue, that such employee on the face of the claim is entitled to credit, and that such credit has not yet been exhausted, such employer need not until such credit be in fact exhausted withhold any tax from payments of salary or wages made to such employee. Every employer with whom affidavits of claim on Form 1115 are filed by employees shall preserve such affidavits until the following calendar year, and shall then file them, attached to his annual withholding return on Form 1042, with the collector on or before March i. In case, however, when the following calendar year arrives such em- ployer has no withholding to return, he shall forward all such affi- davits of claim directly to the Commissioner, with a letter of trans- mittal, on or before March 15. Where any tax is withheld the em- ployer in every instance shall show on the pay envelope or shall fur- nish some other memorandum showing the name of the employee, the date and the amount withheld. This article applies only to payments of compensation by an employer to an employee (Art. 315; Reg. 45, Art. 316.) Form 1 1 15, used to secure relief from withholding by a non-resident alien employee, may also be used by aliens other than employees to establish credit for personal exemption when a complete return of income from sources within the United States is filed. '^ '* See Income Tax Procedure. 1920, page 8:; "' See pages 1273-1276. '"See page 1295. " See page 1296. NON-RESIDENT ALIENS 1317 Refund of taxes erroneously withheld if alien cannot be found. Ruling. Tax erroneously withheld from the wages of a non- resident alien seaman, who can not now be located for the purpose of making refund, should be reported on the annual list return. Form 1042, and paid to the Government, and when the seaman is located he should be advised of his right to file claim for refund. (B. 16-19- 463; O. D. 258.) Refund of tax on establishment of residence. — Rulings. In cases where tax was withheld from wages of em- ployees who refused to sign the old Form 1078, but who have now signed the new Form 1078, the amount of tax should not be refunded by the employer upon execution of the new Form 1078. The amount of tax withheld should be reported on Form 1042 and paid to the col- lector of internal revenue for the district m which the withholding agent is located, subject to claim £or personal exemption provided in section 216 of the Revenue Act of 1918. If the personal exemption is not available to the nonresident alien, the amount of tax can be refunded only upon execution of Form 46, accompanied by a complete return of the individual's income from sources within the United States, and evidence establishing the fact that tax has been withheld in excess of the actual liability. (C. B. I, page 184; O. D. 107.) Any income tax withheld during the calendar year from the wages paid to an alien employee, which has not been paid over to the Gov- ernment, should be refunded to such alien employee upon the estab- lishment of residence by the execution and filing of Form 1078 with his employer. As a condition precedent the employer should require the employee to return the receipts showing the amount of tax pre- viously withheld before making the refund. (C. B. i, page 165; O. D. 302.) The fact that an alien has been employed by a resident corpora- tion for at least three months is not ipso facto sufficient to permit the employer to refund the amount of any tax withheld. Forms 1 115 and 1078 should be filed by resident or nonresident aliens in order to secure refund. (C. B. i, page 165; O. D. 254.) Alien employees — resident and non-rp:sident — with- holding upon change of .status. RuLiNG.s Where the status of an alien changes during the year from that of a resident to that of a non-resident, or from that of a non-resident to that of a resident, the s^^tus which exists at the 1318 SPECIAL CLASSES OF TAXPAYERS end of the taxable year is the one which determines his right to ex- emption as to the whole year. Where an employer has withheld wages from a non-resident during part of the year and thereafter the employee became a resident (before the employer has paid over to the United States the amount withheld), the employer is authorized on receiving proof of the change to refund to the employee the amounts which had been withheld from him during the earlier part of the taxable year, while his status was that of a non-resident (Extract from letter to W. B. Reed, Accounting Secretary, National Coal Association, Washington, D. C, signed by Commissioner Daniel C. Roper, and dated June 12, 1919.) .... If the status of a resident employee changes to that of a non-resident alien, the employer should withhold income tax at the rate of eight per cent from all wages paid to the non-resident employee on and after the date on which the employer had knowledge of the change. Although the employee, in such case, will be taxable as a non-resident alien for the entire taxable year during which his status is changed from that of a resident to that of a non-resident alien, the employer will not be held liable for the deduction of income tax with respect to wages paid preceding the knowledge of the employer as to the change in status. (Extract from letter to W. B. Reed, Account- ing Secretary, National Coal Association, Washington, D. C, signed by Commissioner Daniel C. Roper, and dated August 6, 1919.) Return of tax withheld."- — Regulation, (a) Every withholding agent shall make an annual return to the collector of the tax withheld from interest on corporate '' [Former Procedure ] Withholding from non-resident aliens at 1917 rates prior to February 25, 1919. — Regulation. "In the case of payments made prior to February 25, 1919, where a withholding agent pursuant to the Revenue Acts of 1916 and 1917 withheld only 2 per cent from the income of nonresident alien indi- viduals, he need return only such sum. In all such cases where a withhold- ing agent withheld the tax pursuant to the Revenue Acts of 1916 and 1917 from the income of foreign corporations not engaged in trade or business within the United States and not having any office or place of business therein, he need return only the sum withheld, to an amount not in excess of the aggregate sum required to be withheld by the terms of the Revenue Act of 1918 from the income paid over by the withholding agent. In the case of every payment made after February 24, 1919, the withholding agent must withhold at the rates prescribed by the present statute from the whole payment, not merely from that part which applies to the period after Febru- ary 24, 1919." (Reg. 45, Art. 371.) Withholding in 1918. — Regul.\tion. "Any sum withheld for tax since December 31, 1917, in excess of the aggregate amount required under the terms of the NON-RESIDENT ALIENS 1319 bonds or other obligations on or before March I on Form 1013. He shall also make a monthly return on Form 1012 on or be- fore the 2oth day of the month following that for which the return is made. The original ownership certificates, or the substitute certificates where authorized, must be forwarded to the Commissioner with the monthly return, (b) Every person required to deduct and withhold any tax from income other than such bond interest shall make an annual return thereof to the collector on or before March i on Form 1042 showing the amount of tax required to be withheld for each nonresident alien individual, partnership composed in whole or in part of nonresident aliens and not having an office or place of business within the United States, or foreign corporation not engaged in trade or business within the United States and not having any office or place of business therein, to whom income other than bond interest was paid during the previous taxable year. In every case of both classes the tax withheld must be paid on or be- fore June 15 of each year to the collector (Art. 371 ; Reg. 45, Art. 370.) Return of income from which tax withheld. — Regulation. The entire amount of the income from which the tax was withheld shall be included in gross income without de- duction for such payment of the tax. But any tax actually so with- held shall be credited against the total tax as computed in the tax- payer's return If the tax is paid by the recipient of the income or by the withholding agent it shall not be re-collected from the other, regardless of the original liability therefor, and in such event no penalty will be asserted against either person for failure to return or pay the tax where no fraud or purpose to evade payment is in- volved. (Art. 375; Reg. 45, Art. 376.) Revenue Act of 1918, shall be released by the withholding agent and paid over to the person from whom it was withheld or his proper representative. With reference to how a debtor corporation may release and pay over the amount of tax so withheld in a case where a bank or other collection agency detached the ownership certificate which accompanied an interest coupon and substituted its own certificate (form 1059), which does not disclose the name and address of the bond owner, in such cases the withholding agent shall request the bank or collection agency to disclose the name and address of the owner of the bonds, as shown by the original certificate, and it shall be the duty of the bank or collection agency to make such disclosure to the withholding agent. Where withholding agents have so released any excess of tax, an itemized statement showing the names, addresses and amounts refunded should be attached to the annual list return (form 1013), in order to reconcile any discrepancy between the aggregate amount of taxes returned as shown by the monthly list returns (form 1012) and the aggre- gate amount as shown b}' the annual list return." (Reg. 45, Art. 372.) 1320 SPECIAL CLASSES OF TAXPAYERS Foreign corporations doing business in the United States must file certificate. — Regulation To enable debtors in the United States to distinguish between foreign corporations which have and those which have not any office or place of business in the United States, and also to enable such corporations as have an office or place of business in the United States to claim exemption from withholding the tax on bond interest or other income, a certificate, Form 1086, stating that any such corporation has an office or place of business in the United States should be filed by it with the debtor. (Art. 601.) Return of information as to payments to non-resident aliens. '■'■ — Regulation. In the case of payments of annual or periodical income to nonresident alien individuals, partnerships composed in whole or in part of nonresident aliens and not having an office or place of business within the United States, or to foreign corporations not engaged in trade or business within the United States and not having any office or place of business therein, the returns filed by withholding agents on Form 1042 shall constitute and be treated as returns of information (Art. 1075; Reg. 45, Art. 1076.) Withholding in the case of Alien Property Custodian. — Regulation. Payments made after October 6, 1917, to the Alien Property Custodian are in the same category as payments made to or for citizens or residents of the United States. Withholding at the source is accordingly unnecessary except in the case of interest pay- ments on corporate bonds or other obligations containing a tax-free covenant where no exemption is claimed. The Alien Property Cus- todian should use Form 1000 (revised) in collecting interest on bonds containing a tax-free covenant and in all other cases should use Form looi (revised), except that in cases in which the Alien Property Cus- todian shall, under the trading-with-the-enemy act, demand payment to himself of interest accrued upon bonds or other securities not yet reduced to his custody (even though they be registered in the name of an enemy, ally of an enemy, or his agent or trustee), the corpora- tion paying such income to the Alien Property Custodian is authorized to accept from the Alien Property Custodian ownership certificates, Forms 1000 (revised) and lOOi (revised), altered by the substitution (in lieu of the certificate required thereon) of a certificate that the Alien Property Custodian is entitled to the interest entered therein with or without deduction of tax, as the case may be. No distinction " See Chapter X. NON-RESIDENT ALIENS 1321 is to be made between payments directly to the Alien Property Cus- todian and to his depositaries and between interest on registered bonds and interest on coupon bonds. In the case of enemies or allies of enemies holding a license granted under the provisions of the trading-with-the-enemy act, .withholding is required as in the case of any nonresident alien not an enemy or ally of enemy. (Reg. 45, Art. 375.) Ruling. A nonresident alien enemy is not liable for tax on prop- erty taken over by the Alien Property Custodian until it is returned to him. However, he is liable to tax on such other income as was not taken over by the Alien Property Custodian and should pay the same. If the property ultimately is returned to the enemy, any income de- rived from the property in the hands of the Alien Property Custodian as income, would be subject to tax in the hands of the alien enemy. Such alien should make a return on the proper form, showing all sources of income in the United States and the amount thereof, v/hether or not it was taken over by the Alien Property Custodian. Any tax withheld after October 6, 1917, which, under Treasury Decision 2673, was erroneously withheld, will be deemed to have been erroneously withheld up to the time of restoration of the property to the original owners by the Alien Property Custodian, but, after the restoration of the property, the tax so withheld if otherwise prop- erly withheld in accordance with the Revenue Act of 1916, as amended, if not in excess of the tax liability of such alien, will be deemed to have been properly withheld and, if returned and paid to the Govern- ment as income tax, may be taken as a credit against the tax shown to be due by the return required for the respective year to be sub- mitted at or after the restoration of the property by the Alien Prop- erty Custodian. (C. B. 3, page 219; O. D. 657.) Penalties for failure to withhold. — In case of failure to make returns and payments of tax severe penalties are im- posed. (See Chapter V^I.) License for collection of foreign items. — L.\w. Section 259. That all individuals, corporations, or partner- ships undertaking as a matter of business or for profit the collection of foreign payments of interest or dividends by means of coupons, checks, or bills of exchange shall obtain a license from the Commis- sioner and shall be subject to such regulations enabling the Govern- ment to obtain the information required under this title as the Com- missioner, with the approval of the Secretary, shall prescribe; and whoever knowingly undertakes to collect such payments without having obtained a license therefor, or without complying with such 1322 SPECIAL CLASSES OF TAXPAYERS regulations, shall be guilty of a misdemeanor and shall be fined not more than $5,000, or imprisoned for not more than one year, or both. Regulation. Banks or agents collecting foreign items, as defined in article 1076, and required by article 1079 to make returns of in- formation with respect thereto, must obtain a license from the Com- missioner to engage in such business. Application Form 1017 for such license may Ijc procured from collectors. The license is issued without cost on Form loio. Foreign items shall not be ac- cepted for collection by any bank or collecting agent so licensed un- less properly indorsed or accompanied by proper ownership certifi- cates giving all the information called for by such certificate (Art. nil.) Taxation of Citizens or Residents of United States Possessions and Persons Deriving Income Therefrom Citizens of United States possessions taxed as non-resident aliens. — Law. Section 260. That any individual w^ho is a citizen of any possession of the United States (but not otherwise a citizen of the United States) and who is not a resident of the United States, shall be subject to taxation under this title only as to income derived from sources within the United States, and in such case the tax shall be computed and paid in the same manner and subject to the same conditions as in the case of other persons who are taxable only as to income derived from such sources Regulation. A citizen of a possession of the United States (except the Virgin Islands), who is not otherwise a citizen or a resi- dent of the United States, including only the States, the Territories of Alaska and Hawaii, and the District of Columbia, is treated for the purpose of the tax as if he were a nonresident alien individual. .... His income from sources within the United States is subject to withholding (Art. 1121.) Citizens of Virgin Islands. — Law. Section 260. .... Nothing in this section shall be con- strued to alter or amend the provisions of the Act entitled "An Act making appropriations for the naval service for the fiscal year ending June 30, 1922, and for other purposes," approved July 12, 1921, relat- ing to the imposition of income taxes in the Virgin Islands of the United States. NON-RESIDENT ALIENS 1323 Regulation The Act referred to in section 260 of the statute provided that income tax laws then or thereafter in force in the United States should apply to the Virgin Islands, but that the taxes should be paid into the treasury of the Virgin Islands. Ac- cordingly, a citizen or resident of the Virgin Islands is taxed there under the provisions of the Revenue Act of 1921. (Art. 1121.) Non-residents of Porto Rico or the Philippine Islands. — Law. Section 261. That in Porto Rico and the Philippine Islands the income tax shall be levied, assessed, collected, and paid as provided by law prior to the passage of this Act.'* The Porto Rican or Philippine Legislature shall have power by due enactment to amend, alter, modify, or repeal the income tax laws in force in Porto Rico or the Philippine Islands, respectively. Regulation, (a) A citizen of the United States who resides in Porto Rico, and a citizen of Porto Rico who resides in the United States, are taxable in both places, but the income tax in the United States is credited with the amount of any income, war profits, and excess profits taxes paid in Porto Rico (^) A resident of the United States, who is not a citizen of Porto Rico, is taxable in Porto Rico as a nonresident alien individual on any income derived from sources within Porto Rico, but the income tax in the United States is credited with the tax paid in Porto Rico, (c) A resident of Porto Rico, who is not a citizen of the United States, is taxable in the United States as a nonresident alien individual on any income derived from sources vvithin the United States, and receives no such credit The same principles apply in the case of the Philip- pine Islands. (Art. 1132.) It has been held that a foreign corporation transacting business and having a place of business in both continental United States and in Porto Rico, is not subject to income tax in continental United States upon income derived from Porto Rico under the Act of September 8, 19 16, as amended by the Act of October 3, 1917.''^ This avoidance of double taxation is further supported by the following regulation. Regulation, (a) A United States corporation which derives income from sources within Porto Rico, (b) a Porto Rico corpora- tion which derives income from sources within the United States, and (c) a corporation of a foreign country which derives income " For the provision of prior laws alluded to in tins section, see Income Tax Procedure, 1921, page 1022. "C. B. 2, page ^60,; Q, 976. 1324 SPECIAL CLASSES OF TAXPAYERS both from sources within Porto Rico and from sources within the United States, are all taxable in both places. In the case of the United States corporation the income, war profits, and excess profits taxes in the United States are credited with the amount of any income, war profits, and excess profits taxes paid in Porto Rico. In the case of the Porto Rico corporation there is no such credit. .... The corporation of the foreign country deriving income from both places is subject to no double taxation so far as the United States and Porto Rico are concerned For the purpose of withholding, a Porto Rico corporation is a foreign corporation. .... The same principles apply in the case of the Philippine Islands. (Art. 1133.) Income from sources within the possessions'® of the United States. — In order to avoid the repetition of hardships that have resulted to taxpayers through double taxation such as existed under the law of 19 18, whereby United States citizens resident in the Philippines could be taxed twice upon the same income,'" a new section (262) has been incorporated in the 192 1 law, effective from January i, 192 1. This section de- termines the status of citizens resident in possessions of the United States as to whether, for purposes of taxation, they could be considered non-resident aliens or residents. Law. Section 262. (a) That in the case of citizens of the United States or domestic corporations, satisfying the following conditions, gross income means onlj' gross income from sources within the United States— (i) If 80 per centum or more of the gross income of such citizen or domestic corporation (com.puted without the benefit of this section) for the three-year period immediately preceding the close of the taxable year (or for such part of such period immediately pre- ceding the close of such taxable year as may be applicable) was de- rived from sources within a possession of the United States; and (2) If, in the case of such corporation, 50 per centum or more of its gross income (computed without the benefit of this section) for such '"Law. Section 262. " . . . . (c) As used in this section the term 'pos- session of the United States' docs not include the Virgin Islands of the United States." Regulation. " . . . . The term 'possession of the United States' .... includes Porto Rico, the Philippine Islands, the Panama Canal Zone, Guam, Tutuila, Wake, and Palmyra; it does not include the Virgin Islands." (Art. 1137.) "C. B. 4. Page55; T. D. 3178. NON-RESIDENT ALIENS 1325 period or such part thereof was derived from the active conduct of a trade or business within a possession of the United States; or (3) If, in the case of such citizen, 50 per centum or more of his gross income (computed without the benefit of this section) for such period or such part thereof was derived from the active conduct of a trade or business within a possession of the United States either on his own account or as an employee or agent of another The foregoing subsections (i) and (2) make citizens or domestic corporations having such income derived from sources within United States possessions, subject to taxation on net income computed under section 217 of the 192 1 law. In computing gross income under section 217, taxpayers, in arriving at the percentage necessary to secure the benefit of taxation under section 262, must furnish all the data con- cerning gross income from sources both within and without the United States. In other words, to satisfy the Commissioner as to the correctness of this assumption that they are entitled to the benefits extended by section 262, they must make a return showing their computation to be correct. Law. Section 262 (b) Notwithstanding the provisions of subdivision (a) there shall be included in gross income all amounts received by such citizens or corporations within the United States, whether derived from sources within or without the United States Section 262 (b) means that if United States citizens and domestic corporations remit amounts received in United States possessions to the United States, such amounts must be in- cluded in gross income. If taxpayers have qualified under sec- tion 262 (a) and wish to omit from gross income amounts received from without the United States, it is important that such amounts also Ije disljursed without the United States. CHAPTER XXXVII FIDUCIARIES The sections of the 192 1 law relating to fiduciaries, which differ in no essential features from that of 1918, have clarified rather than changed the provisions of the 1916, 1917, and 1918 laws. Fiduciary defined. — A fiduciary is one who occupies a posi- tion of peculiar confidence toward others. As a general rule, a fiduciary has legal title to the property and those for whom he acts enjoy the beneficial title. The law defines a fiduciary as follows : Law. Section 200 (2) The term "fiduciary" means a guar- dian, trustee, executor, administrator, receiver, conservator, or any per- son acting in any fiduciary capacity for any person, trust or es- tate;^ .... Regulation. "Fiduciary"' is a term which applies to all persons that occupy positions of peculiar confidence toward others, such as trustees, executors, and administrators, and a fiduciary for income tax purposes is a person who holds in trust an estate to which another has the beneficial title or in which another has a beneficial interest, or receives and controls income of another as in the case of receivers. A committee or guardian of the property of an incompetent person is a fiduciary (Art. 1521.) It has been held that property of enemy aliens which w^as seized and is held by the Alien Property Custodian, cannot be said to be held in trust within the meaning- of the Revenue Act ^ [Former Procedure] The act of 1913 included agents in the defini- tion of fiduciaries, but as this clearly did not mean the ordinary agent or attorney, and the Treasury so held, the word was omitted from the 1916 law. Prior to 1918, fiduciaries were considered the agents having the receipt, custody, control and disposal of non-resident alien beneficiaries' income, and as such were required to make return for such beneficiaries, and to pay any and all tax found by such return to be due, provided return was not made by the beneficiary. Since 1918 a fiduciary for a non-resident alien is required to account for any and all normal and surtax upon income paid to such a beneficiary. If this results in payment of excessive taxes, relief must be sought by filing a return and claiming refund. 1326 FIDUCIARIES 1327 of 1918.^ The Alien Property Custodian is construed to be merely an agent or officer of the government and not a trustee or fiduciary such as is required to make returns and pay in- come tax. While it is held that the custodian is not required to make returns and pay tax, the Treasury, before paying out any funds representing accrual of income during retention of the alien's property by the government, may ascertain the taxes due on such income and require that they be paid. Fiduciary distinguished from agent. — Regulation. There may be a fiduciary relationship between an agent and a principal, but the word "agent" does not denote a fidu- ciary. A fiduciary relationship can not be created by a power of attorney. An agent having entire charge of property, with authority to effect and execute leases with tenants entirely on his own responsi- bility and without consulting his principal, merely turning over the net profits from the property periodically to his principal by virtue of authority conferred upon him by a power of attorney, is not a fiduciary within the meaning of the statute. In cases where no legal trust has been created in the estate controlled by the agent and attor- ney the liability to make a return rests with the principal. (Art. 1522.) Rulings. A.n oral agreement wheieby one of a number of brothers and sisters acts as agent for all of them in managing prop- erty held by them as tenants in common under the father's will, and in distributing the income therefrom, is not a legal trust for income- tax purposes, nor is the agent a fiduciary. Each principal should file a separate return including therein his share of the income from the property and claiming a proportionate share of any allowable deduc- tions. (C. B. 2, page 198; O. D. 425.) By an agreement among owners of unequal portions of a royalty interest in oil and gas wells, A was appointed to receive from the purchaser of the oil and gas, moneys arising from the sale and run- ning of the oil and gas and to account therefor to the signers of the agreement. A also had authority under the agreement to sign di- vision orders respecting the sale and running of the oil and gas from the land. The agreement conveyed no property to A. Held, that A is an agent of the signers and not a trustee within the meaning of the Revenue Act of 1918 and is not required to file a return on l-'ornis 1040 or 1041 to account for the income received by him. Since the amounts paid over by him to his principals are 'C. B. 3, page 199; Op. A. G. 2. 1328 SPECIAL CLASSES OF TAXPAYERS not fixed and determinable gains, he is not liable for the filing of re- turns of information under section 256 of the aforesaid Act (C. B. 4, page 14; O. D. 875.) Receivers are all classed as fiduciaries.^ — Law. Section 239 (a) .... In cases where receivers, trustees in bankruptcy, or assignees are operating the property or busi- ness of corporations, such receivers, trustees, or assignees shall make returns for such corporations in the same manner and form as corpora- tions are required to make returns. Any tax due on the basis of such returns made by receivers, trustees, or assignees shall be collected in the same manner as if collected from the corporations of whose busi- ness or property they have custody and control.* .... Responsibility of fiduciary. — A fiduciary cannot be held personally responsible for erroneous or fraudulent re- turns by the decedent, but an}' additional tax arising from such returns would ht a charge against the estate. It might properly be held that such a fiduciary should not make a final distribution until all past returns had been audited. Association" distinguished from trust. — Regulation. Where trustees hold real estate subject to a lease and collect the rents, doing no business other than distributing the income less taxes and similar expenses to the holders of their receipt certificates, who have no control except the right of filling a vacancy among the trustees and of consenting to a modification of the terms of the trust, no association exists and the cestuis que trust are liable to tax as beneficiaries of a trust the income of which is to be dis- tributed periodically, whether or not at regular intervals. But in such a trust if the trustees pursuant to the terms thereof have the right to hold the income for future distribution, the net income is taxed to the trustees instead of to the beneficiaries If, how- ever, the cestuis que trust have a voice in the conduct of the business of the trust, whether through the right periodically to elect trustees or otherwise, the trust is an association within the meaning of the statute.® (Art. 1504.) ^ See footnote 22, page 1341. * See page 1341 where this point is elaborated. "An organization the membership interests in which are transferable without the consent of all the members, however the transfer may be other- wise restricted, and the business of which is conducted by trustees or direc- tors and officers without the active participation of all the members as such, is an association and not a partnership. (Art. 1503.) *As to Massachusetts trusts, see page 93. FIDUCIARIES 1329 It has been ruled that, under the 191 6 law as amended by the 19 17 law, the test as to whether or not a reorganization committee of bondholders constituted an association, depended upon the degree of control which the latter exercised over the former. While the power to terminate a trust is not alone enough to render a trust taxable as an association, retention of sub- stantial control over the management of the trust does operate to make the trust an association within the meaning of the law/ The quesion of substantial control over the management of a trust is one of fact and there must be a clear showing in each case in order that it may be determined whether the trust is to be taxed as an association'^ or not. It was held in Crocker V. Malley^ that : .... The trustees by themselves cannot be a joint stock associa- tion within the meaning of the act unless all trustees with discretion- ary powers are such, and the special provision for trustees in D is to be made meaningless. How Estates and Trusts Are Taxed Rates of tax. — Law. Section 219. (a) That the tax^o imposed by sections 210 and 211 shall apply to the income of estates or of any kind of prop- erty held in trust, including — Income subject to tax. — (i) Income received by estates of deceased persons during the period of administration or settlement of the estate; 'C. B. 3, page 13; Sol. Op. 49. » Cf. Bulletins : C. B. I, page 5; S. 1068 C. B. 3, page 13; Sol. Op. 49 " I, " 7; S. 1205 " 3, " 13; O. D. 6S4 " I, " 9; O. D. 620 " 4, " 10; O. D. 790 and " 2, " 9; S. 1337 O. D. 868 " 2, " 11; O. D. 407 " 4, " 11; O. D. 886 " 3, " 9; O. D. 598 B. 30-21-1741; T. D. 3193 " 3, " 10; Sol. Op. 56 B. 38-21-1830; O. D. 1040 °249 U. S. 223, 63 L. Ed. 573, 39 Sup Ct. 270, 2 A. L. R. looi. " The tax referred to is the normal and surtax imposed in the case of individuals. (See Chapter VII.) I330 SPECIAL CLASSES OF TAXPAYERS (2) Income accumulated in trust for the benefit of unborn or unascertained persons or persons with contingent interests; (3) Income held for future distribution under the terms of the will or trust; and (4) Income which is to be distributed to the beneficiaries period- ically, whether or not at regular intervals, and the income collected by a guardian of an infant to be held or distributed as the court may direct Returns by Fiduciaries Law. Section 225. (a) That every fiduciary (except a receiver appointed by authority of law in possession cf part only of the property of an individual) shall make under oath a return for any of the follow- ing individuals, estates, or trusts for which he acts, stating specifically the items of gross income thereof and the deductions and credits allowed under this title — When returns are required. — (i) Every individual having a net income for the taxable year of $1,000 or over, if single, or if married and not living with husband or wife; (2) Every individual having a net income for the taxable year of $2,000 or over, if married and living with husband or wife; (3) Every individual having a gross income for the taxable year of $5,000 or over, regardless of the amount of his net income; (4) Every estate or trust the net income of which for the taxable year is $1,000 or over; and (5) Every estate or trust of which any beneficiary is a nonresident alien Attention is directed to subdivision (3) in tlie foregoing. The statute now directs that every individual taxpayer having a . 3, page 203; O. D. 598.) Withholding the tax." ~ fhe duties of a fiduciary as with- holding agent are twofold. On payments to non-resident aliens of rent, salary, interest on debts of the estate and of other fixed or determinable annual or periodical income, he acts in the capacity of a withholding agent and, like any other payer of similar income, he is authorized to accept the same ownership certificates and is required to file the same annual list returns. For a description of his duties in this capacity, see pages 297 and 314, dealing with the collection of the tax at the source on miscellaneous income payable to non-resident aliens. In his capacity as a fiduciary, when he pays the net income or profits of the estate to the non-resident alien beneficiaries he proceeds as indicated on page 1300 of Chapter XXXVI, "Non- Resident Aliens." It is not his duty to deduct the tax on payments to citizens or resident beneficiaries. When the fidu- ciary pays over any part of the principal or corpus of the estate no tax is due. The tax is deducted only on income payments. Property coming to the estate by gift, bequest, devise or de- scent may be distributed among the beneficiaries without re- gard to the tax, since such income is expressly declared to be exempt from the law. Gains or income from such property, however, are taxable. On payments to non-resident aliens the tax should be de- ducted regardless of the amount paid. A non-resident alien by filing a complete return of income from sources within the United States may secure the benefit of the personal exemp- tion, if entitled thereto. (See page 1295.) ^ See Chapter XXXVT. '' [Former Procedure] The previous provisions of law, requiring fiduciaries to withhold the tax at the source, were reoealed on October 3, 1917, except as they applied to non-resident aliens. FIDUCIARIES 1357 No penalty for delay in payment in certain cases. — Law. Section 250. .... (e) If any tax remains unpaid after the date when it is due, and for ten days after notice and demand by the collector, then, except in the case of estates of insane, deceased, or insolvent persons, there shall be added as part of the tax the sum of 5 per centum on the amount due but unpaid, plus interest at the rate of i per centum per month upon such amount from the time it became due: .... Determination of Income Taxable to Fiduciaries and to Beneficiaries There has been included in the 1921 law an additional sub- division to section 219. This addition summarizes the appor- tionment of the income of an estate or trust when such income arises from various sources. Law. Section 219 (e) In the case of an estate or trust the income of which consists both of income of the class described in paragraph (4) of subdivision (a) of this section and other income, the net income of the estate or trust shall be computed and a return thereof made by the fiduciary in accordance with subdivision (b) and the tax shall be imposed, and shall be paid by the fiduciary in accordance with subdivision (c), except that there shall be allowed as an additional deduction in computing the net income of the estate or trust that part of its income of the class described in paragraph (4) of sub- division (a) which, pursuant to the instrument or order governing the distribution, is distributable during its taxable year to the bene- ficiaries. In cases under this subdivision there shall be included, as provided in subdivision (d) of this section, in computing the net in- come of each beneficiary, that part of the income of the estate or trust which, pursuant to the instrument or order governing the distribution, is distributable during the taxable year to such beneficiary The foregoing covers the procedure when income includes items taxable to both fiduciary and beneficiarN'. The method prescribed may be summarized as follows: I. The fiduciary computes net income in same manner as for an individual, except that deductions may be made, (a) For gifts directed by the will or trust instru- ment without limitation. 1358 SPECIAL CLASSES OF TAXPAYERS (b) For amounts properly paid or credited to heirs, legatees, or beneficiaries. 2. The beneficiary computes net income as to such items in (a) and (b) above as apply to heirs. For convenience it will be desirable to discuss the deter- mination of net taxable income in the following cases: 1. Income of a deceased person to date of death. 2. Income of an estate in the process of administration. 3. Income when definite trusts have been created. 4. Income paid to non-resident aliens from resident and non-resident estates and trusts. Determination of net taxable income during administra- tion of an estate. — Regulation No taxable income is realized from the passage of property to the executor or administrator on the death of the decedent, even though it may have appreciated in value since the decedent acquired it. In the event of the delivery of property in kind to a legatee or distributee, no income is realized. Where, however, the executor sells property of the estate for more than its value at the death of the decedent, the excess is income or may be capital gain taxable to the estate (Art. 343.)^® Ruling. A died testate in 1917 and his widow qualified as ad- ministratrix with the will annexed in 1918. The entire estate was left to the widow with the exception of lox dollars which was be- queathed to B. The legacy given to B was paid in 1918 and during that year all debts, taxes and costs of administration were paid in full and the widow, as sole beneficiary, reduced whatever remained to her possession as her personal estate. All the income of the estate since the decedent's death has been reported by the widow in her individual returns. Upon making final report and settlement in 1921 a court order was issued discharging the widow from liability as administra- trix. Held, that inasmuch as the estate of A was in the process of ad- ministration until 1921, the widow as administratrix, is required to file a return for the estate for each of the periods from the date of the decedent's death to December 31, 1917, January i, 1918, to De- cember 31, 1918, January i, 1919, to December 31, 1919, January i, "°For definition of "period of administration," see balance of Art. 343. quoted on page 1335. FIDUCIARIES 1359 1920, to December 31, 1920, and January i, 1921, to the date of her discharge, during which the net income of the estate equaled or ex- ceeded $1,000. The return for the period from the date of the de- cedent's death to December 31, 1917, should be on Form 1040 or 1040A, and the administratrix will be required to pay the tax which may be assessed on the basis of such return. In the event the income of the estate for any of the other periods in question was $1,000 or more as computed without deducting the amount paid or credited to the beneficiary, returns covering such periods should also be made on Form 1040 or 1040A, as the case may be. The returns should be accompanied by a statement showing that during each period the en- tire net income was paid or credited to the widow as sole beneficiary. .... (C. B. 4, page 225; O. D. 926.) The net income of an estate in the process of administra- tion is ordinarily determined on the same basis and in the same manner as in the case of a single individual," except that a, credit is allowed for any payments made to a Ijeneficiary and the deduction for charitable contributions (paid or set aside "pursuant to the terms of the will or deed creating the trust"'^'') is not limited to 15 per cent, as in the case of individuals. In- come ordinarily exempt when received by individuals, such as proceeds of life insurance,^'' municipal and other exempt bond interest, etc., is also exempt when received by an estate. A decedent contracts for the sale of certain property and receives, during his lifetime, earnest money binding the contract. After his death and during the period of adminis- tration the sale is consummated, title passes and possession is taken by the purchaser. Held that no income accrues from the transaction to either the decedent or the estate. *° The reason is obvious. No completed transaction occurred dur- ing decedent's lifetime; he merely received the cash deposit and retained title to the ])ropcrty. 'l"he property, with the con- " Estates taxed as entities arc allowed an exemption of $1,000 only. '" Section 2ig (b). " [Former Procedure] Under the 1916 and IQ17 laws all proceeds of life insurance policies payable to others than the individnal beneficiaries were taxable (section 4). The 1913 law (section B) stated that net income should not include "the proceeds of life insurance policies paid upon the death of the person insured." *" C. B. 4, page 224; O. D. 807. 1360 SPECIAL CLASSES OF TAXPAYERS tract, passes to the estate of the decedent at his death and is vakted for inclusion in the corpus of that estate at the sale price agreed upon by the decedent. When the balance of the purchase money is paid there is no difference between the value of the property on the books of the estate and the amount received therefor. Consequently no gain or loss is realized. Current expenses incurred in the management of an estate may be deducted, but the initial expenses may not. The Treasury makes a distinction between such first expenses of the estate as are properly chargeable against the corpus or principal of the estate and to that extent reduce the size of the estate, and other management expenses arising from the nature of the properties and details of the business, which arc prop- erly deductible from the year's gross income. Ruling. Executors who continue the trade or husiness of the decedent may deduct from the gross income of the estate, in computing its net income, all ordinary and necessary expenses paid or incurred during the taxable year in continuing such trade or business, but may not deduct expenses of administration. The amounts which may be deducted as salaries or other compen- sation for personal services are limited to a reasonable compensation for personal services actually rendered in continuing the trade or business of the decedent (C. B. 4, page 119; Sol. Op. 88.) Regulation Expenses of the administration of an estate such as court costs, attorney's fees and executor's commissions, are chargeable against tlie corpus of the estate and are not allowable deductions (Art. 293.) An assessment levied f)n Ijank stock owned by decedent is held by the Treasury to be additional cost of such stock and not a deductiljle loss. Ruling. An assessment of 100 per cent on the par value of bank stock paid by the executor of the estate of a deceased stockholder in fulfillment of a statutory liability is not deductible from the gross in- come of the estate. The amount so paid should be added to the fair market value of the shares as at the date of the testator's death and the resultant sum used as a basis in determining gain or loss realized upon final disposition of the shares of bank stock by the executor. , . . . (C. B. 4, page 213; O. D. 918.) FIDUCIARIES 1361 Gain or loss from sale of stock received as stock dividend. — The manner of determining gain or loss from the sale of stock acquired as stock dividend is fully discussed and exempli- fied in Chapter XXXIII. The taxability of the income of a trust estate arising from such a source is dealt with in the following ruling: Ruling If the income of the trust estate is distributable periodically, including any profit realized on the sale of such capital assets belonging to the estate, any gain realized from the sale of such capital assets is taxable income to the beneficiaries regardless of whether distributed or not. If the income of the trust estate is not distributable or is distributable in the discretion of the trustee, any profit realized from the sale of capital assets is taxable in the hands gf the trustee regardless of whether distributed or not. As will be noted from Article 1547 of Regulations 45, any loss sustained on the sale of capital assets is available as a deduction only to the fiduciary of the estate or trust in determining the income of the estate or trust taxable to the fiduciary and such loss is not available to the benefici- aries who are taxed on their actual distributable income. In the case of stock received as a stock dividend being distributed to the benefici- aries by the fiduciary, this would constitute a distribution in kind of the property of the estate and no taxable gain or deductible loss results to the beneficiaries until such stock is sold or otherwise dis- posed of by them. (Letter to the Safe Deposit and Trust Company, Baltimore, Maryland, signed by E. H. Batson, Deputy Commissioner, dated December 8, 192 1.) Federal estate tax deductible. — Contrary to former pro- cedure" and in keeping with the following decision of the United States Supreme Court,^^ federal estate tax is now de- ductible from the income of the estate in the year when such tax becomes due. Ruling. Federal estate tax paid by executors of an estate is an allowable deduction, under section 214, in ascertaining the net taxable income of the estate for the year in which said estate tax "accrued," which means became due. (C B. 4, page 153; T. D. 3195.) The decision is based entirely on the fact that when the "[Former Procedure] Reg. 45 (1918), Art. 134: " . . . . Federal estate taxes arc not deductible." " U. S. V. Woodward. Supreme Court, June 6, 1921, advance opinions, 65 L. Ed. 728. 1362 SPECIAL CLASSES OF TAXPAYERS 1918 income tax law was promulgated it provided for the deduction of '"taxes paid or accrued within the taxable year imposed (a) by the authority of the United States except income, war profits, and excess profits taxes. "*^ At the time of such promulgation an estate tax was in existence and, further, was reimposed in Title IV of the 1918 law itself. No steps were taken to make the estate tax a non-deductible item from gross income; therefore it is logical to assume that Congress did not intend to exclude it. In view of this decision, executors and administrators \yho have filed returns since September 9, 1916, (the effective date of the 1916 law) without claiming the federal estate tax as a deduction for the year in which it became due, should file a claim for refund or credit. In this connection, however, due notice must be taken of the limitations imposed by the various laws on claims for refund. Other taxes. — Taxes or assessments for local benefits are not ordinarily deductible.*^ It has been held that where such taxes are paid by a tenant on behalf of, and under agreement with, his landlord, they may be considered as additional rent paid by the tenant.*'^ When such rent is a business expense the item would, therefore, be deductible in determining net taxable income. Unrealized losses not deductible by the estate. — Ruling. A loss can not be claimed in a return rendered for a decedent covering the taxable period to the date of his death where the cost of securities, or their fair market value as at March i, 1913, if acquired prior thereto, is in excess of the value established by appraisal for the purposes of administering the estate, except in the case of a decedent who was a dealer in securities and regularly in- ventoried his securities and made his return accordingly. The exec- utor should not make returns of book gains or losses, either up to the date of death or on transfer of the property to tlie legatee or to *^ 1918 law, section 214 (a-3). "Law. section 214 (a-3) and (c). "Digest II, page 116; O. D. 373. FIDUCIARIES 1363 a trustee under the will, or from one trustee to a succeeding trustee, the appraised value remaining as the basis for computing all subse- quent realizations of losses or gains in cash. (C. B. 1, page 180; O. D. 219.) In Chapter XXVI, "Deductions for Expenses," deductions for exhaustion of the principal of life or other terminable interest acquired by gift, bequest, or inheritance are discussed, particularly having regard to section 215 (b) of the 192 1 law, which specifically forbids such deductions by beneficiaries of such interest. Expenses connected with sale of property deductible — when ? — Ruling. An executor who pays to another, as agent, a commis- sion upon the sale of property belonging to the estate may deduct from the selling price the amount so paid in determining the gain or loss arising from the sale. An executor who retains as his commission a portion of the amount received by him from the sale of property belonging to the estate may not deduct the amount in preparing a return for the estate since any service performed by him in that connection is deemed to be a part of his duties as executor. Such a commission, however, should be included in the gross income reported in the executor's personal return for the year in which received. Where property owned by an estate is sold, the amount of the stamp tax upon the deed conveying title to the property constitutes an allowable deduction in the return of the estate. (C. B. 3, page 204; O. D. 632.) Deduction for depreciation. — In the illustration in arti- cle 347 neither the estate as a unit nor the beneficiary receives credit for the actual depreciation. The following quotation from Bulletin "F" indicates a more logical solution, viz., that whether or not the estate is treated as a unit, depreciation will be allowed. Ruling. An individual who receives income from a trust estate may not deduct from gross income in his individual income tax return any amount representing depreciation of property belonging to the estate. However, under the Revenue Act of 1918 it is permis- sible for the fiduciary in ascertaining the net income of the estate 1364 SPECIAL CLASSES OF TAXPAYERS or trust for which he acts to deduct a reasonable allowance to cover the depreciation sustained during the taxable year, whether or not the terms of the will or agreement creating the estate or trust or a decree of court provide for taking care of the depreciation which may be sustained on the property held in trust. Estates and trusts in certain circumstances are treated as units and in other cases may represent aggregates of distinct interests, to all of which the fiduciaries are responsible. Irrespective of whether the estate or trust is or is not treated as a unit, the fiduciary in com- puting the net income upon which he is required to pay the tax may claim a deduction for depreciation in accordance with section 214 (a) 8 Revenue Act of 1918 and articles 161-171 Reg. 45. See also T. D. 2987. (Bulletin "F," page 32.) Deductions for net losses. — The provisions in section 204 of the 191 8 law for the deduction of net losses sttstained dur- ing any taxable year ended October 31, November 30, or December 31, 191 9, has, with some modification, been revived in the new law and made effective from January i, 1921. Under the 1918 law the net loss arrived at in accord with the requirements of this section was deducted from the prior year's income, so far as such income permitted, and the bal- ance, if any, was deductible from the following year's income. The 192 1 law, however, assigns all deductions in this respect to future years only.'*" Law. .Section _'04. .... (c) The benefit of this section shall be allowed to the members of a partnership and the beneficiaries of an estate or trust (d) If it appears, upon the production of evidence satisfactory to the Commissioner, that a taxpayer having a fiscal year beginning in 1920 and ending in 1921 has sustained a net loss during such fiscal year, such taxpayer shall be entitled to the benefits of this section in respect to the same proportion of such net loss which the portion of such fiscal year falling within the calendar year 1921 is of the entire fiscal year. The benefit is extended to beneficiaries, as such. Assume a year's income from an estate during the period of admin- istration to be made up as follows : " .See page 1021. FIDUCIARIES 1365 Net income from investments $60,000 Loss on operation of decedent's business 20,000 Net income of estate $40,000 Under the terms of the will the income from the invest- ments was to be distributed among two beneficiaries in equal shares. The earnings of decedent's business went to a third beneficiary and formed his only source of income. The first two beneficiaries receive their $30,000 each ; the latter receives nothing, since there were no earnings from the business, but a loss instead. Under section 204 of the law, however, the $20,000 loss will be deductible in the two succeeding taxable years to the extent that the income during those years shall be sufficient to equal the loss. The inclusion of beneficiaries specifically in this provision is intended to remove any question that might otherwise arise as to their status in relation thereto. A fiduciary who carries on the regular business of the decedent and distributes the income therefrom to beneficiaries as and when received, would not be subject to tax. The beneficiaries pay the tax under such circumstances.*^ Without the provision under discussion it might technically be held, under these conditions, that the law did not permit of the deduction by a beneficiary of net losses. Deduction for contributions. — Law. Section 219 (b) .... except that (in lieu of the deduction authorized by paragraph (11) of subdivision (a) of section 214) there shall also be allowed as a deduction, without limitation, any part of the gross income which, pursuant to the terms of the will or deed creating the trust, is during the taxable year paid or permanently set aside for the purposes and in the manner specified in paragraph (11) of subdivision (a) of section 214 '** Ruling. The amount of undistributed net income which is re- tained and permanently set aside for certain charitable and educa- " Law, section 219 (d). "Section 214 (a-ii) refers to deduction for contributions. 1366 SPECIAL CLASSES OF TAXPAYERS tional organizations designated by the will of a decedent, which were in existence at the time such income was permanently set aside, and was then reinvested for the estate, falls within the meaning and intent of part of section 219 (b) of the Revenue Act of 1918.^^ .... Therefore the income so permanently set aside, retained, and invested by the executors and trustees is not subject to tax. This does not, however, apply to income set aside for the benefit of an organization not fully in existence, as to which no deduction is au- thorized.''''' (C. B. 3. page 203; A. R. R. 280.) The foregoing ruling, which appHes to the 19 18 law, was evidently based upon a recent case'^'^ decided by a Circuit Court of Appeals under the laws prior to the 1918 act. The facts in this case were as follows : Decision. By his will Alexander J. Derbyshire, who died in 1879, devised his residuary estate to "the contributors to the Penn- sylvania Hospital," a corporation of Pennsylvania created for char- itable uses and purposes, and no part of the net income thereof is for the benefit of any private stockholder or individual. The devise was subject to the payment to certain annuitants, all of whom, save one, have died. The residuary estate amounts to several hundred thousand dollars, its annual income is substantially $15,000 and up- wards, and the remaining annuity is for a few hundred dollars per year. The construction of the will came before the Supreme Court of Pennsylvania in Biddle's Appeal, 99 Pa. 525, wherein the title to the residuary estate was adjudged vested in the hospital It will thus be seen that, while the residuary estate remains theo- retically and for purposes of accounting in the hands of the trustee, it is already in the possession of the hospital in the shape of money loaned on mortgage, and upon such loan the hospital is paying to the trustee only such interest as takes care of administrative charges and the surviving annuity. Under such circumstances, the collector as- sessed and collected, under protest, from the trustee on June 26, 1917, the sum of $4,273.42, being on the income of the residuary estate for the years 1913, 1914, 191 5, and 1916, and on June 11, 1918, an income and excess profit tax of $6,842.02 upon the income of the residuary estate of 1917. It is, of course, apparent the trustee has no financial interest in the residuary payment, and while this large " Section 219 (b) of the 1921 law is similar to the like numbered section of the 1918 law. ="C. B. I, page 175; O. D. 278. " Lederer v. Stockton, 266 Fed. 676 ; certiorari granted October 25, 1920, TT Q ^or 254 U. S. 625. FIDUCIARIES 1367 sum is in theory assesssed as a tax on income received by the trustee or the testator's estate, the whole sum is paid at the expense, and from the property, of the hospital. The question, then, in substance and practice, resolves itself into this : Is this hospital liable for income tax? .... The court, in deciding that no tax was due, said : Decision From the above, it is clear to us, first, that the United States, the taxing power and real defendant in this case, speaking by its legislative branch in plain language enacted its purpose and will to exempt from taxation the income of "any corporation or association organized and operated exclusively for religious, char- itable, scientific, or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individ- ual ;" second, that the action of the United States by its executive officer, in this case the collector of internal revenue, in assessing and collecting this income tax from the hospital, was not warranted by the taxing statutes; and, third, that it is the duty of the United States, acting by its third agency, the federal courts, to prevent its executive branch from illegally defeating its expressed will in the law enacted by its legislative branch. The sentence in article 342 of Regulations 62 which pro- vides that "the imposition of the tax is not affected by the fact that an ultimate beneficiary may be a person exempt from tax" appears to be in conflict with the decision in the foregoing case and with the following ruling : Ruling. A testator bequeathed and devised property to trustees to pay a part of the income therefrom to A during his life. The will provided that upon A's death the rest and residue of the estate, to- gether with any accumulated income, should go to a numicipality in perpetual trust to hold the same as a permanent trust estate and fund, the income from which was directed to he used exclusively in the exercise of a normal governmental function. Held, that the income received by the trustees under the will other than that distributed to the annuitants named in the will is not tax- able in the hands of the trustees under the Act of October 3, 1913, the Revenue Act of 1916, as amended, the Revenue Act of 1917, or the Revenue Act of 1918 (B. 28-21-1724; O. D. 972.) When executor is obligated to estate. — Ruling. Amounts paid ])y an executor of an estate, out of his personal funds in discharge of obligations of the estate, such amounts 1368 SPECIAL CLASSES OF TAXPAYERS being credited against the executor's liability for interest to the estate, are nevertheless income to the estate to the extent that they represent interest accrued since the death of the testator on obligations of the executor to the estate. (C. B. i, page 175; O. D. 51.) Credits allowed when tax is payable by the fiduciary. — Law. Section 219. .... (c) .... In such cases [paragraph(i), (2) or (3) of subdivision (a)] the estate or trust shall, for the purpose of the normal tax, be allowed the same credits as are allowed to single persons under section 216.''" .... Regulation, (a) An estate or trust taxed to the fiduciary is allowed the same credits against net income as a single person, in- cluding a personal exemption of $1,000, but no credit for depend- ents, (b) In the case of an estate or trust taxed to the beneficiaries each beneficiary is allowed for the purpose of the normal tax, in addi- tion to his individual credits, his proportionate share of such dividends as described in Article 301 and of such interest not entirely exempt from tax upon obligations of the United States and bonds of the War Finance Corporation as are received by the estate or trust. Each beneficiary is entitled to but one personal exemption, no matter from how many trusts he may receive income (Art. 346.) Credit for taxes. — Law. Section 222. (a) That the tax computed under Part II of this title [Income Tax] shall be credited with: .... (4) In the case of any such individual who is a member of a partner- ship or a beneficiary of an estate or trust, his proportionate share of such taxes of the partnership or the estate or trust paid during the taxable year to a foreign country or to any possession of the United States, as the case may be.^ ■ .... Taxable income when trusts have been established.— I f the income from an estate or trust is held for distribution to unborn or unascertained persons or persons with contingent °' The credits so specified in section 216 are: (i) dividends, (2) in- terest on United States government bonds and bonds of the War Finance Corporation, (3) an exemption of $1,000. See Chapter XX for deter- mination of taxable Liberty bond interest. [Former Procedure] The specific exemption allowed to estates under the acts of 1913 and 1916 was $3,000. In 1917, two specific exemp- tions, one of $3,000 and one of $1,000, were permitted. Under all acts, if the income of the estate or the amount payable to any beneficiary was less than the exemption, no return was required from the fiduciary. " See Chapter XXVIII for discussion of this credit. FIDUCIARIES 1369 interests and there is no periodic distribution of income, the net taxable income is determined in substantially the same manner as is prescribed for estates in the process of admin- istration. If, however, income is distributed periodically to beneficiaries or part is distributed and part held in trust, the determination of the taxable income of the estate or trust and of the beneficiaries becomes a more difficult problem. Follow- ing is the latest Treasury regulation on this subject : Estates or trusts which cannot be treated as units.''' — Rk(;ulation. In the case of an estate or trust, the income of which consists both of income to be distributed to beneficiaries period- ically and other income, the net income of the estate or trust shall be computed and a return thereof made by the fiduciary in accordance with section 219 (b)'"'" and the tax shall be imposed and paid by the fiduciary in accordance with section 219 (c)/'" except that there shall be allowed as an additional deduction in computing tlie net income of the estate or trust that part of its income of the class described in section 219 (a) (4)''^ which, pursuant to the will or trust deed, is distributable during its taxable year to the beneficiaries. Each of such beneficiaries shall include, in computing his net income, that part of the income of the estate or trust wdiich, pursuant to the instrument or order governing the distribution, is distributable to him during the taxable year. (Art. 347.) " [Former Procedure] Regulation. In the case of a trust estate where the terms of the will or trust or the decree of a court of competent jurisdiction provides for keeping the corpus of the estate intact, and where physical property forming a part of the corpus of such estate has sufifered depreciation through its employment in business, a deduction from gross income for the purpose of caring for this depreciation, where the deduction is applied or held by the fiduciary for making good such depreciation, may be claimed by the fiduciary in his return of income. Fiduciaries should set forth in connection with their returns the provision of law, trust, or decree requiring such depreciation deduction where any exists or when actual depreciation occurs, the amount thereof, and that the same has been or will be preserved and applied as such. All amounts paid by fiduciaries to beneficiaries of trust estates from the income of such trust estates, whether from reserves or otherwise, are held to be distributions of income and will be treated for income-tax purposes in accordance with the provisions of law and regulations applicable to income of such beneficiaries. (Par. 199, Reg. 33; the 1916 and 1917 laws.) •■"See page 1335. ""Sec page i347- °' See page 1329, 13/0 SPECIAL CLASSES OE TAXPAYERS An example of the application of the provisions of the fore- going regulation was contained in an amendment to the ar- ticle of the 19 18 regulations dealing with the same subject. Ruling For example, a trust is created the income of which is distributable periodically for the life of the beneficiary, the remainder over to others. The trust has the following items of income. Rent, $3,000; interest, $2,000; gain on sale of capital assets, $1,500; cash div- idend, $1,000; and deductions, general expenses (all deductible from distributable income), $700; depreciation, $300; loss on sale of capital assets, $3,000. Under the terms of the trust $5,300 will be distributed to the beneficiary, viz., rent, $3,000; plus interest, $2,000; plus dividend, $1,000; less general expenses, $700. The gain and loss on the sale of capital assets will be considered capital items affecting the corpus only, and the items of depreciation will not affect the amount to be dis- tributed, there being no rule of State law or provision of the trust requiring this deduction from distributable income. In such a case the fiduciary must report on form 1041 showing a net income for the trust of $3,500, and nmst show as the distributive share of the bene- ficiary the $5,300 to which he is entitled. The beneficiary must account for the amount actually distributable to him as income, viz., $5,300, as provided in section 219 (d) and will be entitled to a credit of $1,000 on account of the dividends in computing the normal tax, but not to any deduction on account of depreciation or capital losses. If there had been no loss on the sale of capital assets so that the net income of the estate or trust was $6,500, Form 1041 should show the distributive share of the beneficiary as $5,300, and the dis- tributive share of the fiduciary as $1,200; and the fiduciary should file a separate return on Form 1040 A, reporting $1,200 for taxation. (Art. 347, amended, C. B. 2, page 180; T. D. 2987.) Treasury Decision 2987 (dated March i, 1920) was made retroacti^■e to January i, 1918, and all former rtilings incon- sistent tlierewith were revoked. The significant feature of the amended article 347 of Jvegulations 45, which was issued for the administration of the 19 1 8 law, was the refusal to allow as a deduction by a beneficiary of an estate or trust, any loss, depreciation or de- pletion sustained by the estate or trust but not deducted from income distribtited or distributable to the beneficiary. This regulation by the Treasury Department was not based on any section of the 1918 law which specifically so provided. The FIDUCIARIES 1371 192 1 law embodies such a provision, however, which reads as follows: Law. Section 215. [Items not deductible] . . . . (b) Amounts paid under the laws of any State, Territory, District of Columbia, pos- session of the United States, or foreign country as income to the holder of a life or terminable interest acquired by gift, bequest, or in- heritance shall not be reduced or diminshed by any deduction for shrink- age (by whatever name called) in the value of such interest due to the lapse of time, nor by any deduction allowed by this act for the purpose of computing the net income of an estate or trust but not allowed under the laws of such State, Territory, District of Columbia, pos- session of the United States, or foreign country for the purpose of computing the income to which such holder is entitled. The Treasury regulation pertaining to this section of the 192 1 law gives an example of its effect. Regulation. Amounts paid to the holder of a life or terminable interest acquired by gift, bequest, or inheritance shall not be subject to any deduction for shrinkage (whether called depreciation or any other name) in the value of such interest due to the lapse of time. In other words, the holder of such an interest so acquired may not set up the value of the expected future payments as corpus or princi- pal and claim deductions for shrinkage or exhaustion thereof due to the passage of time. No deductions shall be allowed in the case of a life or a terminable interest acquired by gift, bequest, or inheritance, where the estate or trust is entitled to a deduction under the statute but there is no reduction of the income of the life or terminable interest. For ex- ample, an estate or a trust in a certain State sells securities at a loss; if, under the laws of that State, the beneficiary suffers no actual loss, then even though the estate or trust is permitted to deduct such loss in making its return, the beneficiary whose income has not been diminished thereby is not entitled to a deduction on account of such loss but nuist include in his return the full amount distributed or distributable (Art. 295.) Inasmuch as section 215 (b) gives the sanction of law from January i, 1921, on, to the position previously taken in administering the 1918 law, the following opinion of the So- licitor of the lUireau of Internal Revenue is in part repro- duced. RuLiNc The present statute specifies class (3) "Income held for future distribution under the terms of the will or trust" and 1372 SPECIAL CLASSES OE TAXPAYERS class (4) "Income which is to be distributed to the beneficiaries period- ically, whether or not at regular intervals " It seems clear that the part of the income which is distributable falls within class (4) and that the part which is accumulated falls within class (3). It is clear that the total amount in question is income for which some one should account, and that it would be highly inequitable and unjust to tax the present beneficiary upon income which is not distributable to him and to which he is not beneficially entitled. It is equitable and just, however, that the fiduciary should pay the tax upon income accumulated for the benefit of the remainder-men, thereby deducting the tax from the amount to be distributed to the remainder-men in the future. It is therefore evident that in this case the two classes of income must be treated diiTerently in spite of the general treatment of estates and trusts as a unit by the statute (C. B. 2, page 181; O. 1013; Sec. I.) Regarding the allocation of capital losses to distributable income, it is argued that such losses are not ordinarily allow- able deductions to the life tenant, because such deductions belong to the remainderman and, regardless of whether or not there are capital gains to offset such losses, the life tenant is not equitably entitled to take the losses. Denial of such deductions to the life tenant is deemed to be necessary to protect the interests of the remainderman. Ruling Trustees may be induced to make such sales in order to register a loss for the benefit of the life tenant. The remain- derman is thus prevented from registering the loss at a later date when his remainder becomes vested in possession, and [he] may be compelled to account for an unduly large gain at some time in the future (C. B. 2, page 181 ; O. 1013; .Sec. III.) The reasoning relative to allowance and depreciation to lite tenants is stated concisely as follows: Ruling. Items of deduction (according to income tax statute) which are disregarded by the State courts in making distributions, there being no term of the will or trust or rule of law requiring their deduction from distributable income, e. g., depreciation and depletion. In Law Opinion 456 it was held, under the Revenue Act of 1916 as amended, that the beneficiaries should compute their distributive shares after deduction of depletion. That statute, however, differed from the present one. In Advisory Tax Board recommendation No. 56 a similar ruling was made with reference to depreciation under the Revenue Act of 1918. FIDUCIARIES ^?>73 These rulings were based upon the literal interpretation of the statute previously discussed and upon the theory that where a will provided for the distribution of income without deduction for de- preciation or depletion the beneficiary really received partly income and partly capital. The line of reasoning developed in solving case (III), however, indicates that this result is erroneous. Deductions for depletion and depreciation are deductions designed to restore capital and as such affect the interest of the remainderman and do not affect the distributive share of the life tenant. Probate courts in general disregard depreciation (other than amounts actually ex- pended for repairs) and depletion unless the trust specifically pro- vides that deduction shall be made on that account. The sums received by the beneficiaries in such cases are clearly part of the gross income of the estate or trust and should not be reduced by deduc- tions made to restore capital to which they are not entitled. The answer is the same as the answer to case (IH)."* (C. B. 2, page 18 r ; O. 1013; Sec. IV.) The Treasury seemed to realize tliat serious objection would be made to the principles stated in article 347 of Regu- lations 45. Ruling The principal objection to the answers given to questions (III) and (IV) will be that the construction there adopted may deprive both life tenant and remainderman of the benefit of these deductions for the reason that there will be no income subject to the same treatment in some years from which to deduct them. It is obvious, however, that in many cases a part of the income will be accumulated for future distribution or part of the income will consist of gains from sale of capital assets so that such deduction may be taken. In such cases the equity of the classification of items of gross income and deductions adopted above is emphasized. Such cases will be readily solved by an application of the principles pre- viously stated. The fact that a theoretically correct deduction is not beneficially deducted by anyone is a common occurrence and in no way decisive. The deduction is beneficially allowed if the same interest has a large enough gross income. An individual who has no income loses the benefit of depreciation deductions to which he is entitled. (C. B. 2, page 181; O. 1013; Sec. W) Replying to the objection that denial of deduction of capital losses by life tenants is contrary to the express provi- sion of the statute (section 219), which stipulates that the °* Section III of this ruling deals with capital losses. 1374 SPECIAL CLASSES OF TAXPAYERS aggregate distributable shares shall not exceed the income of the trust or estate computed as a unit, the Treasury says : Ruling. This applies a literal interpretation of the statute, but reaches a result which should be avoided if possible since it is con- trary to the fundamental rights of the parties and to the spirit and purpose of income taxation in j^eneral. ( C. B. 2. page iSi ; O. 1013; Sec. III.) How closeh' the procedure outlined in article 347 of Regu- lations 45 is to be considered as indicating the intent of the 1 9 18 law as regards estates, rights and their beneficiaries, re- mains to be determined, as the courts have not yet passed on the question. The enactment of section 215 (b) of the 1921 law is not necessarily to be deemed to express the intent of the 1918 law. For a discussion of this question, particularly as to the legality of article 347, the reader is referred to pages 1045 to 1046 of Income Tax Procedure, 192 1. Tax on capital gains. — The "capital gains'' provision of the 192 1 law is of importance to estates and trusts because of the amelioration of surtax burdens when considerable gains are realized on sales of investments. This subject is discussed at length in Chapter XVTI, and the principal question which needs to be specially considered when applying section 206 to estates and trusts is, as to the starting point for the pre- scribed two-year period during which investments must l3e held to obtain the benefits of the "capital gains" provision. As to securities purchased by the fiduciany\ the two-year period obviously runs from the date of purchase. As to secur- ities which form a portion of the corpus of the estate or trust at its inception, the author's opinion is that the two-year period runs from the time the estate comes into the hands of the fiduciary or the trust is created. The time during which a testator or the creator of a trust had held securities afterward sold by a fiduciary cannot be considered as being equivalent to ownership by estate or trtist. A decedent's estate or a trust created by an irrevocable deed of trust are separate entities. FIDUCIARIES 1375 Profits or losses on subsequnt sales of securities are based, not on the cost thereof to the decedent in his lifetime or to the maker of the trust, but on their values at the time they came ino the hands of the fiduciary. Similarly, the two-year period under the "capital gains" section starts from the time the secur- ities came into the hands of the fiduciary. Taxable income under profit-sharing plans. — With the growth of various profit-sharing plans, instituted by employ- ers for the benefit of employees, the law now includes a new provision which defines what is taxable income to the dis- tributees under such a plan. Law. Section 219. .... (f) A trust created by an employer as a part of a stock bonus or profit-sharing plan for the exclusive bene- fit of some or all of his employees, to which contributions are made by such employer, or employees, or both, for the purpose of distribut- ing to such employees the earnings and principal of the fund accumu- lated by the trust in accordance with such plan, shall not be taxable under this section, but the amount actually distributed or made avail- able to any distributee shall be taxable to him in the year in which so distributed or made available to the extent that it exceeds the amounts paid in by him. Such distributees shall for the purpose of the normal tax be allowed as credits that part of the amount so dis- tributed or made available as represents the items specified in sub- divisions (a) and (b) of section 216. Rfx.uuation. .Subdivision (f) of section 219 provides that a trust created h)' an enipliwer as a part of a stock bonus or profit-sharing plan for the exclusive I)enefit of some or all of his employees, to which contributions are made by such employer, or employees, or both, for the purpose of distributing to such employees the earnings and prin- cipal of the fund accunudated by tiie trust in accordance with such plan, shall not be taxable under this section, but the amount actually distributed or made available to any distributee shall be taxable to him in the year in which so distributed or made available to the extent that it exceeds the amounts paid in by him. Such distributees shall for the purpose of the normal tax be allowed as credits that part of the amount so distributed or made available as represents the divi- dend and interest items specified in subdivisions (a) and (b) of sec- tion 216. (Art. 348.) The question of profit-sharing funds and of the treatment 1376 SPECIAL CLASSES OF TAXPAYERS of income derived therefrom is dealt with fully in the chapter on "Income from Personal Services."'^ The last sentence of section 219 (f) refers to the allow- ance as credits of the proportionate share of such exempt dividends and interest referred to in section 216 (a) and (b) as may form a part of the earnings received by, or credited to, the distributee. "Chapter XIV. CHAPTER XXXVIII INSURANCE COMPANIES The problem of taxing insurance companies in an equitable manner under the income and excess profits tax provisions which govern corporations was considered at length when the 19 1 8 law was being formulated. The Senate Committee pro- posed and the Senate adopted an entirely new plan for taxing these companies, but the proposal was lost because the House conferees refused to concur/ termining the taxable income of insurance companies (other than mutual insurance companies) which had been proposed and rejected in 1918. A number of sections of the 192 1 law The 192 1 law," however, embodies the principle for de- ' "A new basis is recommended for the taxation of life insurance com- panies (Part IV, sections 245, 246, 247). The tax is in form an income tax, but is imposed upon a net income defined with special reference to the peculiar conditions of the business of life insurance. Roughly, it consists of the gross income from interest, dividends and rents, less tax-free interest, investment expenses and taxes and other expenses paid exclusively in con- nection with real estate owned by the compan}'. In the case of a domestic life insurance company there is also a specific deduction of $2,000. Thus the tax falls upon the true income of the company; that is, its income from investments; and tlie rate is so fixed that this tax takes the place of the income tax, war excess profits tax, capital stock tax and the tax on the issuance of policies. It will yield considerably more revenue than the taxes which it is designed to replace, and has the great merit of simplicity and certainty. Above all, it avoids the almost insuperable difficulty of defining the invested capital of a life insurance company for purposes of the war excess profits tax." (lu'port to Senate, by Senator Simmons, December 6, 191 8, page 9.) "Your conferees did not think that its scheme would be equitable or satisfactory if the deductions were eliminated, and, after much controversy and much discussion, reflection and investigation — for wc did investigate a good deal to see if we could not reach a basis of compromise — finding our- selves unable to come to any satisfactory adjustment with reference to the Senate scheme, the Senate receded." (Senator Simmons, February 11, 1919, Congressional Record, page Z777.) " [Former Procedure] In view of the radical changes effected by the 1921 law in the determination of taxable income, no attempt will be made in this chapter to give in detail the former procedure with respect to the vari- ous items of gross income and deductions. Those who desire to a.scertain former procedure are referred to Chapter XXXV of Income Tax Proced- ure, 1 921. f377 1378 SPECIAL CLASSES OF TAXPAYERS are devoted specifically to insurance companies. Sections 243- 245 define the taxable income of life insurance companies, and sections 246-247^ define the taxable income of insurance companies other than life or mutual insurance companies. W'ith the exception of those companies which are entirely ex- empt under section 231 (10), mutual insurance companies are taxable under sections 232-236 which define the taxable in- come of ordinary corporations. The last named sections, however, contain certain provisions applicable specifically to mutual insurance companies. Regulation. Insurance companies include both stock and mutual companies, as well as mutual benefit insurance companies. A volun- tary unincorporated association of employees formed for the pur- pose of relieving sick and aged members and the dependents of deceased members is an insurance company, whether the fund for such purpose is created wholly by membership dues or partly by con- tributions from the employer. But a corporation which merely sets aside a fund for the insurance of its employees is not required to file a separate return for such fund if the income and disbursements therefrom are included in tlie corporation's own return. (Art. 1508.) To facilitate consideration of the law and regulations per- taining to the dift'erent classes of insurance companies, this chapter is divided into the following sections : 1. i.ife Insurance Companies 2. Insurance Companies Other than Life and Mutual Companies 3. Mutual Insurance Companies 4. Exempt Insurance Companies Life Insurance Companies Definition of life insurance company. — Law. Section 242. That when used in this title the term "life insurance company" means an insurance company engaged in the busi- ^ Sections 246-247 are effective from January i, 1922, while sections 243-245 are effective from January i, 1921. Insurance companies which after 1921 are taxable under sections 246-247, are taxed for 1921 under sec- tions 232-236 which define the taxable income of ordinary corporations. INSURANCE COMPANIES 1379 ness of issuing life insurance and annuity contracts (including con- tracts of combined life, health, and accident insurance), the reserve funds of which held for the fulfillment of such contracts comprise more than 50 per centum of its total reserve funds Rates of tax, — Law. Section 243. That in lieu of the taxes imposed by sections 230 and 1000 and by Title III, there shall be levied, collected, and paid for the calendar year 192 1 and for each taxable year thereafter upon the net income of every life insurance company a tax as follov/s: (i) In the case of a domestic life insurance company, the same percentage of its net income as is imposed upon other corporations by section 230;^ (2) In the case of a foreign life insurance company, the same percentage of its net income from sources within the United States as is imposed upon the net income of other corporations by section 230. Regulation. For the calendar year 1921 and thereafter, life insurance companies, as defined in section 242, shall pay the tax im- posed by section 243, in lieu of the taxes imposed by sections 230 and 1000 and by Title III of the statute. The rate for 1921 is 10 per cent and for subsequent years 12^ per cent, as in the case of other corporations, but the net income upon which the tax is imposed differs from the net income of other corporations. In- surance companies are entitled to the benefit of section 204 (net losses) but not of section 206 (capital net gain). All pro- visions of the statute and of these regulations not inconsistent with the .specific provisions of sections 242 to 245, inclusive, are applicable to the assessment and collection of this tax, and life insurance com- panies are subject to the same penalties as provided in the case of returns and payment of income tax by other corporations. In de- termining whether an insurance company is a "life insurance com- pany" as defined in section 242, no reserve shall be regarded as held for the fulfillment of life insurance and annuity contracts unless the company is entitled to a deduction from gross income on account thereof under the provisions of section 245 (a) (2) and article 6S1. As to foreign companies see section 24S(c) and article C87. (Art. 661.) Life insurance companies not subject to excess profits tax. Regulation Life insurance companies are not subject to the tax (Art. 75,1.) * Section 230 imposes a tax of 10 per cent on the net income of cor- porations for the calendar year 1921, and 12^ per cent for succeeding years. 1380 SPECIAL CLASSES OF TAXPAYERS Gross income defined. — Life insurance companies include in gross income only the amounts received as interest, divi- dends and rents. No part of premiums received from the as- sured is now to be included in the return. Law. Sectidii 244. (a) That in the case of a life insurance com- pany the term "gross income" means the gross amount of income re- ceived during the taxable year from interest, dividends, and rents Net income defined. — Regulation. Net income in the case of life insurance compan- ies is gross income from interest, dividends and rents less the de- ductions allowed by section 245. Gross income comprises items 25-34, inclusive, of the income page of the annual statement for life companies (edition of 1920) adopted by the National Convention of Insurance Commissioners and items 23-30, inclusive, of the income page of the annual statement for miscellaneous stock companies if any other branches of the insurance business are conducted by the company; except that the rental value of the space occupied by the company in its own building or buildings if included in gross income shall be determined according to the provisions of section 245(b) and article 686. As to "reserve funds required by law," see article 681. (Art. 671.) Deductions. — Deductions are allowed to take into consid- eration conditions peculiar to insurance companies, particularly conditions imposed by state laws. The deductions allowed by the 192 1 law are materially different from those permitted by the 1918 law. It will be noted among other things that no deduction is provided by the 192 1 law for losses on invest- ments, thotigh on the other hand gains realized from sale of securities are not required to be reported as gross income. Exempt interest. — Law. Section 245. (a) (i) The amount of interest received dur- ing the taxable year which under paragraph (4) of subdivision (b) of section 213 is exempt from taxation under this title; .... The interest referred to includes that on United States obligations and those of states, municipalities, etc. For full treatment of this subject, see Chapters XIX and XX. INSURANCE COMPANIES 1381 Reserve eund earning allowance. — Law. Section 245. (a) .... (2) An amount equal to the ex- cess, if any, over the deduction specified in paragraph (i) of this sub- division, of 4 per centum of the mean of the reserve funds required by law and held at the beginning and end of the taxable year, plus (in case of life insurance companies issuing policies covering life, health, and accident insurance combined in one policy issued on the weekly premium payment plan, continuing for life and not subject to can- cellation) 4 per centum of the mean of such reserve funds (not re- quired ijy law) held at the beginning and end of the taxable year, as the Commissioner finds to be necessary for the protection of the hold- ers of such policies only; .... The definition of '"reserve funds required by law" is 'given below : Law. Section 244. .... (b) The term "reserve funds required by law" includes, in the case of assessment insurance, sums actually deposited by any company or association with State or Territorial of- ficers pursuant to law as guaranty or reserve funds, and any funds maintained under the charter or articles of incorporation of the com- pany or association exclusively for the payment of claims arising under certificates of membership or policies issued upon the assessment plan and not subject to any other use. The effect of the deductions referred to in subdivisions ( i ) and (2) of section 245 (a), is to permit a deduction of 4 per cent of the year's average reserves required by law, together with 4 per cent of the mean of certain other reserves not re- quired by law at the discretion of the ("ommissioner. Regulation. Under paragraphs (r) and (2) of section 243(a). life insurance companies are entitled to deduct from gross income: (1) Interest which is exempted in the case of other taxpayers by section 213(b) (4) and articles 74-H3 ; and (2) the excess, if any, of the reserve deduction specified in section 245 (a) (2) over the amount of such interest. The reserve deduction is based upon the re- serves required by express statutory provisions or by the rules and regulations of the State insurance departments when promulgated in the exercise of a power conferred by statute; but such reserves do not include assets required to be held for the ordinary running expenses of the business nor do they include the reserve or net value of risks reinsured in other solvent companies lo the extent of the reinsurance. In the case of life insurance companies issuing policies covering life, health, and accident insurance combined in one policy issued on the weekly premium payment plan, continuing for life and not 1382 SPECIAL CLASSES OF TAXPAYERS subject to cancellation, it is required that reserves thereon be based upon recognized tables of experience covering- disability benefits of the kind contained in policies issued by this particular class of companies. Only reserves peculiar to insurance companies are to be taken into consideration. Reserves '"maintained to provide for the ordinary running expenses of a business, definite in amount, and which must be currently paid by every company from its income if its business is to continue, such as taxes, salaries, reinsurance and unpaid brokerage" (Maryland Casualty Co. z'. United States, 251 U. S., 342), will not be considered. A compan}' is permitted to make use of the highest aggregate reserve called for by any State in which it transacts business, but the reserve must have been actually held as shown by the annual statement. Generally speaking, the fol- lowing will be considered reserves as contemplated by the law : Items 7, 8, 9, 10, and 11 of the liability page of the annual statement for life companies," and items 16, 17, 18, 19, and 26 of the liability page of the annual statement for miscellaneous stock companies,*' if a life insurance company is also transacting other kinds of insurance business. If other reserves are claimed, sufficient information must be filed with the return to enable the commissioner to determine the validity of the claim. Reference should be made to the item in which the reserve appears in the annual statement and to the State statute or insurance department ruling requiring that such reserves be held. (Art. 681.) Cert.\in din'idend.s deductible. — Law. Section 245. (a) .... (3) The amount received as divi- dends (A) from a domestic corporation other than a corporation en- titled to the benefits of section 262, or (B) from any foreign corporation when it is shown to the satisfaction of the Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year pre- ceding the declaration of such dividends (or for such part of such period as the foreign corporation has been in existence) was derived from sources within the United States as determined under section 217; . , . . The (leditctioii is idfiUical with that allowed ordinary cor- porations tinder section 234 (a-6). Dividend reserve earning allowance. — L.'\w. Section 245. (a) . . . . (4) An amount equal to 2 per centum of any sums held at the end of the taxable year as a reserve Treasury Bulletin "H," page 27. 'Treasury Bulletin "H," page 47. INSURANCE COMPANIES 1383 for dividends (other than dividends payable during the year following the taxable year) the payment of which is deferred for a period of not less than five years from the date of the policy contract; .... Regulation. The deduction for deferred dividends under section 245 (a) (4) will be based upon item 37' of the liability page of the annual statement for life companies but shall not include any dividend payable during the year immediately following the taxable year. (Art. 682.) Investment expenses. — Law. Section 245. (a) . . . . (5) Investment expenses paid during the taxable year: Proz'idrd. That if any general expenses are in part assigned to or included in the investment expenses, the total deduction under this paragraph shall not exceed one-fourth of i per centum of the book value of the mean of the invested assets held at the beginning and end of the taxable year; .... Regulation. If any general expenses are in part assigned to or included in the investment expenses, the total investment expenses (other than taxes and expenses with respect to real estate) allowable as a deduction shall not exceed one-quarter of i per cent of the mean of the book value of the invested assets held at the beginning and end of the taxable year. If there be no allocation of general expenses to investment expenses' the deduction may consist of in- vestment expenses actually paid during the taxable year, in which case an itemized schedule of such expenses must be appended to the return. The invested assets are items 1-6, inclusive, item 9, and items 10 and 11 (if interest-bearing assets) of the asset page of the annual statement for life companies, and items 1-4, . inclusive, item 7, and items 27-30, inclusive (if interest-bearing assets), of the asset page of the annual statement for miscellaneous stock companies. If the method used by any company in ascertaining the investment ex- penses where there is any allocation of general expenses shall be changed so that a greater deduction is claimed, the company shall file with its return, information sufficient to enable the commissioner to determine the validity of the claim. The maximum allowance of one- (juarter of i per cent will not be granted unless it is shown lo the satisfaction of the Connnissioner that such allowance is justified. (Art. 683.) Depreciation. — Law. Section 245. (a) .... (7) A reasonable allowance for the exhaustion, wear and tear of property, including a reasonable al- ' "Amounts set apart, apportioned, previously ascertained, calculated, declared, or held awaiting apportionment upon deferred dividend policies " 1384 SPECIAL CLAS.SES OF TAXPAYERS lowance for obsolescence. In the case of property acquired before March i, 1913, this deduction shall be computed upon the basis of its fair market price or value as of March i, 1913; .... For the limitation in regard to allowances for deprecia- tion, see section 245 (b) below. Taxes and expenses with respect to real estate.— Law. Section 245. (a) . . . . (6) Taxes and other expenses paid during the taxable year exclusively upon or with respect to the real estate owned by the company, not including taxes assessed against local benefits of a kind tending to increase the value of the property assessed, and not including any amount paid out for new buildings, or for permanent improvements or betterments made to increase the value of any property. The deduction allowed by this paragraph shall be allowed in the case of taxes imposed upon a shareholder or member of a company upon his interest as shareholder or member, which are paid by the company without reimbursement from the shareholder or member, but in such cases no deduction shall be allowed the shareholder or member for the amount of such taxes; .... This deduction is subject to the proviso contained in sec- tion 245 ( b) lielow. Regulatiox. This deductiun comprises items 31 and 32 of the disbursement page of the annual statement for life companies and items 34 and 35 of the disbursement page of the annual statement for miscellaneous stock companies, except as noted below, and any sum included in any other item representing taxes imposed upon the individual shareholders' or members' interest in the real estate of the corporation which is paid by the corporation without reimburse- ment from the individual shareholder or member. In the latter case the amount allowable as a deduction (subject to the provisions of Art. 686) shall be that proportion of the total tax imposed upon the individual shareholders' or members' interest in the corporation which the book value of the real estate owned by the corporation at the end of the taxable year is of the book value of all the corporation's ledger assets, and so much thereof as represents a tax upon real estate oc- cupied in whole or in part by the company must be included in the calculation referred to in article 686. The amount so included shall be that proportion of the total amount allowable as a deduction which the book value of the real estate owned and occupied in whole or in part is of the book value of all the real estate owned. Full details must accompany the return. Any other taxes and expenses (and de- preciation) upon any real estate owned and occupied in whole or in part by the company must also be included in the calculation referred INSURANCE COMPANIES 1 385 to in article 686. Taxes shall not include assessments against local benefits of a kind tending to increase the value of the property assessed and expenses shall not include any amount paid out for build- ings or for permanent improvements and betterments made to in- crease the value of any property. (Art. 684.) Limitation on deduction for taxes and deprecia- tion. — Law. Section 245 (b) No deduction shall be made under paragraphs (6) and (7) of subdivision (a) on account of any real estate owned and occupied in whole or in part by a life insurance company unless there is included in the return of gross income the rental value of the space so occupied. Such rental value shall be not less than a sum which in addition to any rents received from other tenants shall provide a net income (after deducting taxes, depreciation, and all other expenses) at the rate of 4 per centum per annum of the book value at the end of the taxable year of the real estate so owned or occu- pied Interest paid or accrued. — Law. Section 245. (a) (8) All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness in- curred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 191 7, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title; .... This deduction is identical with that allowed other cor- porations under section 234 (a-2) with the exception that: Regulations this deduction includes item 18 of the dis- bursement page of the annual statement of life companies to the ex- tent that interest on dividends held on deposit and surrendered dur- ing the taxable year, is inchult'd therein (Art. 685.) No deduction shall be made for any taxes, expenses, or depreciation on account of any real estate owned and occupied in whole or in part by a life insurance company unless there is included in the return of gross income the rental value of the space so occupied. Such rental value shall not be less than a sum which in addition to any rents received from other tenants shall pro- vide a net income (after deducting taxes, depreciation, and other ex- penses) at the rate of 4 per cent per annum of the book value at the end of the taxable year of the real estate so owned and occupied. For example, if the book value of a parcel of real estate owned and occupied in whole or in part by the company is $r,ooo,ooo, the 1386 SPECIAL CLASSES OF TAXPAYERS rents received from other tenants $30,000, taxes and expenses $40,000, and depreciation $20,000, the company would have to inchide in its gross income a sum not less than $70,000 ($40,000 taxes and expenses, plus $20,000 depreciation, minus $30,000 rents from tenants, plus 4 per cent of $r, 000,000) as the rental value of the space occupied by it in order to avail itself of the deductions of $40,000 and $20,000. In any case the rents received from other tenants must be included in gross income. (Art. 686.) Specific credit. — Law. Section 245. (a) .... (9) In the case of a domestic life insurance company, the net income of which (computed without the benefit of this paragraph) is $25,000 or less, the sum of $2,000; but if the net income is more than $25,000 the tax imposed by section 243 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000 This provision is identical with the corresponding allow- ance made for income tax purposes to other corporations under section 236 (b). Taxable income of foreign company. — The net income of a foreign company subject to United States income tax is ascer- tained as follows : Law. Section 245. .... (c) In the case of a foreign life in- surance company the amount of its net income for any taxable year from sources within the United States shall be the same proportion of its net income for the taxable year from sources within and without the United States, which the reserve funds required by law and held by it at the end of the taxable year upon business transacted within the United States is of the reserve funds held by it at the end of the taxable year upon all business transacted. Regulation. Foreign life insurance companies holding reserve funds upon business transacted within the United States are taxed under section 243 upon their net income from sources within the United States. All business transacted by a United States branch or agency of a foreign insurance company, for which a reserve fund is required by the laws of any State or Territory of the United States or of the District of Columbia, will be regarded as business transacted within the United States. A foreign life insurance company not doing an insurance business within the United States and holding no re- serve funds upon business transacted within the United States, but which derives income from sources within the United States as de- INSURANCE COMPANIES 1387 fined in section 217* .... is subject to the tax imposed by section 230 upon income derived from sources within the United States. .... As to taxation of life insurance companies between United States and Porto Rico and Philippine Islands, see article 1133. (Art. 687.) Insurance Companies Other than Life and Mutual Companies Sections 246 and J47 of the 1921 law, which are appHcable to this class of insurance companies are effective only from January i, 1922. Therefore, for the year 1921 these com- panies are taxed under sections 232 to 236 which, in their application to insurance companies, are considered later in this chapter." Insurance companies in this class are also subject to excess profits tax and to capital stock tax for the year 1921. Following are the law provisions effective from January I, 1922 : Rates of tax. — Law. Section 246. (a) That, in lieu of the taxes imposed by sections 230 and 1000, there shall be levied, collected and paid for the calendar year 1922, and for each taxable year thereafter, upon the net income of every insurance company (other than a life or mutual in- surance company) a tax as follows: (i) In the case of such a domestic insurance company the same percentage of its net income as is imposed upon other corporations by section 230; (2) In the case of such a foreign insurance company the same percentage of its net income from sources within the United States as is imposed upon the net income of other corporations by section 230 The rate provided by section 230 for the year 1922 and subsequent years is 123^ per cent. Regulation. For the calendar year 1921 all insurance companies (other than life) are subject to taxes imposed by sections 230 (cor- poration income tax) and 1,000 (capital stock tax) and Title III (war profits and excess profits tax). For the calendar year 1922 and thereafter, however, in lieu of such taxes, insurance com- ' See pages 1272, 1278. " See pages 1394, 1401. 1388 SPECIAL CLASSES OF TAXPAYERS panics, except life and mutual companies, are subject to the tax imposed by section 246. Mutual insurance companies (other than life) remain subject to the taxes imposed by sections 230 and 1,000. In articles 691-693 the term "'insurance companies" means only those companies subject to the tax imposed by sectiqn 246. The rate of the tax imposed by section 246 is the same as the rate imposed by section 230 (12^ per cent), but the net income upon which the tax is imposed, as defined in sections 246 and 247, differs from the net income of other corporations. Insurance companies are entitled to the benefit of section 204 (net losses) but not of section 206 (capital net gain). All provisions of the statute and of these regu- lations not inconsistent with the specific provisions of sections 246 and 247 are applicable to the assessment and collection of this tax, and insurance companies are subject to the same penalties as provided in the case of returns and payment of income tax by other corpor- ations. Since section 246 provides that the underwriting and invest- ment exhibit of the annual statement approved by the National Con- vention of Insurance Commissioners shall be the basis for computing gross income and since the annual statement is rendered on the calen- dar year basis, the first returns under section 246 will be for the tax- able year ending December 31, 1922, and will be made on or before March 15, 1923. (Art. 691.) Gross income defined. — Law. Section 246. .... (b) In the case of an insurance com- pany subject to the tax imposed by this section — (i) The term "gross income" means the combined gross amount, earned during the taxable year, from investment income and from underwriting income as provided in this subdivision, computed on the basis of the underwriting and investment exhibit of the annual state- ment approved by the National Convention of Insurance Commis- sioners; .... Investment income. — Law. Section 246. .... (b) .... (3) The term "invest- ment income" means the gross amount of income earned during the taxable year from interest, dividends and rents, computed as follows: To all interest, dividends and rents received during the taxable year, add interest, dividends and rents due and accrued at the end of the taxable year, and deduct all interest, dividends and rents due and accrued at the end of the preceding taxable year; .... Underwriting income. — Law. Section 246 .... (b) .... (4) The term "under- writing income" means the premiums earned on insurance contracts INSURANCE COMPANIES 1389 during the taxable year less losses incurred and expenses in- curred Premiums earned. — Law. Section 246 (b) .... (5) The term "premi- ums earned on insurance contracts during the taxable year" means an amount computed as follows: From the amount of gross premiums written on insurance con- tracts during the taxable year, deduct return premiums and premiums paid for reinsurance. To the result so obtained add unearned premiums on outstanding business at the end of the preceding taxable year and deduct unearned premiums on outstanding business at the end of the taxable year; .... Net income defined. — Law. Section 246. .... (b) .... (2) The term "net in- come" means the gross income as defined in paragraph (i) of this subdivision less the deductions allowed by section 247; .... Regulation. Net income is gross income as defined in section 246 less the deductions allowed in section 247. Gross income is the combined gross amount earned during the taxable year from interest, dividends, rents, and premium income, computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Com- missioners. Gross income does not include gain derived from sale of disposition of capital assets, nor are losses sustained from such sale or disposition allowable deductions. It does not include increase in liabilities during the year on account of reinsurance treaties; re- mittances from home office of a foreign insurance company to United States branch; borrowed money; gross profit on maturity of capital assets; gross increase due to adjustments in book value of capital assets and premium on capital stock sold. 11 ic underwriting and investment exhibit is presumed clearly to reflect the true net income of the company, and in so far as it is not inconsistent with the provisions of the statute will be recognized and used as a basis for that purpose. All items of the exhibit, however, do not reflect an insurance company's income as defined in the statute. l>y reason of the definition of investment income, profit or loss on investment items is ignored, as well as those miscellaneous items which are intended to reflect surplus but do not properly enter into the computation of income, such as dividends declared, home ofiice remittances and receipts, and special deposits. Gain or loss from agency balances and bills receivable not admitted as assets on the underwriting and investment exhil)it will be ignored, excepting only such agency bal- I390 SPECIAL CLASSES OF TAXPAYERS ances and bills receivable as have been charged off the books of the company as bad debts, or having been previously charged off are recovered during the taxable year. (Art. 692.) Deductions.^" — The statutory deductions allowed insurance companies other. than life and mutual companies after 1921." are as follows : Ordinary and necessary expenses. — Law. Section 247. (a) . . . . (1) All ordinary and necessary expenses incurred, as provided in paragraph (i) of subdivision (a) of section 234; .... The deduction is the same as that allowed to other cor- porations. Regulation. For the calendar year 1921 insurance companies (other than life insurance companies) are entitled to the same de- ductions from gross income as other corporations, and also to the deduction of the net addition required by law to be made within the taxable year to reserve funds and of the sums other than dividends paid within the taxable year on policy and annuity contracts. After December 31, 1921, such insurance companies, except mutual com- panies, are entitled only to the deductions allowed by section 247. .... Mutual insurance companies (other than life) are not en- titled to the deductions allowed by section 247, but are entitled to the deductions allowed by section 234 "Paid" includes "ac- crued" or "incurred" (construed according to the method of account- ing upon the basis of which the net income is computed) during the taxable year, but does not include any estimate for losses incurred but not reported during the taxable year (Art. 568.) "Expenses incurred" defined. — Law. Section 246. .... (b) .... (7) The term "expenses incurred" means all expenses shown on the annual statement approved by the National Convention of Insurance Commissioners, and shall be computed as follows: To all expenses paid during the taxable year add expenses unpaid at the end of the taxable year and deduct expenses unpaid at the end of the preceding taxable year. For the purpose of computing the net income subject to the tax imposed by this section there shall '"Law. Section 247. "(c) Notliing in this section or in section 246 shall be construed to permit the same item to be twice deducted." " For law and regulations applicable to these companies during 1921, see pages 1380 and 1395. INSURANCE COMPANIES ^391 be deducted from expenses incurred as defined in this paragraph all expenses incurred which are not allowed as deductions by sec- tion 247. Interest paid or accrued. — Law. Section 247. (a) . . . . (2) All interest as provided in para- graph (2) of subdivision (a) of section 234; This section allows the deduction of all interest paid or accrued, except that arising from the purchase or carrying of tax-exem]:)t securities (other than original subscriptions to United States obligations issued after September 24th, 191 7). For full treatment see Chapter XXVII. Taxes paid ok accrued. — Law. Section 247. (a) .... (3) Taxes as provided in para- graph (3) of subdivision (a) of section 234; .... Regulation Among the items which may not be de- ducted are income and profits taxes, paid or accrued, imposed by the United States and so much of the income and profits taxes imposed by any foreign country or possession of the United States as is allowed as a credit under section 238; taxes assessed against local benefits; donations; decrease during the year due to adjustments in book value of capital assets; decrease in liabilities during the year on account of reinsurance treaties; dividends paid to stockholders; remittances to home office of a foreign insurance company by United States branch; and borrowed money repaid. (Art. 693.) Credit for taxes. — Regulation A domestic insurance company is also entitled to the credit for income, war profits, and excess profits taxes paid during the taxable year to any foreign country or to any pos- session of the United States which is allowed other domestic cor- porations by section 238.^^ .... (Art. 693.) For full treatment of the subject of taxes, see Chapter XXVIII. Losses. — Law. Section 247. (a) .... (4) Losses incurred; .... "Losses incurred" defined. — Law. Section 246 (b) .... (6) The term "losses " See page 947. 1392 SPECIAL CLASSES OF TAXPAYERS incurred" means losses incurred during the taxable year on insurance contracts, computed as follows: To losses paid during the taxable year, add salvage and reinsurance recoverable outstanding at the end of the preceding taxable year, and deduct salvage and reinsurance recoverable outstanding at the end of the taxable year. To the results so obtained add all unpaid losses out- standing at the end of the taxable year and deduct unpaid losses out- standing at the end of the preceding taxable year; .... It will be noted that the term "losses incurred" is so nar- rowly defined that it cannot include losses sustained on invest- ments. On the other hand, as is also true in the case of life insurance companies,''* the gains from investments, as dis- tinguished from investment income'^ therefrom ("interest dividends and rents") are not required to be included in tax- able gross income. Bad debts. — Law. Section 247. (a) • • • • (5) Bad debts in the nature of agency balances and bills receivable ascertained to be worthless and charged off within the taxable year; .... The subject of bad debts is treated at length in Chapter XXX. Certain dividends deductible. — Law. Section 247. (a) .... (6) The amount received as dividends from corporations as provided in paragraph (6) of sub- division (a) of section 234; .... The dividends in question are those received from domestic corporations and from foreign corporations of whose gross in- come for the preceding three-year period more than 50 per cent was derived from sources within the United States. This subject is dealt with in Chapter XXII. Exempt interest. — Law. Section 247. (a) . . . . (7) The amount of interest earned during the taxable year which under paragraph (4) of subdivi- sion (b) of section 213 is exempt from taxation under this title, and " See page 1380. " Section 246 (b-3). INSURANCE COMPANIES 1393 the amount of interest allowed as a credit under subdivision (a) of section 236; .... The interest which may be deducted is that from obHga- tions of the United States or its possessions, a state, territory or any poHtical subdivision thereof, or the District of Colum- bia, also from Farm Loan bonds and bonds issued by the War Finance Corporation. See Chapters XIX and XX. Depreciation. — Law. Section 247. (a) .... (8) A reasonable allowance, for the exhaustion, wear and tear of property, as provided in paragraph (7) of subdivision (a) of section 234; .... For a full treatment of depreciation, see Chapter XXXI. Specific credit. — Law. Section 247. (a) .... (9) In the case of such a domes- tic insurance company, the net income of which (computed without the benefit of this paragraph) is $25,000 or less, the sum of $2,000; but if the net income is more than $25,000 the tax imposed by section 246 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000 Taxable income of foreign company. — The law contains in the case of "insurance companies other than life and mutual insurance companies" no specific direction as to how the gross or net income of foreign companies is to be determined. It is simply stated in section 246 (a-2)^'' that ''its net income from sources within the United States" is to be subjected to tlie same rate of tax as is imposed upon the income of ordinary corporations. It is to l)e assumed that from the gross income from sources within the United States [subject to the defini- tions of such income contained in section 246 (b)^"] are to be subtracted the deductions allowed by section 247." These deductions are subject to the following limitation : ""' See page 1387. "See pages 1388, 1389. " See page 1390. 1394 SPECIAL CLASSES OF TAXPAYERS Law. Section 247. .... (b) In the case of a foreign cor- poration the deduction allowed in this section shall be allowed to the extent provided in subdivision (b) of section 234 Section 234 (b)^® limits the deductions of foreign corpora- tions to those "connected with income from sources within the United States." Mutual Insurance Companies Mutual insurance companies other than those which are exempt'" are taxed on a basis similar to that of other corpora- tions, with certain exceptions noted below. For the year 192 1 this basis also applied to insurance comj^anies "other than life and mutual insurance companies" which after December 31, 192 1, are taxed under special sections of the 1921 law."" In- surance companies taxed on this basis are sul)ject to excess profits tax for 1921 and to capital stock tax. Gross income. — Section 233, in defining gross income for corporations generally, makes applicable thereto the provisions of section 213 (individuals) and section 217 (non-resident alien individuals). The only specific reference to insurance companies is "that mutual marine insurance companies shall include in gross income the gross premiums collected and re- ceived by them less amounts paid for reinsurance." Law. Section 2t,Ti. (a) That in the case of a corporation sub- ject to the tax imposed by section 230 the term "gross income" means the gross income as defined in sections 213 and 217, except that mutual marine insurance companies shall include in gross income the gross premiums collected and received by them less amounts paid for rein- surance Section 230 imposes a corporation income tax of 10 per cent for 1921, and 1214 per cent for each year thereafter. Regulation. The gross income of mutual insurance companies (other than life) consists of their total revenue from the operation " See page 1292. '^ .See page 1401. ^ Sections 246-247 ; see pages 1387- 1389. Insurance companies 1395 of the business and of their income from all other sources within the taxable year, except as otherwise provided by the statute. Gross in- come includes net premiums (that is, gross premiums less returned premiums on policies cancelled and premiums on policies not taken), investment income, profits from the sale of assets, and all gains, profits, and income reported to the State insurance departments, ex- cept income specifically exempt from tax. Premiums received by mutual marine insurance companies which are paid out for I'einsur- ance should be eliminated from gross income and the payments for reinsurance from disbursements. Deposit premiums on perpetual risks received and returned by mutual fire insurance companies should be treated in the same manner, as no reserve will be recognized covering liability for such deposits. The earnings on such deposits, including such portion, if any, of the deposits as are not returned to the policy- holders upon cancellation of the policies, must be included in the gross income. A net decrease in reserve funds required by law within the taxable year must be included in the gross income to the extent that it is released to the general uses of the company and increases its free assets. Any net decrease in reserves shall be added to the gross income, unless the company shall show that such decrease resulted from the application of reserves to the purposes for which they were established (Art. 549.) Shipowners' mutual protection and indemnity asso- ciations. — If such associations are not organized for profit and no part of the earnings inures to the benefit of any stock- holder, they are subject to tax only on net income from interest, dividends and rents. Regulation. The following additional exclusions from gross income .... are allowed by the Revenue Act of 1921. .... (4) Receipts of shipowners' mutual protection and indemnity associations not organized for profit and no part of the net earnings of which inures to the benefit of any private stockholder or member. Such associations, however, shall be sub- ject as other taxpayers to the tax upon their net income from in- terest, dividends, and rents. In other words, they are subject to the taxes imposed by section 230, but only upon net income from in- terest, dividends, and rents; .... (Art. 89.) Deductions allowed. — The deductions allowed mutual com- panies are those provided in .section 234'"' (not those detailed in "See Chapters on Expenses (XXVI), Interest (XXVII), Taxes (XXVIII), Losses (XXIX), Bad Dcbt.s (XXX), and Depreciation (XXXI). 1396 SPECIAL CLASSES OF TAXPAYERS section 247), with certain additional deductions to meet the special circumstances obtaining in the case of insurance com- panies. Additions to reserve funds. — Law. Section 234. (a) . . . . (10) In the case of insurance companies (other than life insurance companies), in addition to the above (unless otherwise allowed) : (A) The net addition required by law to be made within the taxable year to reserve funds (including in the case of assessment insurance companies the actual deposit of sums with State or Territorial officers pursuant to law as additions to guarantee or reserve funds) ; and (B) the sums other than dividends paid within the taxable year on policy and annuity contracts. After December 31, 1921, this subdivision shall apply only to mutual insur- ance companies other than life insurance companies; .... Regulation. This article applies to all insurance companies (except life) for the calendar year 1921 ; thereafter it applies only to mutual companies. Insurance companies may deduct from gross income the net addition required by law to be made within the tax- able year to reserve funds, including in the case of assessment insur- ance companies the actual deposit of sums with State or Territorial officers pursuant to law as additions to guaranty or reserve funds. Reserve funds "required by law" include not only reserves required by express statutory provisions but also reserves required by the rules and regulations of State insurance departments when promul- gated in the exercise of an appropriate power conferred by statute, but do not include assets required to be held for the ordinary running expenses of the business, such as taxes, salaries, reinsurance, and unpaid brokerage. Only reserves commonly recognized as reserve funds in insurance accounting are to be taken into consideration in computing the net addition to reserve funds required by law. In the case of a fire insurance company the only reserve fund commonly recognized is the "unearned-premium" fund. Casualty companies may deduct losses incurred within the taxable year ; but unless the net addition to the unpaid loss reserve required by law exceeds such losses incurred, no deduction for the net addition to the unpaid loss reserve may be taken. In any event only the excess of such net ad- dition over such losses may be deducted. Mutual hail and mutual cyclone insurance companies are entitled to deduct from gross in- come the net addition which they are required to make to the "guaranty surplus" fund or similar fund (Art. 569.) Rulings. The decision of the United States Supreme Court in Maryland Casualty Company v. United States-- does not authorize "251 U. S. 342. INSURANCE COMPANIES 1397 any insurance company to deviate from the present method of com- puting the "net addition to reserve funds" deductible from gross in- come. The amount deductible is the excess of the total reserve funds as required by law at the end of the taxable year over the total of such reserve funds at the beginning of the year regardless of the fact that during the year the reserve funds are increased on account of new business, and decreases in such funds are inevitable when policies mature, lapse, or arc surrendered. (C. B. 2, page 2 [6; O. D. 427.) Reserve funds "required by law" include not only reserves re- quired by express statutory provisions, but also reserves required by the rules and regulations of State insurance departments when pro- mulgated in the exercise of an appropriate power conferred by statute, but do not include assets required to be held for the ordinary running expenses of the business, such as taxes, salaries, reinsurance, and unpaid brokerage. Where there is a net decrease in the reserve funds required to be maintained by an insurance company, so much of the decrease as is released to the general uses of the company and increases its free assets is income to the company. Any net decrease in reserve shall be added to the gross income, unless the company shall show that such decrease resulted from the application of reserves to the purposes for which they were estab- lished. (C. B. 2, page 216; L. O. 1032.) It would seem that outstanding liabilities for expenses such as salaries should be set up and deducted as such instead of being included in the reserve "required by law." Ruling. A reserve for the expense of investigating loss claims of an insurance company is not a "reserve" within the meaning of paragraph G (b) of the Act of October 3, 1913, and therefore any net addition thereto may not be deducted in determining net income subject to tax. (C. B. 3, page 276; Sol. Op. 76.) As stated above, accrued expenses sliouUl be deducted as such and not as a "reserve." The deduction, however, is permitted only when taxpayers keep their books on the accrual system. It would appear from the foregoing ruling that the deduction was denied because it was not properly accrued on the books at the time. In passing on the question of "whether the reserve set up by a fire insurance company against unpaid losses is a reserve within the meaning of the provision .... permitting a 1398 SPECIAL CLASSES OF TAXPAYERS deduction from gross income in the case of insurance com- panies, of the 'net addition required by law to be made withm the taxable year to reserve funds,' " the SoHcitor of Internal Revenue stated"'^ that : RuLiNC. The insurance commissioners of the several States re- quire fire insurance companies to return each year as an item of their liabilities the net amount of unpaid losses whether actually ad- justed or in process of adjustment or resisted, and it is contended on behalf of such insurance companies that, under the decision of the Supreme Court of the United States in the case of the Maryland Casualty Company v. United States, 251 U. S. 342 (T. D. 3013), the amount of this item constitutes a "reserve" within the meaning of the provision of the Revenue Act of igiS above cited.^' The Sohcitor further stated, however, that : It has been repeatedly stated on behalf of the fire insurance companies, and never denied, that their books are kept upon an accrued and incurred basis. It is clear, therefore, that under the law they are entitled to deduct the several items included in un- paid losses as "losses" and to allow them also to include these items in reserves the net additions to which may be deducted from gross income in determining the taxable income of such companies, would be in effect to permit them a double deduction, a result which can not be presumed to have been intended by Congress, and which could only be reached under the compulsion of an express pro- vision of the statute. It is hardly conceivable that insurance companies would intentionally claim a double deduction for losses. It would appear from the Solicitor's opinion that, while he holds that unpaid losses are not deductible as ''reserves,'' they are de- ductible as "losses" if a company's books are kept on an ac- crual basis. Special deductions in the case of combined life, health and accident policies, — Law. Section 234. (a) . . . . (11) In the case of corpora- tions (except those taxed under section 243)'-" issuing policies covering ■^ C. B. 4, page 297 ; L. O. 1056. "'Section 234 (a-io-a), re-enacted without substantial change in 1921 law. "'Life insurance companies. INSURANCE COMPANIES 1399 life, health, and accident insurance combined in one policy issued on the weekly premium payment plan continuing for life and not sub- ject to cancellation, in addition to the above, such portion of the net addition (not required by law) made within the taxable year to re- serve funds as the Commissioner finds to be required for the pro- tection of the holders of such policies only. This subdivision shall not be in effect after December 31, 1921; .... Regulation, Corporations which issue combination policies of life, health, and accident insurance on the weekly premium pay- ment plan, continuing for life and not subject to cancellation, may deduct from gross income only such portion of the net addition not required by law made within the taxal)le year to reserve funds as is needed for the protection of the holders of such combination policies. In general the net addition to any fund especially maintained for the protection of such policyholders may be deducted. The deter- mination by the company of the need for such addition is subject to review by the commissioner, and the return of income should be accompanied by a full explanation of the basis upon which such fund and the additions to it are determined. This article does not apply to life insurance companies taxed under section 243 nor to any taxable period after December 31, 1921. (Art. 570.) After the enactment of the 19 18 law, some insurance com- panies writing poHcies described in section 234 (a-ii) con- tended that, since no reserve for the purpose was recognized prior to the 19 18 law, the entire reserve might now be de- ducted, including the portion set up prior to 1918. The Solici- tor of Internal Revenue, replying to this contention, cited a statement made in a Federal Court case"*^ that, "there is no safer or better settled canon of interpretation than that when language is clear and unambiguous it must be held to mean what it plainly expresses, and no room is left for construction," and pointed out that the law specifically provided that the de- duction to be allowed is only for "the net addition .... made within the taxable year." He further pointed out that the portion of the addition to be allowed as a deduction is by law within the discretion of the Commissioner and that the latter had promulgated a regulation (article 570, Regulations 45) the effect of which was that the maximum deduction is "^Szvarls v. Siecjcl, 117 Fed. 13, 18. I400 SPECIAL CLASSES OF TAXPAYERS the net addition (not required by law) within the taxable year to reserve funds. Premium repayments by mutual marine insurance companies. Law. Section 234. (a) . . . . (12) In the case of mutual marine insurance companies, there shall be allowed, in addition to the deductions allowed in paragraphs (i) to (10) inclusive, and paragraph (14), unless otherwise allowed, amounts repaid to policyholders on account of premiums previously paid by them, and interest paid upon such amounts between the ascertainment and the payment thereof; .... Regulation. Mutual marine insurance companies should include in gross income the gross premiums collected and received by them less amounts paid for reinsurance They may deduct from gross income amounts repaid to policyholders on account of premiums previously paid by them, together with the interest actually paid upon such amounts between the date of ascertainment and the date of payment thereof. The remainder of the premiums accordingly form part of the net income of the company, except to the extent that they are subject to the deductions allowed such insurance companies and other corporations. (Art. 571.) Premium deposits returned or retained. — Law. Section 234. (a) . . . . (13) In the case of mutual in- surance companies (including interinsurers and reciprocal underwriters, but not including mutual life or mutual marine insurance companies) requiring their members to make premium deposits to provide for losses and expenses, there shall be allowed, in addition to the deduc- tions allowed in paragraphs (i) to (10), inclusive, and paragraph (14), unless otherwise allowed, the amount of premium deposits returned to their policyholders and the amount of premium deposits retained for the payment of losses, expenses, and reinsurance reserves; .... Regulation. Mutual insurance companies (other than mutual life and mutual marine insurance companies), which require their members to make premium deposits to provide for losses and ex- penses, are allowed to deduct from gross income the aggregate amount of premium deposits returned to their policyholders or retained for the payment of losses, expenses, and reinsurance reserves. In de- termining the amount of premium deposits retained by a mutual fire or mutual casualty insurance company for the payment of losses, ex- penses, and reinsurance reserves, it will be presumed that losses and expenses have been paid out of earnings and profits other than pre- miums to the extent of such earnings and profits. If, however, any portion of such amount is applied during the taxable year to the pay- INSURANCE COMPANIES 1401 ment of losses, expenses, or reinsurance reserves, for which a separate allowance is taken, then such portion is not deductible; and if any portion of such amount for which an allowance is taken is subse- quently applied to the payment of expenses, losses, or reinsurance re- serves, then such payment can not be separately deducted. An amount of premium deposits retained for the payment of expenses and losses, and the amount of such expenses and losses, may not both be deducted. A company which invests part of the premium deposits so retained by it in interest-bearing securities may nevertheless deduct such part, but not the interest received on such securities. A mutual fire in- surance company which has a guaranty capital is taxed like other mutual fire insurance companies. A stock fire insurance company, operated on the mutual plan to tlie extent of paying dividends to certain classes of policyholders, may make a return on the same basis as a nmtual fire insurance company witli respect to its business conducted on the mutual plan. (Art. 572.) Ruling. In determining the amount of premium deposits retained by a mutual fire or mutual casualty insurance company for the payment of losses, expenses and reinsurance reserves, it is to be presumed that losses and expenses have been paid out of earnings and profits, other than premium, to the extent of such earnings and profits. Office Decision 403 (Bulletin 7-20) overruled. (C. B. 3, page 279; L. O. 1050.) Insurance Companies Which Are Exempt Mutual insurauce companies which conform to certain specified requirements are exempt from taxation. Fraternal beneficiary societies.-' — Law. Section 231 (3) Fraternal beneficiary societies, orders, or associations, (a) operating under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system; and (b) providing for the payment of life, sick, ac- cident, or other benefits to the members of such society, order, or as- sociation or their dependents; .... Mutual insurance companies and like organizations. — Law. Section 231 (10) Farmers' or other mutual hail, cyclone or fire insurance companies, mutual ditch or irrigation com- panies, mutual or cooperative telephone companies, or like organiza- tions of a purely local character, the income of which consists solely For rulings regarding fraternal beneficiary societies, see Chapter II. 1402 SPECIAL CLASSES OF TAXPAYERS of assessments, dues, and fees collected from members for the sole purpose of meeting expenses; .... Regulation. It is necessary to exemption that the income of the company be derived solely from assessments, dues, and fees col- lected from members. If income is received from other sources, such as cash premiums or premium deposits, the corporation is not exempt, even though its additional income is tax exempt. Income, however, from sources other than those specified does not prevent exemption where its receipt is a mere incident of the business of the company. Thus the receipt of interest upon a working bank balance, or of the proceeds of the sale of badges, office supplies or equipment, will not defeat the exemption. The same is true of the receipt of interest upon Liberty bonds, where they were purchased as a patriotic duty and were afterwards sold. Where, however, such bonds are bought as a permanent investment, the receipt of the interest destroys the exemption. The receipt of what is in substance an entrance fee, charged by a mutual fire insurance company as a condition of mem- bership, does not render the company taxable, although this fee is called a premium. A farmers' mutual fire and lightning insurance company does not become taxable because it makes advance assess- ments for the sole purpose of meeting future losses and expenses, where any balance of such assessments remaining at the end of the year is retained to meet losses and expenses in the ensuing year. But the issuance of policies for stipulated cash premiums prevents exemp- tion. A local exchange or association to insure the owners of auto- mobiles against fire, theft, collision, public liability, and property damage is exempt, since it performs functions of the same character as a mutual fire insurance company, and is a like organization within the meaning of the statute. A local reservoir and ditch com- pany may likewise be exempt from tax. An organization doing business on the "interindemnity" or "reciprocal insurance' plan through an attorney in fact subject to direction of an advisory board of policyholders, which requires advance deposits to cover the cost of the insurance and maintains investments or deposits from which substantial income is derived, is not exempt. The exemption does not include a telephone clearing association, whose business is to apportion toll rates between independent telephone companies handling the same calls and whose income consists of compensation paid by such companies and receipts from the sale of form blanks. The phrase "of a purely local character" qualifies all the organizations enumerated in subdivision (10) of section 231. An organization of a "purely local character'" is one whose business activities are con- fined to a particular community, place, or district, irrespective, how- ever, of political subdivisions. The word "purely"' intensifies and limits "local,'" and indicates a clear intention on the part of Congress INSURANCE COMPANIES 1403 to exempt from taxation only such organizations as are entirely and unqualifiedly "local" in their operations. (Art. 521.) It has been held that a farmers' mutual fire and lightning insurance company does not lose its exempt status by reason of having funds on hand at the end of its taxable year due to additional assessments to meet expenses for the ensuing year. The following quotation from the opinion of the Solicitor of Internal Revenue is of interest: Ruling. Assessments are made by mutual fire insurance com- panies either after losses occur or in anticipation of such losses. It is thought that the majority of such companies at the present time make assessments to meet estimated future losses, the assessments be- ing made quarterly, half-yearly, or yearly, as the case may be. The advantages of making assessments in this manner are obvious, avoiding as they do operating expenses incidental to the making of a large number of assessments to meet particular losses as they occur. Where assessments are made in this manner, the resulting fund is held by the company, and any unexpended balance at the end of the year is retained and applied to expenses and losses for the ensuing year, the assessment or assessments for that year being reduced accordingly. The unconsumed portion of the assessments is not returned to the policyholders as in the case of premium deposits The policyholder is in precisely the same position as where the assessment is made subsequent to the loss, except that he is called upon to make his payment at an earlier time and is spared the an- noyance of a large number of payments to meet the individual losses as they occur. In either case the amount he eventually i)ays should be the same. (C. B. 4, page 270; Sol. Op. 99.) Static created mutual liabieity insurance company NOT EXEMPT. — The exemption of a mutual liability insurance company created by the act of a state depends upon the nature of the controlling management. Ruling. The funds contemijlak-d by article .S4 of Regulations 45^* are only those managed and controlled directly by the State through State officers, that is to say those funds the management and control of which constitute an activity of the State. A mutual liability insurance company created by an act of the State legislature to pro- vide insurance for employers to cover their liability under the State employers' liability act and workmen's compensation law, which is See Art. 87 of the 1021 regulations vvliicli is identical. I404 SPECIAL CLASSES OF TAXPAYERS not so managed and controlled, is not exempt from taxation under section 213 (b) 7, or under any other provision of the Revenue Act of 1918. (B. 43-21-1883; O. D. 1074.) Reciprocal indemnity exchange not necessarily EXEMPT. — A number of manufacturers incorporated as a re- ciprocal indemnity exchange to insure their businesses against fire loss, each subscriber depositing a fixed amount to meet losses, and at the end of the period any unexpended balance being returned to the depositors. This exchange was originally held to be exempt.-^ The earlier decision was, however, overruled by the following: Ruling. A number of manufacturers incorporated as a recipro- cal indemnity exchange to insure their business against fire loss on the reciprocal and inter-insurance plan through an attorney in fact having the power to issue policies, collect premiums and adjust losses. While the subscriber's contract provides that there shall be no joint funds, the rules of the association show that the provision is not carried out in letter or spirit. The advance payments are not all made directly to the attorney but direct to the exchange and are charged in the nature of advance premium deposits. Provision is made in the rules of the association for cancellation of the policies on a short rate basis. In view of the above facts it is held that the association does not come within the exemption provided in paragraph 10, section 231 of the Revenue Act of 1918, and will therefore be required to file returns of annual net income. (C. B. 4, page 269; O. D. 866.) Automobile owners insurance exchange held to be exempt. — An insurance company incorporated for the pur- pose of permitting automobile owners to exchange contracts of insurance and indemnity without becoming jointly liable as subscribers on any risks, its only sotirce of income being from assessments collected from members for the sole purpose of meeting- expenses, was held to be exempt.^*' Rulings holding certain corporations not exempt. — The following corporations have been held by the Treasury not to be exempt under section 231 (3) and ( 10) : an associa- '■* C. B. 2, page 210; O. D. 538. '" C. B. I, page 207; O. D. 312. INSURANCE COMPANIES 1405 tion operated under the lodge system, its charter providing for the union of its members into a grand fraternal beneficiary educational and patriotic society which assessed its members to provide for sick and death benefits, but derived income from subscriptions to a paper which it published as well as from job printing and other sources;"^ a mutual liability insurance compan}^ which derived its inc(jme from i)reiniums and assess- ments of its members which were used to defray operating expenses and indemnify policyholders against payments under a workmen's compensation law f' a travelers* association pro- viding for fixed death benefits to the beneficiaries of its mem- l)ers f^' a mutual irrigating ditch company which derived in- come from rents for the use of its surplus water;''* a casualty insurance association organized for the purpose of insuring its members throughout a state ^\•hich issued policies for stipu- lated cash premiums."'' An association qualified as a "like organization under sec- tion 231 (10) but was held not to be of a purely local char- acter'' when its business activities w'ere not confined to a par- ticular community, place or district, but covered an entire state. ^^ Returns of Insurance Companies Regulation. Insurance companies transacting business in the United States or deriving an income from sources tlierein arc re- quired to file returns of income. 'J'hc return shall be on Form 1120, except that life insurance companies shall make return on Form 1120 L. As an aid in auditing the returns, wherever possible a copy of the report to the State insurance department should be submitted with the return. Otherwise a copy of schedule D, parts i, 3 and 4, of tlie report should l)e attached to the return, showing the Federal, State, and municipal obligations from which the interest omitted from gross income was derived, and a copy of the complete report should be furnished as soon as ready for filing. (Art. 623.) " C. B. 2. page 207 ; O. D. 508. ^'C. B. I, page 206; O. D. 252. "C B. I, page 206; O. D. 63. •'*C. B. I, page 207; O. D. 318. ^C. B. I, page 203; O. 790. " C. B. I, page 205; O. 792. l4o6 SPECIAL CLASSES OF TAXPAYERS Net Losses The provision of the 1921 law" whereby taxpayers may deduct net losses resulting from the operation of their regular trade or business from the net income of the succeeding tax- able year, and from the second succeeding taxable year, if nec- essary, extends to all insurance companies. °' Section 204; sec pages 1022-1029. CHAPTER XXXIX FARMERS The lowering of the specific exemption to $i,ooo and $2,000 in 191 7 had the efYect of bringing many thousands of farmers within the class of income tax payers. There are many difficulties involved in the assessment of tax upon the true net income of a farmer, the accounting difficulty being very serious. It is now generally recognized, however, that accurate accounting of the income and expenses incident to the business of farming is practicable and is very beneficial to the farmer. The attempt by the Commissioner of Internal Revenue to secure returns which reflect actual operating re- sults should have unanimous support. It has been charged in the past that law makers legislate in favor of the farmer whenever possible. It is questionable whether the farmer ever demanded si)ecial favors. It may rather be assumed that all he asked was a square deal, that is. the right to insist that no undue burden be placed upon him. It has not been shown that farmers as a class have knowingly evaded income tax requirements. Inability to understand the laws and difficulty in determining actual net income have prob- ably deterred many from making returns. Under saner laws and intelligent administration it may be expected that many returns and substantial taxes will be received. To the extent that a farmer is not required to return as income that part of his crops which is consumed as food by himself and his family he receives an allowance for living expenses. This is an allowance which is not permitted to any other class of taxpayers. As soon as possible the allowance should be withdrawn. In Great Britain a method was devised under which a farmer's taxable income was assumed to have a definite rela- 1407 I4o8 SPECIAL CLASSES OF TAXPAYERS tion to the rental value of the farm. Such a method would liardly meet with favor in the United States; but if a farmer is not willing to keep books and ascertain, even roughly, his net income some plan should be devised whereby to impose a reasonable tax in all cases in which a tax obviously is due. T\\Q introduction of the inventory system will do more than anything else to prove to the farmer that there may be an increase in net worth even though his bank balance has not increased. Gross income. — Farmers of course are taxable on any gain derived from sale of all or part of their farm property. In such cases the rules applicable to gains arising from sales are applicable.^ During 19 19 and 1920 many thousands of farms changed hands and it is said that enormous profits were realized by the sellers. The return of such profits should have yielded a large tax. Under the 1921 law the gain arising from the sale of farms, title to which has not changed within two years, immediately prior to the sale, will be subject to the maximum rate of 1234 per cent imi)osed u\h>u capital gains. Such crops as form part of the sale should not l)e included among capital assets. Rkgui.a rrox. A fanner reportiiii;- on the basis of receipts and disbursements ( in wliich no inventory to determine profits is used) shall include in his gross income for the taxable year ( 1 ) the amount of cash or tlie value of merchandise or other property received from the sale of live stock and produce which were raised during the taxable year or prior years, (2) the profits from the sale of any live stock or other items which were purchased, and (3) gross income from all other sources. The profit from the sale of live stock or other items which were purchased is to be ascertained by deducting the cost from the sales price in the year in which the sale occurs, except that in the case of the sale of animals purchased as draft or work ani- mals or solely for breeding or dairy purposes and not for resale, the profit shall be the amount of any excess of the sales price over the amount representing the difference between the cost and the de- ' See page 535. FARMERS 1409 preciation theretofore sustained and allowable as a deduction in computing net income. In the case of a farmer reporting on the accrual basis (in which an inventory to determine profits is used) his gross profits are ascer- tained by adding to the inventory value of live stock and products on hand at the end of the year the amount recei.ved from the sale of live stock and products, and miscellaneous receipts for hire of teams, machinery, and the like, during the year, and deducting from this sum the inventory value of live stock and products on hand at the beginning of the year and the cost of live stock and products purchased during the year. In such cases all live stock raised or purchased for sale shall be included in the inventory at their proper valuation determined in accordance with the method authorized and adopted for the purpose. Also live stock acquired for draft, breeding, or dairy purposes and not for sale may be included in the inventory, instead of being treated as capital assets subject to depreciation, provided such practice is followed consistently by the taxpayer. In case of the sale of any live stock included in an inventory their cost must not be taken as an additional deduction in the return of income, as such deduction will be reflected in the inventory Sale of machinery equipment, etc. — In every case of the sale of machinery, farm equipment, or other capital assets (which are not to be included in an inventory if one is used to determine profits) any excess over the cost thereof less the amount of depreciation theretofore sustained and allowable as a deduction in com.puting net income, shall be included as gross* income. Exchange of produce for merchandise. — Where farm produce is exchanged for merchandise, groceries, or the like, the market value of the article received in exchange is to be included in gross income. Rents. — Rents received in crop shares shall be returned as of the year in which the crop shares are reduced to money or a money equivalent. Proceeds of insurance. — Proceeds of insurance, such as hail and fire insurance, on growing crops should be included in gross income to the amount received in cash or its equivalent for the crop injured or destroyed. Computing income on crop basis. — If a farmer is engaged in producing crops which take more than a year from the time of planting to the time of gathering and disposing, I4IO SPECIAL CLASSES OF TAXPAYERS the income therefrom may be computed upon the crop basis; but in any such cases the entire cost of producing the crop must be taken as a deduction in the year in which the gross income from the crop is realized. Definition of -"farm." — As herein used the term "farm" embraces the farm in the ordi- narily accepted sense, and includes stock, dairy, poultry, fruit, and truck farms, also plantations, ranches, and all land used for farm- ing operations. All individuals, partnerships, or corporations that cultivate, operate, or manage farms for gain or profit, either as owners or tenants, are designated farmers. "Gentlemen" farmers. — A person cultivating or operating a farm for recreation or pleasure, the result of which is a continual loss from year to year, is not re- garded as a farmer (Art. 38.) Regulations If an individual owns and operates a farm, in addition to being engaged in another trade, business, or call- ing, and sustains a loss from such operation of the farm, then the amount of loss sustained may be deducted from gross income received from all sources, provided the farm is not operated for recreation or pleasure (Art. 145.) .... If a farm is operated for recreation or pleasure and not on a commercial basis, and if the expenses incurred in connection with the farm are in excess of the receipts therefrom, the entire receipts from the sale of products may be ignored in rendering a return of income, and the expenses incurred, being regarded as per- sonal expenses, will not constitute allowable deductions (Art. no.) It may be inferred from the foregoing that if a person makes a profit out of operating a farm he is a farmer. The Treasury's position is as follows: Ruling. It is held that where a farm is operated on a basis other than the recognized principles of commercial farming, such a farm is not to be classed as a commercial enterprise, inasmuch as it does not form a part of the owner's business or trade, and until it is placed upon a profit-paying basis the gross receipts are not to be reported under "gross income" and the expenses are not to be claimed as a deduction. (Extract from letter to a taxpayer, February 9, 1920.) FARMERS 1411 , The regulations are quite right in refusing to allow losses unless it can be shown that a farm is operated as if it were a transaction undertaken for profit. If a taxpayer conducts the farm or estate chiefly for rec- reation or pleasure, and not as he would conduct a business for profit, the loss, if any, is apparent only. The deficit is a family, personal or living expense. But if a taxpayer in good faith embarks in the farming business and loses money during one or more years the loss is an allowable deduction under the law, to the same extent that losses are allowable in other businesses. The question to be decided is whether the farm is being operated as a business or for recreation or pleasure. It is nec- essary to judge the facts of each case before the point can be settled. In a case that has been given considerable promin- ence in the press, ^ the court charged the jury as follows : Decision. That, if the plaintiff was a person cultivating and operating a farm for recreation or pleasure, other than on the recog- nized principles of commercial farming, then he was not a farmer. That if the jury find that the plaintiff was the owner of a body of land devoted to agriculture, either to the raising of crops or pasture, for the purpose of selling the products as a business, then they are entitled to find a verdict in favor of plaintiff on this issue. Business is that which occupies the time, attention and labor of men for the purpose of a livelihood or profit. It is that which is his personal concern, interest or regular occupation. In deciding the foregoing case the jury found (and the court sustained the finding) that the following constituted a "business" farm : The Continental Village farm was located in Putnam County, and consisted of 1,300 acres, 900 of woodland and 400 cultivated. The place was equipped with cow barns and there were 40 cows there, and there was evidence of it being a cattle farm. There were no profits upon the farm, although there was reasonable probability of believing that some day there would be. It was also decided that another farm was maintained for recreation or pleasure : ' Stuyvesant I'isli v. Roscoc Jnviii, U. S. Dist. Ct., No. Dist. of N. Y., July 29, 1 92 1. I4I2 SPECIAL CLASSES OF TAXPAYERS The Glenclyffe farm consisted of 480 acres, and only 70 were cultivated and the testimony was that there never was a profit or reasonable expectancy of a profit, that the expenses were far in excess of what legitimately would be a farm venture, that the raising of crops was more of a hobby than a business. Ruling. When an executor operated a decedent's farm prior to disposition thereof, the costs of operation were deductible even though the decedent was not entitled to such deduction. It could not be held that the executor operated the farm as a hobby or for pleasure. (C. B. 3, page 145; A. R. R. 249.) Farmers' associations. — Regulation, (a) Cooperative associations, acting as sales agents for farmers, fruit growers, dairymen, etc., and turning back to them the proceeds of the sales, less the necessary selling ex- penses, on the basis of the produce furnished by them, are exempt from income tax. Thus cooperative dairy companies, which are engaged in collecting milk and disposing of it or the products thereof and distributing the proceeds, less necessary operating expenses, among their members upon the basis of the quantity of milk or of butter fat in the milk furnished by such members, are exempt from the tax. If the proceeds of the business are distributed in any other way than on such a proportionate basis, or if the associa- tion deducts more than necessary selling expenses, it does not meet the requirements of the statute and is not exempt. The maintenance of a reasonable reserve for depreciation or possible losses or a reserve re- quired by State statute will not necessarily destroy the exemption. A corporation organized to act as a sales agent for farmers and having a capital stock on which it pays a fixed dividend amounting to the legal rate of interest, all of the capital stock being owned by such farmers, will not for that reason be denied exemption. (b) Cooperative associations organized and operated as purchas- ing agents for farmers, fruitgrowers, dairymen, etc., for the pur- pose of buying supplies and equipment for the use of members and turning over such supplies and equipment to members at actual cost, plus necessary expenses, are also exempt. In order to be exempt under either (a) or (b) an association must establish that it has no net income for its own account. An association acting both as a sales and a purchasing agent is exempt if as to each of its func- tions it meets the requirements of the statute. (Art. 522.) Expenses deductible. — Regulation. A farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming. FARMERS T413 Tools. — The cost of ordinary tools, of short life or small cost, such as hand tools, including shovels, rakes, etc., may be included. Feeding and raising live stock. — The cost of feeding and raising live stock may be treated as an ex- pense deduction, in so far as such cost represents actual outlay, but not including the value of farm produce grown upon the farm or the labor of the taxpayer Farm machinery and buildings. — The cost of farm machinery, equipment, and farm buildings repre- sents a capital investment and is not an allowable deduction as an item of expense. Development expenses. — Amounts expended in the development of farms, orchards, and ranches prior to the time when the productive state is reached may be regarded as investments of capital. Cost of draft or work animals or live stock. — Amounts expended in purchasing work, breeding or dairy animals are regarded as investments of capital Cost of automobile not deductible. — The purchase price of an automobile, even when wholly used in carrying on farming operations, is not deductible, bul is regarded as an investment of capital. Upkeep of automobile may be deductible. — The cost of gasoline, repairs and upkeep of an automobile if used wholly in the business of farming is deductible as an expense; if used partly for business purposes and partly for the pleasure or conven- ience of the taxpayer or his family, such cost may be apportioned according to the extent of the use for purposes of business and pleas- ure -or convenience, and only the proportion of such cost justly attributable to business purposes is deductible as a necessary expense. . . . . (Art. no.) Depreciation. — Regulation. A reasonable allowance for depreciation may be claimed on farm buildings (other than a dwelling occupied by the owner), farm machinery, and other physical property. A reason- able allowance for depreciation may al'^o be claimed on live stock I4I4 SPECIAL CLASSES OF TAXPAYERS acquired for work, breeding, or dairy purposes, unless they are in- cluded in an inventory used to determine profits in accordance with article 38. Such depreciation should be based on the cost and the estimated life of the live stock. If such live stock be included in an inventory no depreciation thereof will be allowed, as the cor- responding reduction in their value will be reflected in the in- ventory. .... (Art. 171.) Ruling. An owner of an orchard which has reached an income- producing stage is entitled to deduct from gross income in his annual tax returns an annual allowance for depreciation, based upon the capital invested, which comprises the original purchase price of the trees together with the necessary expenditures incurred in bringing them to the producing age; and the rate of depreciation is to be de- termined by the average life of the trees under normal conditions. (C. B. 2, page 130; O. 797.) Losses. — Regulation. Losses incurred in the operation of farms as busi- ness enterprises are deductible from gross income (Art. 145.) Depreciation of fruit trees and the computation of deductible loss in event of death. Rulings. Receipt is acknowledged of your letter dated Febru- ary 24, 1920, quoted here as follows: "I have a 20-acre prune or- chard of two thousand (2,000) six-year-old trees. Last year, two hundred and fifty (250) of them died from some unavoidable cause. Am I allowed any depreciation on same ?" In reply, you are advised that the loss sustained by the killing of the trees is the cost of the trees killed, and the amount of such loss is deductible from your income for the taxable year 1919. If the orchard had not reached an income producing stage at the time the trees were killed, the cost of the trees would be the initial cost, or fair market value on Alarch i, 1913, if the trees were acquired prior to that date, plus the capitalized expenditures incurred in bring- ing them to maturity. In the event the orchard had reached the income producing stage at the time the trees were destroyed, the cost would be the initial cost or fair market value as of March i, 1913, plus the capitalized expenditures incurred in bringing them to maturity less depreciation sustained. The basis of computing depreciation is the cost of the trees at the time the orchard has reached an income producing stage, includ- ing initial cost and capitalized expenditures incurred in bringing them to maturity, and the rate of depreciation is to be determined by the average life of the trees from the income producing stage under FARMERS 1415 normal conditions. (Letter to C. M. McKinney, Walla Walla, Wash- ington, signed by G. V. Newton, Acting Assistant to the Commis- sioner, by S. Alexander, Head of Division, dated March, 1920,) In the case of orchards and vineyards acquired subsequent to March i, 1913, and later destroyed, any deduction for loss should be confined to the amounts of capital originally invested in the grow- ing trees and in the new nursery stock which was totally destroyed and the amount expended from date of acquirement to date of de- struction in an endeavor to bring such trees and stock to an income- producing stage, eliminating all expenditures on account of perma- nent improvements or on account of trees and vines the growth of which was merely retarded and not entirely destroyed. (C. B. 2, page 127; O. D. 374.) Attorney's fees deductible. — Ruling. A tenant at work on the farm of a taxpayer was in- jured. In defending suit for damages on account of negligence the taxpayer incurred expenses for attorney's fees. It is held that if the taxpayer was engaged in farming he was carrying on a trade or business, and that the attorney's fees consti- tuted compensation for personal services actually rendered which is deductible as an ordinary and necessary expense. If the farm was rented, the amount so paid is deductible as a business expense inci- dent to the earning of the rent. (B. 48-21-1947; O. D. 11 17.) Deterioration or loss by casualty. — Regulation If farm products are held for favorable markets, no deduction on account of shrinkage in weight or physical value or by reason of deterioration in storage shall be allowed, except as such shrinkage may be reflected in an inventory if used to determine profits. The total loss by frost, storm, flood, or fire of a prospective crop is not a deductible loss in computing net in- come (Art. 145.) However, if the farmer's accounts are kept on the accrual basis, he receives credit, in effect, for the loss of the destroyed crop because it appears in neither sales nor inventory (which enter into the determination of his gross income), while the cost of the crop is included among the deductions. If the ac- counts are kept on the cash basis, the destroyed crop would not appear among the gross income (sales of produce) but the cost would be allowed as a deduction. I4l6 SPECIAL CLASSES OF TAXPAYERS Loss FROM DEATH OF STOCK RAISED ON FARM. Regulation A farmer engaged in raising and selling stock, cattle, sheep, horses, etc., is not entitled to claim as a loss the value of animals that perish from among those animals that were raised on the farm, except as such loss is reflected in an inventory if used. Loss FROM DEATH OF STOCK PURCHASED. If live stock has been purchased for any purpose, and afterwards dies from disease, exposure, or injury, or is killed by order of the authori- ties of a State or the United States, the actual purchase price of such stock, less any depreciation sustained and allowable as a deduction in computing net income, with respect to such perished live stock, and less also any insurance or indemnity recovered, may be deducted as a loss. The actual cost of other property, less deprecia- tion sustained and allowable as a deduction in computing net income, destroyed by order of the authorities of a State or of the United States, may in like manner be claimed as a loss; but if reimburse- ment is made by a State or the United States in whole or in part on account of stock killed or property destroyed, the amount received shall be reported as income for the year in which reimbursement is made. The cost of any feed, pasturage, or care which has been de- ducted as an expense of operation shall not be included as part of the cost of the stock for the purpose of ascertaining the amount oi a deductible loss. Inventory method when used will reflect loss. — If gross income is ascertained by inventories, no deduction can be made for live stock or products lost during the year, whether pur- chased for resale or produced on the farm, as such losses will be reflected in the inventory by reducing the amount of live stock or products on hand at the close of the year (Art. 145.) Inventories of livestock raisers and other farmers. — Regulation, (i) Farmers may change the basis of their re- turns from that of receipts and disbursements to that of an inventory basis, which necessitates the use of opening and closing inventories for the year in which the change is made. There should be included in the opening inventory, all farm products (including live stock), purchased or raised, which were on hand at the date of the inventory, but inventories must not include real estate, buildings, permanent im- provements, or any other assets subject to depreciation. (2) Because of the difficulty of ascertaining actual cost of live stock and other farm products, farmers who render their retivrns upon an inventory basis may at their option value their inventoiies FARMERS 1417 for the current taxable year according to the "farm-price method" which provides for the valuation of inventories at market price less cost of marketing. If the use of the "farm-price method" of valuing inventories for any taxable year involves a change in method of pricing inventories from that employed in prior years, the ope n- ing inventory for the taxable year in which the change is made should be brought in at the same value as the closing inventory for the preceding taxable year. If such valuation of the opening inventory for the taxable year in which the change is made results in an abnormally large income for that year, there may be submitted with the return for such taxable year an adjustment statement for the preceding year based on the "farm-price method" of valuing inven- tories; upon the amount of which adjustments the tax, if any be due, shall be assessed and paid at the rate of tax in effect for such preced- ing year. (3) Where returns have been made in which the taxable net in- come has been computed upon incomplete inventories, the abnormal- ity should be corrected by submitting with the return for the cur- rent taxable year a statement for the preceding year in which such adjustments shall be made as are necessary to bring the closing in- ventory for the preceding year into agreement with the opening complete inventory for the current taxable year. If necessary to reflect the income, similar adjustments may be made as at the be- ginning of the preceding year, and the tax, if any be due, shall be assessed at the rate of tax in effect for such year. (Art. 1586.) Ruling. Article 1586 of Regulations 45 (1920 edition) revokes all previous rulings and instructions inconsistent therewith. It is not permissible for farmers, in changing to the inventory basis of making their returns, to make adjustments by calculating their net income for the current taxable year without taking as a credit the inventory of live stock, crops, and other products at the beginning of the year in accordance with the instructions on page 4 of Form 1040-F. (C. B. 4, page 54; O. D. 939.) Treasury Decision 3104 does net require adjustment of taxes for years prior to 191 7, in cases in which farmers change to the inventory basis in rendering their income tax returns for the current taxable year because in most cases records for such prior years are not avail- able. If, however, adequate records for the years 1915 and 1916 arc available, adjustments may be made for those years also. (C. B. 4, page 53; O. D. 802.) It is not contemplated by Treasury Decision 3104 that farmers must obtain formal permission in order to change the basis of their returns from that of receipts and disbursements to that of an inven- tory basis. The use of opening and closing inventories for the year in which the change is made is, however, necessary, and there must 1418 SPECIAL CLASSES OF TAXPAYERS be submitted with the return for the current taxable year an adjust- ment sheet for 1917 and each year thereafter (prior to the year in which the change is made) based on the inventory method, upon the amount of which adjustments the tax shall be assessed and paid (if any be due) at the rate of tax in effect for each respective year. (C. B. 4, page 53; O- D. 841.) The Treasury makes it as easy as possible for a farmer to change from a cash receipts to an accrual basis. If tax- payers have not taken inventories heretofore, the information required for the years prior to the current year may be sup- plied by estimating their inventories as of past dates. Farm price method. — Article 1586^ permits farmers to use market as the basis of inventory (in contrast with cost or market). This is apparently the only case in which apprecia- tions would be taxed before realization, excepting when dealers in securities use the "market value" basis of inventorying per- mitted by article 1585. Rulings. The purpose of the adjustment sheets required in article 1586, Regulations 45, is properly to allocate over the period from 191 7 to date, the net dift'erence in gain or loss due to changing from a cash basis to an inventory basis. Opening and closing inventories for these years are first ascer- tained from the best source of information available, and the gross income of each year is adjusted by adding or subtracting, as the case may be, the additional gain or loss due to the difference between the opening and closing inventory in each year. A separate adjustment sheet should be made for each year from 1917 to date, in order that the sheet for each year may be attached to the return for that par- ticular year. The net income is then adjusted conformably, and from this information the tax on each return is recomputed in this office at the rate at which the tax was originally computed. (B, 47-21-1928; O. D. 1 105.) Florists are not required to use inventories of growing plants for the purpose of calculating their net income for income tax purposes and should not compute the cost of goods sold during the year by using an inventory value of growing plants on hand at the beginning and end of the taxable year. (B. 34-21-1774; O. D. 995.) It should be noted that farmers are entitled to the benefit ° See page 1416. FARMERS 1419 of section 204 of the 192 1 law"*; and if a net loss is sustained in any taxable year, beginning after December 31, 1920, the loss may be applied against the profits of the succeeding year and any excess of such loss may be applied against the profits of the next succeeding year. Farmers who keep books. — The regulations provide that farmers who keep books according to an approved system may prepare their returns therefrom. Several accounting systems for farmers have been devised. It is claimed that with little effort a correct record of the finan- cial position and income and expenses of farmers may be kcpt.° The claims sound rather optimistic to the author. Operating a farm is conducting a business for profit. Ac- curate results cannot be ascertained unless inventories are taken. Otherwise a farmer who is breeding stock and accumulating a large herd might show no income (or a loss) for several years and then, if he were to' dispose of all his stock in one year, he would have to pay an excessive tax, although the profit would be properly distributable over several prior years. The accurate and fair method would be to inventory his stock annually and pay the tax on the profit as it accrues an- nually and as shown by his books. Use of form 1040F optional. — Ruling. The use of form 1040F is optional since it is designed merely to assist farmers in computing their net income. Therefore, it is unnecessary to file same where the taxpayer has made return and paid the taxes due. ( C. B. r, page 71; O. D. 266.) * [Former Procedure] Under section 204 of the 1918 law, if a net loss was sustained in any taxable year, beginning after October 31, 1918, and ending prior to January i, 1920, such net loss was deductible from the profits of the preceding year or of the succeeding taxable year. Farmers, of course, if their fiscal year ended at any date between January and Oc- tober, were not entitled to the benefit of section 204. Presumably most farmers make up their accounts on the basis of the calendar year, so that there was no discrimination against them, as was the case with many cor- porations. 'For details of a system see the Magazine of Wall Street for January 24, 1920, pages 392-3. A bibliography on farm accounting will be found in Accountant's Index, 1921, pages 46-53. 7^7, 788. 1420 SPECIAL CLASSES OF TAXPAYERS The following statement appears as instruction 7 on form 1040: If you are a farmer or a farm owner renting your farm out on shares and keep no books of account, or keep books on a cash basis, obtain from the Collector, and attach to this return, Form 1040F, Schedule of Farm Income and Expenses. Enter the net farm income as Item 5, page i of the return. If your farm books of account are kept on an accrual basis, the filing of Form 1040F is optional. Report income from salaries, interest, rents, sales of property, etc., in Itcmi I to 7 of the return. PART V MISCELLANEOUS TAXES CHAPTER XL FEDERAL ESTATE TAX This tax, which forms Title IV of the Revenue Act of 1 92 1, bears at least the merit of antiquity as a part of federal taxation, although some authorities think that this source of revenue should be left exclusively to the states. As long ago as 1797 there was imposed, under the Stamp Act of that year, an inheritance tax. This latter act was in force for five years. It was a war measure, as have been all subsequent inheritance tax acts. The Civil War was responsible for the next law of this nature, imposed in 1862, with a life of eight years; while the Spanish-American War produced the Act of 1898 which remained in force for four years. Within the last decade appeared the Revenue Act of 1916, Title II of which was termed an "Estate Tax," amended twice in 1917 (March 3 and October 3), and the Act of February 24, 1919, (known as the Revenue Act of 1918), the last prior to the one herein discussed. It will be noticed that the Stamp Act of 1797 imposed an "inheritance tax." This term cannot be used in relation to the existing tax. True, it is a tax on the transfer of property which passes by inheritance, but it is distinctly a tax on the transfer and not on the manner of that transfer. The law, section 401, states that the tax "is hereby imposed on the transfer of the net estate . . . ." It further imposes a tax on the transfer of property by will or trust in antici- pation of death. It is tentatively assumed that all property transferred within two years prior to death has been trans- ferred to avoid the tax, and the amount of any such property must be included in the return of the gross estate, unless transferred by "a bona fide sale for a fair consideration in 1423 1424 MISCELLANEOUS TAXES money or money's worth, "^ or unless any such transfer being made without valuable consideration within two years of decedent's death, can be established not to have been made in contemplation of death. In any case, the property must be described in the return and its value shown therein. The bur- den of proof regarding the non-inclusion of the value of such property in the gross estate lies with the legal representatives of the decedent. The latter are likewise responsible for the filing of the notice, the return itself,^ and the payment of the tax.^ The tax is computed on the value of the net estate at varying rates and in graduated blocks or brackets. Herein it differs from most of the state taxes of this nature which are based on the several distributive shares of the net estate, different exemptions being allowed according to the status of the beneficiaries in relation to the decedent. In the federal tax the total net estate is taxed, the net amount having been ar- rived at in accordance with the regulations hereinafter men- tioned, less, in the case of resident estates, a single exemption of $50,000. It is obvious, therefore, that resident estates whose net transfer values do not amount to $50,000 are not subject to the estate tax.* The law dealing with the estate tax forms sections 400-411 of the Revenue Act of 192 1, w^iich is eff'ective from November 23, 1921. Prior to this date, the 1918 law was in effect. The latest regulations are known as Regulations 37 and deal with the 1918 law. Regulations for the 192 1 law have not yet been issued. Summary of Law s. :ax. Section 402. Determination of gross estate. Section 400. Definitions Section 401. Rates of tax ^1921 law, section 402 (c). ' 1921 law, section 404. ^ 1921 law, section 407. ' See Reg. 37, Art. 77. Sec page 1497. FEDERAL ESTATE TAX 1425 Property owned by decedent. Dower and curtesy. Transfers in contemplation of death. Interest of decedent in joint estate. Property passing under a power of appointment by will or deed. Insurance on life of decedent payable to his estate or to in- dividual beneficiaries in excess of $40,000. Section 403. Determination of net estate (deductions allowable). Funeral and administration expenses; claims, etc. Decedent's share in estate of prior decedent taxed within previous five years. Charitable bequests, etc. Specific exemption of $50,000 (for residents only). Sections 404, 405. Returns, by whom and when made. Sections 406, 411. Tax, when due and by whom payable. Definitions. — The following definitions appearing in section 2, Title I, of the Revenue Act of 192 1, are applicable to the estate tax : "Person" includes partnerships and corporations as well as individuals ; "Corporation" means associations, joint-stock companies, and insurance companies; "United States" means, in a geographical sense only the states, the Territories of Alaska and Hawaii, and the District of Columbia. "Taxpayer" means any person, trust, or estate subject to taxation under this act. "Executor" is defined as "the executor or administrator of the decedent, or, if there is no executor or administrator, any person in actual or constructive possession of any property of the decedent" (law, section 400). Rates of Tax. — The rates of tax imposed by the 1921 law are identical with those under the 19 18 law. The exemption of $50,000 applies only to residents. Law. Section 461. That, in lieu of the tax imposed by Title IV of the Revenue Act of 1918, a tax equal to the sum of the following 1426 MISCELLANEOUS TAXES percentages of the value of the net estate (determined as provided in section 403) is hereby imposed upon the transfer of the net estate of every decedent dying after the passage of this Act, whether a resi- dent or nonresident of the United States: 1 per centum of the amount of the net estate not in excess of $50,000 ; 2 per centum of the amount by which the net estate exceeds $50,000 and does not exceed $150,000; 3 per centum of the amount by which the net estate exceeds $150,000 and does not exceed $250,000; 4 per centum of the amount by which the net estate exceeds $250,000 and does not exceed $450,000; 6 per centum of the amount by which the net estate exceeds $450,000 and does not exceed $750,000; 8 per centum of the amount by which the net estate exceeds $750,000 and does not exceed $1,000,000; 10 per centum of the amount by which the net estate exceeds $1,000,000 and does not exceed $1,500,000; 12 per centum of the amount by which the net estate exceeds $1,500,000 and does not exceed $2,000,000; 14 per centum of the amount by which the net estate exceeds $2,000,000 and does not exceed $3,000,000; 16 per centum of the amount by which the net estate exceeds $3,000,000 and does not exceed $4,000,000; 18 per centum of the amount by which the net estate exceeds $4,000,000 and does not exceed $5,000,000; 20 per centum of the amount by which the net estate exceeds $5,000,000 and does not exceed $8,000,000; 22 per centum of the amount by which the net estate exceeds $8,000,000 and does not exceed $10,000,000; and 25 per centum of the amount by which the net estate exceeds $10,000,000. Regulation. For the purpose of computing the tax, the net estate is divisible into blocks, each block being taxed at a different and increasing rate. The preceding table gives the amount at the various blocks and the applicable rate of tax under each of the taxing acts. For example, the tax upon the net estate of $1,240,000 of a decedent dying on or after February 25, 1919. would be computed as follows: Amount of first block $50,000 at i per cent $500 Amount of second block 100,000 at 2 per cent 2,000 Amount of third block 100,000 at 3 per cent 3,000 Amount of fourth block. . .• 200,000 at 4 per cent 8,000 Amount of iifth block 300,000 at 6 per cent 18,000 Amount of sixth block 250.000 at 8 per cent 20,000 Remainder 240,000 at 10 per cent 24,000 Total net estate $1,240,000 Total tax . . .$75,500 FEDERAL ESTATE TAX 1427 There is subjoined a table for ascertaining the tax without the detailed computation given above. An illustration of its use is as follows. The net estate of a decedent dying on or after February 25, 1919, amounts to $1,240,000. By reference to the table it will be seen that the last complete block prior to this amount is $1,000,000, and that the total tax on a million dollars under the rates in force amounts to $51,500. Upon the remainder of the estate, $240,000, the tax is computed at the rate contained in the following line, or at 10 per cent. The tax on this amount is consequently $24,000. The following, result is thus obtained : Total tax on $1,000,000 $51,500 Tax on 240,000 24,000 Total $1,240,000 $75,500 < H W H < H W o H o u O w < OOOOOOOQOOOOOOOO • oooooooooooooooo • a.T3 ^g 13 ^^ cf "S CO H-T hT w" i-T i-T i-T h-T i-T M i-T i-T m" • _,00 o ►H CDtoOvo 0\0 •*■*■* ■rl-\o 00 ■ >o 5, i-M w n Tt\o oo o^ 01^ -^vo ; w w w w~ . oooooooooooooooo ■ oooooooooooooooo • igooooooooooooooo : *^ of f^OO-QO' o" o" o' d~ o" o" o' o' o" o" o • ■* X H "rt u 1-1 cs lovo •^vooo o o o N 01 . mmmNNNNC^ • c i-C rt aS ■I CS fC rf\0 00 O 0) -^VO 00 O O O O N lO K-S WHHWi-ii-iMojOJOlCSCN OOOOOOOOOOOOOOOO • 92°5200ooooooooo • OOOOOOOOOOOOOOOO • ^ ^3 •— < s o H m- MO) looo -^OTroooooocoooiN ' -O > >-i C^ CO iO\0 00 O Cl_ "2 f^ • ^^'T: -i'- oooooooooooooooo • X OOOOOOOOOOOOOOOO f*^ ^'So q o^ o__ o_^ o_^ o_^ o_ o_ o o o o o o o__ o ; =^•2- m" -"t^vo" O" lO o" o" o" o" o" o" o" o" o" d" • «<9- 1-1 PO W VO ^ -^UD 00 O O O (N 0) • • 0\ J3 i-i>-"i-iC^O< CO irjO 00 o\ w w . o H OOOOOOOOOOOOOOOO • mooooiooooooooooo • lN.Oir)Oi^t>«0000000000 • ':r-m c X n CO H ^'^ CO -^ of of oo' "S lo in d in o' o* o" o' o ■ >-i04i-i'^'^oo-i 1-1 OJ CO ^ ir-i-O t^OO • oooooooooooooooo • oooooooooooooooo • t-t ^.:_vt-i 5>S° ji ■oooo^^omoooooooooo • ^^ of CO 00* in of o* o' o' o" d d d o' o* o" ; ■^Ti •*-• H 1-1 1-1 CO CO txoo o\ o o o o o ; V i"~: i; o^ 11 0^ CO -^ in mvo vo 1^00 C\ o o o O o o 1/3 « 1-1 1-c M l-l M l-l oooooooooooooooo • QOOOOOOOQOQOOOOO • oooooooooooooooo • ooQooooooooocdo-o ■ mOOOOmOOOOOOOOQO w- 1-1 1-1 M CO o< m m q q 0__ o_^ o_ q_ q_ o_ ; o , 1 oooooooooooooooo • oooooooooooooooo • s r*1 As q o_ o_^ o_^ o o_^ q_ o_^ o_^ o o o o o o o • W c" d o" o' o" o" o" o c o o d o d d d d ' inininvninooooooooooo ' s o^ ■e^i-ioi'^j^oincoooooooo ' !^S 12; 1-1 1-1 0) CO Tl- io\0 t^OO C\ o • •oooooooooooooooo •oooooooooooooooo •73 •oooooooooooooooo : o" o' o" o" o" d o' o' o" o" o" o" o' o" o" c' fj.« .inmininmooooooooooo .{;^M01r}-t>.OinOOOOOOOOO til ; 1-1 1-1 0) CO -I- invo Koo C\ O < p^ 1428 FEDERAL ESTATE TAX 1429 Description of taxable estates. — Regulation. The tax is imposed in the case of the estate of "every decedent," although, by reason of an exemption, the net es- tate of a resident decedent, in order to be taxable, must exceed $50,000. (See Sec. 403 (a) 4.) The estate of a nonresident decedent, however, is taxable if any part of it is situated in the United States. The statute takes no account of the citizenship of the decedent, but prescribes -different rules according to whether the decedent was a "resident" or a "nonresident" of the United States A "resi- dent" is one who at the time of his death resided in the States, the Territories of Alaska or Hawaii, or the District of Columbia. All other persons are "nonresidents." .... (Reg. 37, Art. 4.) The tax is imposed on the estate of every resident domiciled in the United States at the time of death, quite apart from the question of nationality. The apphcation of the law to non-residents is shown concisely in the above regulation. Special regulations such as those concerning deductions, where non-resident estates are involved, are dealt with under their respective headings. Definition of "resident." — Regulation. A person is a "resident" of the United States, for the purposes of this tax, only in case he has a domicile therein at the time of his death. A person acquires a domicile in a place by livinj; there, for even a brief period of time, with no definite present inten- tion of later removing therefrom. Residence without the requisite in- tention to remain will not suffice to constitute domicile, nor will in- tention to change domicile effect such a change unless accompanied by actual removal. A decedent who died while abroad will be presumed to be a nonresident, and the burden of proving the contrary rests upon the executor. (Reg. 37, Art. 5.) In the 192 1 act the definition of the term "resident" is also extended to citizens regarding whose property any probate or administration proceedings are had in the United States Court for China.^ No satisfactory conclusive or general definition of "resi- dent" can be given. Intention plays a large part, and each case must be decided on its merits. ° See page 1516, I430 MISCELLANEOUS TAXES Military exemption. — Law. Section 401 The taxes imposed by this title or by Title II of the Revenue Act of 1916 (as amended by the Act entitled "An Act to provide increased revenue to defray the expenses of the increased appropriations for the Army and Navy and the extensions of fortifications, and for other purposes," approved March 3, 1917) or by Title IX of the Revenue Act of 1917, or by Title IV of the Revenue Act of 1918, shall not apply to the transfer of the net estate of any decedent virho has died or may die from injuries received or disease contracted in line of duty while serving in the military or naval forces of the United States in the war against the German Government, or to the transfer of the net estate of any citizen of the United States who has died or may die from injuries received or disease contracted in line of duty while serving in the military or naval forces of any country while associated with the United States in the prosecution of such v.'ar, or prior to the entrance therein of the United States, and any tax col- lected upon such transfer shall be refunded to the estate of suchf decedent. The intent of this section is as obvious as it is just. While the above section inchides only those affected by the late AA'orld War, it might be well made applicable to any per- son on active service generally in the military or naval forces. This attitude has been taken in Title II (income tax) in regard to pensions. "^ Doubt might exist as to just what is comprised under the term ''military or naval forces of the United States." Help in this direction is given in the following definition : Regulation The term '"military or naval forces of the United States" includes, among- other units, the Marine Corps, the Coast Guard, the Army Nurse Corps, Female, and the Navy Nurse Corps, Female. This exemption applies to any estate tax imposed, whether by the Revenue Act of 1916 or subsequent statutes. If the tax has been collected, the executor should make claim for refund. (Reg. Z7, Art. 9.) It would appear that relief froin taxation under the statutes mentioned is intended to apply merely to those persons em- ployed directly by the government in the prosecution of the war, and no mention is made of the large army of non-com- batants who, while not directly in government pay, were sub- ject to the risks of death and disease in the service. Included Section 213 (b-9). FEDERAL ESTATE TAX 143 1 in this latter category might be the Red Cross workers whose duties entailed the same hardships and' sufferings as those performed by the Army Nurse Corps, a body specifically mentioned in the regulation quoted 'above. The distinction is arbitrary and, in practice, might obviously work an injustice to those who helped in the World War. The attitude of the Department in excluding members of the Public Health Ser- vice from income tax exemption would indicate that the let- ter, rather than the spirit of the law, governs these exemptions. Any collection made on the transfer of an estate exempt from taxation under this section, is subject to refund but the burden of proving such exemption lies with the executor. A formal claim must be made on form 793 as soon as the nec- essary supporting evidence can be secui*ed. This evidence should consist of the following data : Regulation Where the decedent died while serving in the military or naval forces, but after the termination of the war with Germany, there should be submitted : (i) Certificate of The Adjutant General, Surgeon General of the Navy, or commanding officer as above, stating the occurrence of death while in the service, and the cause of death. (2) Affidavits or other evidence to show that the death resulted from injuries received, or disease contracted, while serving in the military or naval forces during the war with Germany. Where the decedent died after discharge from the military or naval forces there should be submitted : (1) Certificate of discharge from the service, or copy of such certificate. (2) Certified copy of public record of death, showing cause of death. (3) Affidavit of physician who attended decedent during last ill- ness, setting forth the medical history of the decedent while under his treatment. (4) Affidavits or other evidence to show that the death resulted from injuries received, or disease contracted, while serving in tl'e military or naval forces during the war with Germany (Reg 37, Art. 10.) Claims for refund arising from military exemption. — In view of the fact that the granting of this exemption is retro- active, attention is particularly called to the following: 143^ MISCELLANEOUS TAXES Regulation. Prior to the passage of the Revenue Act of 1918 there was no military exemption from estate tax except with respect to the increase of rates imposed by the Revenue Act of 1917. The provision in the Revenue Act of 1918 granting the exemption is retroactive, and authorizes the refund of all estate taxes collected under the provisions of former acts from estates now entitled to the exemption. Where such taxes have been collected, the executor should file a claim for refund on Form 46, accompanied by the same evidence as is required in support of a claim for military exemption. (Reg. 37, Art. 11.) Gross Estate — Individual Property The intention of the lawmakers is to impose the tax upon what may be called the "realizable" value of the estate. Since the use of the word "realizable" might in some cases lead to abuses, the word "value" is used; but it is intended in all cases that the word is to mean the fair or market or reasonable or realizable value in so far as the aggregate net value, as determined, shall yield a tax fair to the government and fair to those upon whom it is imposed. Tax laws must be con- strued most strictly against the government.^ This just prin- ciple is not of great importance when tax rates are low; but where tax rates reach 25 per cent it would be harsh, inequi- table, and would lead to wholesale evasions if all doubtful questions were decided against taxpayers. Property for which there is no broad and active market must not be overvalued or the tax collected would be in excess of that which is intended. If an item of property were valued at $4,000 when the readily realizable value is $1,000, the actual tax rate would be 100 per cent instead of 25 per cent. These questions will be dis- cussed in detail hereafter. At this point only the general principle is to be noted. Law. Section 402. That the value of the gross estate of the de- cedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated — (a) To the extent of the interest therein of the decedent at the ' Gould V. Gould, 245 U. S. 151. 38 Sup. Ct. 53, 62 L. Ed. 211. FEDERAL ESTATE TAX 1433 time of his death which after his death is subject to the payment of the charges against his estate and the expenses of its administration and is subject to distribution as part of his estate; .... . The two regulations following are very complete and ex- plicit and leave little room for doubt as to the items of property which should, or should not, be included in the gross estate of the decedent. Regulations. This provision is designed to include all property interests of the decedent, of whatever character. It is the common- est form of taxable transfer. As a basis for tax, there must be an actual, beneficial ownership in the decedent, not a bare legal ti^^le, or one held in trust. Thus, property actually devoted to religion^- or charitable purposes, and placed in the name of an individual solely for convenience in administration, is not included in his gross estate. The statute also includes only property rights existing in the decedent in his lifetime and passing to his estate. It consequently does not in- clude a right which came into existence only after the decedent's death, such as a cause of action by statute for causing the death. The proceeds of such a cause of action should not be included in the gross estate, whether payable generally to the estate or to some speci- fied class of persons, such as the widow or children. The value of a vested remainder should be included in the gross estate. Nothing should be included, however, on account of a con- tingent remainder where the contingency does not happen in the life- time of the decedent, and the interest consequently lapses at his death. Nor should anything be included on account of a life estate in the de- cedent. There should be included, however, the value of an annuity'^ payable to the decedent upon the life of a third person who survives him, and the value of an estate for the life of a person other than the decedent (Reg. 37, Art. 12.) Specific property to be included. — Regulation. Real property owned by the decedent, when situated in the United States, should be included in the gross estate, whether the decedent was a resident or a nonresident, and whether the prop- erty came into the possession and control of the executor or admin- istrator or passed directly to heirs or devisees. Real property not situated in the United States should not be included, whether the decedent was a resident or nonresident. Where the decedent was a resident, all personal property owned by him should be included, wherever situated. Where decedent was a nonresident, so much ofi "For rules as to valuing such annuities and illustrations, sec Reg. 2i7, Art. 20. y^34 MISCELLANEOUS TAXES his personal property as was actually situated in the United States at the time of his death should be included. For further discussion of the rules relating to the estates of nonresidents, see Arti&le 60. A cemetery lot owned by the decedent is part of his gross estate, but its value is limited to the salable value of such part of it as is. not designed for the interment of the decedent or members of his family. Rent which had accrued upon real property at the time of the de- cedent's death, whether then payable or not, is included in the gross estate. The amount of interest accrued upon bonds on the day of death, whether payable then or subsequently, should be included. All matured coupons, whether presented for payment or not, should be included. The value of notes or other claims held by the decedent should be included, though they are canceled by his will or appear to be barred by the statute of limitations. As to the valuation of notes or claims apparently barred, see Article 15, paragraph 3. All bonds, wdiether federal, state, or municipal, and whether or not containing a tax-free covenant, should be included. Dividends, whether upon preferred or common stock, should not be included unless actually declared prior to the date of death. The amount of dividends upon stock which have been declared, but not paid, must be returned where the value of the stock at the time of the decedent's death does not reflect the dividends ; that is, where the death occurs after the closing of the books of the corporation and the stock consequently sells "ex dividend." Where the death occurs before the closing of the books, the value of the stock reflects the dividend, and it should not be included. • Example: A 5 per cent dividend upon stock is declared March i, payable on April i to stockholders of record on March 15. If the death occurred on March 10 and the market price on that day was 90, the value to be returned for both stock and dividend is 90, the divi- dend being reflected in the quoted price. If the death occurred on March 20, the books have been closed and the dividend is not re- flected in the selling price. Under these circumstances the dividend must be returned in addition to the quoted price of the stock ; and the proper return would be stock 90, dividend $5. (Reg. 37, Art. 13.) Determination of value of property included in GROSS ESTATE. — From the point of view of those responsible for the fiHng of estate tax returns, the question of the deter- mination of values is, naturally, the crux of the whole situa- tion. The regulations, full as they are in substance, cannot deal with every contingency that arises in fact. There are appraisal companies which, in order to secure business, adver- tise their ability to furnish appraisals which they guarantee FEDERAL ESTATE TAX 1435 will be accepted by the Treasury Department. The guarantee carries the danger that an appraisal sufficiently high would always be acceptable to the Department. In other words, an appraisal company engaged on this implied basis would be working against the interest of the taxpayer in order that it might make good its initial claim as to acceptance of its appraisal. Instead of being an inducement to make an engage- ment, such an assertion should be a warning to the executor. Undeniably, expert advice should be sought where an estate is large, its affairs complicated, and its assets varied. Any advice tendered on a "money back if you're not satisfied" basis should be avoided. Regulation. The value at which property included in the gross estate is to be returned for tax purposes is the value at the time of the decedent's death. Neither depreciation nor appreciation in value subsequent to the date of death is considered. The value to be as- certained is the market, or sale, value of the property. The highest price obtainable for the property within a reasonable period of f.he decedent's death is the value to be included. A sale of the property, however, in order to be accepted as the criterion of value, must be made in such manner as to insure the best price obtainable under ex- isting circumstances. This requires (a) that the sale be made as a matter of business, and not merely in order to establish value; (b) that it be made in absolute good faith, with a view to realizing as high a price as possible; and (c) that reasonable care and skill be exerci.sed to obtain such price. If one method brings better results than another, the better method must be employed. For example, if individual sales of property are better adapted to procure a good price than auction sales, the price obtained at an auction sale will be accepted only after reasonable effort to find individual purchasers has been made. See further on this point Article 15. Great care must be exercised by the executor to arrive at a fair valuation of every asset of the gross estate. (Reg. 37, Art. 14.) The legal definition of the word "vahie" is by no means settled. The word is held to mean one thing in one law and something else in another law. Generally speaking, the gov- ernment attempts to fix too high a value, and taxpayers fix too low a value, upon the property the value of which is dif- ficult to determine. Some value in between the two is fair. There should be brought into the determination lawyers and 1436 MISCELLANEOUS TAXES accountants whose wide experience and familiarity with actual values insure an equitable adjustment. In view of the fact that many months may elapse between the determination of values for inclusion in the gross estate and their inevitable review by an officer of the Internal Rev- enue Bureau® it is necessary that all calculations and methods of computation used should be carefully preserved in a man- ner that will permit of easy reference. This is, indeed, called for,^° but that it is an essential will be readily recognized by an executor who has to make good his estimates to satisfy the investigating officer at any length of time after they have been made. It would be well for all parties concerned if this lapse of time could be shortened so that administration of the decedent's estate could be speedily concluded and a distribution to the legatees made. Apparently, unnecessary expense and hardship is involved under existing conditions. A suggestion that a final assessment of the tax be made within sixty days of the filing of the return, presented to the Com- mittee on Ways and Means prior to the passing of the Revenue Act of 1918, produced no tangible reform in this direction. Consideration of the following shows exactly how far the suggestion was acted on, taking the expression "as soon as practicable" at its putative worth in so far as the Department of Internal Revenue is concerned. Regulation It is the purpose of the Bureau to make these investigations as soon as practicable after the filing of tlie re- turn. Whenever there are special and urgent reasons for an early investigation, the collector should be notified in order that the case may be given special attention. Upon completion of the investigation the executor will be apprised by the examining officer of his findings, and will be given an opportunity to discuss the case and present such data as he may desire, to be considered by the Bureau in connection with the examining officer's report. Upon the completion of the review and audit by the Bureau of the return and the examining officer's re- port, the executor will be informed by letter from the Commissioner of the result of the audit. If the letter contains notification of an Reg. ^^7, Art. 79- " Section 410. FEDERAL ESTATE TAX 1437 unpaid balance of tax, the executor should make payment to the col- lector. After the expiration of 30 days from receipt of the notification interest will accrue upon the excess tax at the rate of ten per centum per annum. If the executor wishes to file claim for abatement of any part of the excess tax, such claim must be filed within 30 days of re- ceipt of notification, or he may pay the tax in order to prevent the running of interest, and submit claim for refund. (Reg. 2>7' Art. 79. Valuation of property. — Guidance in determining values in accord with what is called for in section 402 (a) of the law, quoted above, is given in the ensuing regulations. Valuation of cash. — Regulation (4) Bank deposits should be returned at the amount for which the bank would be liable if the deposit were with- drawn upon the date of the decedent's death. Interest which the bank agreed to pay upon condition that the money remain on de- posit after the death should not be included. (Reg. 37, Art. 15.) Real estate. — Regulation, (i) Where real property has been sold, the amount received will be taken as its value provided the sale was made within a reasonable period of the decedent's death, and in such manner as to insure the highest possible price. Where no sale has been made, the criterion of value is the best price which could have been obtained within a reasonable period of the decedent's death. The amount brought at an auction sale should be considered, but will be accepted only if it appears that there was no available method of obtaining a higher price. The assessed valuation of the property should be considered, but is not conclusive. All relevant facts and all elements of value should be considered in every case (Reg. 37, Art. 15.) The one consideration in determining values of real estate, and, in fact, of any other item of property to be included in the gross estate of the decedent, is to arrive at a figure accep- table to the examining officer and at the same time to act fairly by the estate. The regulation just cited is full of indetermin- ate expressions, any one of which might form a basis for con- troversy and possible revision of the value submitted by the executor. Definition of ^''a reasonable period," proof as to 1438 MISCELLANEOUS TAXES what will be considered "a proper manner" of obtaining the highest price, establishment of the "best price" which could have been obtained, are all factors w^hich, if utilized, should be supported by every possible shred of evidence likely to en- sure their acceptance. It should be borne in mind that any haphazard estimate of value, or any item included which could .not be substantiated by adequate evidence, might, if detected, lead to the discounting of other facts possibly of vital interest to the taxpayer. The regulations are not the law. They can only be recog- nized as indicative of the interpretation of the law by the Bureau of Internal Revenue. They are of undeniable assist- ance in preparing returns which must satisfy that Bureau. The regulations should be followed in all possible respects. Im- proper or negligent methods of determining the reported values wall be summarily dealt with. Slipshod valuations result in the Commissioner fixing values with an eye, always, to "highest price." Unless determined by bona fide sales, the fair value of real estate is, at best, a hypothetical proposition. In the absence of sale it w'ould appear that the most acceptable method is to establish a value by appraisal conducted by reputable appraisers, and to submit such appraisals (three or more in number) in the form of affidavits. It is likely that such a procedure would be accepted without question. Care should be taken to instruct the appraisers as to the basis called for in the following : Regulation. Where expert appraisers are to be employed, care should be taken to see that they are men of recognized competence with respect to the particular class of property involved. In order to facilitate the acceptance of the appraisal, appraisers should be employed whose competence is well established. The basis to be employed in appraising articles of this character is what they would bring at a bona fide sale to individual purchasers, to dealers, or upon a well-advertised auction sale. If there has been an actual bona fide sale, the amount received may be returned as the value of the property. Where property is valued by legatees for purposes of distribution, such value will not necessarily be ac- cepted. The original cost of the articles is not necessarily a proper FEDERAL ESTATE TAX 1439 basis, on account of depreciation or appreciation in value. (Reg. Z7, Art. 19.) Cases have arisen where appraisers whose competence was unquestionable have been employed on valuations; yet the Treasury has refused to accept their valuations, although such valuations were accepted by the surrogate's court of the state in question and by the state tax commission. The Treasury should initiate some procedure whereby co-operation with the appraisers appointed by the surrogate's court would be possible, thereby eliminating duplications which result in such disagreements as those referred to above. Stocks and bonds. — Regulation (2) The value of stocks and bonds listed upon a stock exchange should be obtained by taking the mean between the highest and the lowest sale price upon the day of death, provided the sales were made in the regular course of business, and not for the special purpose of establishing value. If there were no sales upon the date of death, the price nearest to that date, and within a reasonable period thereof, either before or after death, should be taken. Such sale price obtains irrespective of the number of shares held by the estate. If the security was listed upon more than one exchange, the records of the exchange where the security is princi- pally dealt in should be employed. If the decedent died on Sunday or a legal holiday, the business of the previous day will govern. If the stock is not listed upon an exchange, but is dealt in actively by brokers or has other active market, the latest sale price prior to the day of death will govern. If there is no active market for the stock and no sales of it have been made within a reasonable period of the decedent's death, and in particular where it is closely held (stock of a "close corporation"), return should be made upon the basis of the value of the stock, as evidenced by the clear value of the excess of the assets of the corporation over its liabilities, and its earning capacity for the five years preceding the death of the de- cedent. Where the earnings of the corporation have been greater than a fair return on its invested capital, computed according to the nature of the business, and where the business is a going business, there should be added to the net value of the other assets of the business the value of the good will, computed in accordance with sound accounting principles. Where the earnings of the corporation have been less than a fair return on the invested capital, if the dif- ference is material and the decreased earnings affect value, the net I440 MISCELLANEOUS TAXES worth of the corporation as disclosed by its balance sheet may be adjusted on a reasonable basis to allow for this decreased value. In all cases where stock of this character forms a principal asset, there should be submitted with the return, Form 706, a copy of the balance sheets for the five preceding years, and of the balance sheet on the day of death or the nearest date thereto, together with a state- ment of the net earnings of the invested capital for the preceding five years. The full value of securities pledged to secure a loan should be included in the gross estate. If the decedent had a trading account with a broker, all securities belonging to the decedent held by the broker at the date of death must be included at their market value on that date. Securities purchased on margin for the decedent's ac- count and held by the broker should also be returned at their market value on the day of death. The amount of the decedent's indebtedness to the broker will be allowed as a deduction from the gross estate. (Reg. 37, Art. 15.) The foregoing formula may result in the determination of the fair value of stocks or bonds, but in many cases it is un- sound and will not be sustained by the courts. In the case of listed stocks, the quotations or the actual transactions for one day may be misleading. The trend of the market may be up or down and the number of shares sold may be insufficient to fix conclusively the value of any considerable number of shares. If a decedent leaves 100 shares of United States Steel common stock, the formula in the regulation is fair; if the decedent leaves a large number of shares of an inactive stock, the sale of a few hundred shares may only be the start- ing point in determining the value of the greater number of shares. In the case of a ''close corporation," the earnings for the preceding years may be a major factor in arriving at a fair price, but if there is an abnormal period during those years, or if there is a decided trend towards the end of the period, any buyer of the stock would give more weight to the probable earnings or losses following the date of death than to the results of any of the years preceding death." As an illustration, consider a close corporation in which '^ For methods of arriving at fair value, see Chapter XLI, "Capital Stock Tax." FEDERAL ESTATE TAX 1441 the estate is interested to the extent of 1,000 shares of 7 per cent non-cumulative preferred stock. A few isolated sales to employees or officers of the corporation have been effected at par. According to the book figures, the excess of liquid assets over liabilities shows a backing behind the preferred stock of $130 per share issued. The dividend has been regu- larly paid. The corporation also has an issue of common stock which is cared for by an excess of all assets over liabilities (exclusive of goodwill) and after providing for the preferred stock at par, in a sum representing over $83 per share. Earn- ings for five years averaged 12^ per cent on the common stock after allowing for 7 per cent on the preferred. Accord- ing to earnings shown by these book figures, the preferred stock of this corporation would be worth at least par. By reason of the fact that the corporation is a "close corporation" and its ramifications are known only to the few directly inter- ested, it would be a matter of considerable difficulty to find a purchaser for the 1,000 shares included in the estate. An intelligent investor would say "at what price can I purchase 7 per cent preferred shares in any well-known and quoted stock in a similar line of business?" By this means he knows he can buy an issue which he is able to dispose of readily and the price of which is regulated by the prevailing supply, demand, and general business conditions. He finds that the average price of such securities is 91. Why should he pay $100 for what he knows nothing about and which he might have some diffi- culty in disposing of, if need be, when he can get the same thing for $91 in a form more easily negotiable and the price of which is established on an accepted financial basis. The fundamental principle on which "fair value" is based demands the possibility of a willing buyer and a willing seller. In appraising values of stocks in close corporations strictly in accord with the regulations, it would seem that this principle may very easily be lost sight of and that an arbitrary figure may be cstal^lished which, on consideration, does not repre- sent a fair value. 1442 MISCELLANEOUS TAXES Whatever other factors may obtain, it cannot be denied that the stock of a close corporation should never be valued in excess of the fair market price of shares of stock of cor- porations in a similar line of business according to quotations on the open market. Investigation has proven that the applica- tion of this principle shows how little the actual book value does reflect the fair market value of corporation stock generally. A comparison of the market price of stocks of sixty-one corporations with the book value of those same stocks arrived at by reference to the last preceding balance sheets, as pub- lished by the best-known authority, revealed that the average book value per share was $137.80, whereas the average sell- ing price per share was v$75.84. In other words, the selling price represented only 55 per cent of the book value, at or about the date selected. While 55 per cent cannot be a constant relative factor as between the selling price of stock and its book value, the fact that it was so in the investigation mentioned, conclusively shows how far from being a "fair market value" would be any figure determined solely on a valuation of the corporate assets. The principle, however, may well be used where circum- stances allow of its introduction. The book value of corpora- tions which issue similar stocks, together with the market value thereof, should be listed and the percentage of the latter to the former should be determined. This percentage should then be applied to the book value of the assets under consid- eration, and the resultant stock value per share should be utilized as the actual value or in support of a value computed under some alternative method. Generally speaking, it will be found in practice that the valuation of holdings in close corporations presents a problem to be solved by a general review of conditions from without as well as from within. As has been mentioned before, "a revenue law cannot be made elastic enough to deal with unusual problems."^" Recognizing this fact, the authors of the Revenue "Excess Profits Tax Procedure, 1921, page 338. FEDERAL ESTATE TAX 1443 Act of 1 92 1, of which the estate tax is Title IV, have, in Title III (sections 327 and 328) inserted relief clauses to cover cases where a literal interpretation of the law relating to the war-profits and excess-profits tax would work evident hard- ships on the corporation taxpayer. The spirit of compromise here offered might well be used in principle in the valuation of stocks and bonds for estate tax purposes. While balance sheets of organizations which come under the category of close corporations are called for in substanti- ation of determined values of their stock, there would appear to be no reason why the component parts of the balance sheets should not have to be appraised as to value. In this event, and in submitting balance sheets in evident support of values arrived at, it would be necessary to show comparative figures depicting "fair value" as against "book value." A piece of real estate held for a number of years will, under normal circumstances, have a different value at the time of the dece- dent's death from the figure at which it vvas purchased. In fact, the whole list of items shown in a balance sheet, where such method of determining the value of stock is used, should be subjected to the same scrutiny for worth at the date re- quired as are the items which are comprised in the gross estate itself and upon the same lines as are suggested for them. Valuation of notes. — Regulation (3) Notes, whether secured or unsecured, will be presumed to be worth their full face value, plus accrued interest to the date of decedent's death, unless the executor establishes the right to return them at a lower valuation. Interest should be computed upon the basis of 365 days to the year. In the case of an unsecured note it must be shown by satisfactory evidence, in order to justify failure to include it, that the note is uncollectible, either in whole or in part, from the maker or other parties to the note, an account of the insolvency of the parties thereto, or other cause. Where the note is secured it must also be shown that the security is insufficient to satisfy it. Where a note appears to be barred by the statute of limitations its value must be included in the gross estate in the absence of proof that the liability has not re- vived by promise to pay or part payment, and also that the parties 1444 MISCELLANEOUS TAXES liable refuse to pay the debt and intend to assert the defense. (Reg. 37, Art. 15.) It will be observed that the above regulation demands the valuation of notes at their face value unless a right to establish a lower value is supported by satisfactory and suffi- cient evidence. This is a question which depends entirely on circumstances. When the decedent leaves a business in active running order, which is ultimately to be carried on continu- ously by his successors, the face value of the assets may well be maintained. In instances, however, when a liquidation of all or part of the assets is necessary, unless value has already been determined by sales, the items under this caption should be included in the gross estate at their readily realizable value at the time of death. Reference to the law^^ demands the inclusion "of all property, real or personal, tangible or intangible," at the "value" at the time of death. An interpre- tation of the law which differentiates as to the meaning of the term "value at- time of death" as between the various prop- erties involved, is an erroneous one. The value of bonds which are quoted on the active market is determined primarily by their yield and due date. These quotations are accepted by the Treasury Department in connection with their inclusion in the gross estate. The principle of ready realization being thus established, the same principle should apply to all assets. Valuation of interest in business. — Regulation (5) Care should be taken to arrive at an accurate valuation of any business in which the decedent was interested whether as partner or pi-oprietor. A fair appraisal as of the date of death should be made of all the assets of the business, tangible and intangible, and the business should be given a net worth equal to the amount which a purchaser, whether an individual or corporation, would be willing to pay therefor at a normal sale in view of the net value of the assets and the demonstrated earning capacity. Special attention should be given to fixing an adequate figure for the value of the good will of the business in all cases where the decedent " Law, section 402, quoted on page 1432. FEDERAL ESTATE TAX T445 has not, for a fair consideration in money or money's worth, agreed that his interest therein shall pass at his death to his surviving partner or partners. (Reg. 37, Art. 15.) Comments heretofore made regarding the valuation of real estate, stocks, and bonds apply as well to many other items of property. A careful audit of the accounts of a going busi- ness should be made and a detailed financial statement pre- pared. Each item in the balance sheet should be fairly valued. Valuation of goodwill, patents, etc. — Regulation (6) The basis for valuation of intangible assets of this character is the present worth of the estimated future earnings of the exclusive right during the rest of its existence. The return received by the decedent should be considered in estimating future earnings. (Reg. 37, Art. 15.) The formula laid down in the foregoing regulation regard- ing the value of goodwill is a sound one in all cases when goodwill is the subject of sale. When an active partner dies, the value of goodwill is usually overestimated. The greater the personal interest of a decedent in a going business, the less the goodwill is worth. The latter part of the regulation is not clear. Frequently goodwill under partnership agreements passes to the surviving partners without valuation. In such cases the decedent has divested himself of any interest in the goodwill and it is dif- ficult to see the importance of ascertaining the value which he might have obtained for it if the partnership agreement had provided otherwise. The profit a man might, but does not realize is hardly taxable as property at his death. Of course if, in contemplation of death, a transfer of valuable good- will should be made within two years before a decedent's death, the transaction would be open to question, as would be any other transfer similarly made. The following digest of a memorandum issued by the Com- mittee on Appeals and Review^* indicates the methods of "Method of obtaining value of intangible assets, C. B. 2, page 31; A. R. M. 34. 1446 MISCELLANEOUS TAXES computation of goodwill values acceptable to the Bureau of Internal Revenue. Brands. Take price at which article under specific brand sold as against similar article with no brand. Difference multiplied by number of units sold during given period equals profits attributable to use of brand. Do this for a sufficient number of years to give a constant figure and capitalize result at 20 per cent. Brands or Goodwill, etc. (i) Take known cash price at which goodwill, or brand, etc., may have been sold. Compare business done by vendor with business done by concern under review. A proportionate value can thus be established. (2) Take average earnings for five years, apply 10 per cent of this to tangible assets and apply residue, at five years' purchase, to good- will. In case of a business not subject to fluctuations or manufacturing article of daily necessity, reduce return on tangibles to 8 or 9 per cent and capitalize residue for goodwill at 15 per cent instead of 20 per cent. Representative periods should be used in arriving at adjustments. Years showing extraordinary factors to be eliminated. In capitalizing earnings, percentage shown by the return on actual cost of the business should be considered. If earnings at one of the figures sug- gested above is in excess of such percentage, the smaller figure should be used. This memorandum was further supplemented^^ by the sug- gestion that in determining net earnings under the third para- graph above, a reasonable amount on account of salaries for owners actively engaged in the business be deducted. The formula set forth in article 15 above is sound when applied to the valuation of patents. It is not the same as the formula prescribed by the income tax unit of the Bureau of Internal Revenue for the valuation of goodwill (quoted above). As is the case with stocks of close corporations and goodwill, prospective buyers always attach much importance to the probable future earnings of the properties they buy. Valuation of accounts receivable.^ — Regulation (7) A fair valuation for assets of this character at the time of death should be fixed by the executor ac- cording to the best information available to him at the time of ''C. B. 4, page 43; O. D. 937. FEDERAL ESTATE TAX 1447 making return. A right of action which died with the decedent should not be inckided in the gross estate. (Reg. 37, Art. 15.) Accounts receivable should be valued either on the basis of a going business or of a business in liquidation. If the business is being continued and periodical audit reports are available, there is little need to go behind the book value. Should the contrary be the case, a verification of the accounts should be made by direct correspondence with the debtors where necessary, and every care should be exercised in the determination of their collectibility or otherwise. Claims or judgments should not be accepted at face value without due scrutiny as to age and possible collectibility. Valuation of furniture, jewels, etc., and growing CROPS. — Regulations (8) For the method of valuation to be employed in the case of household furniture and personal effects see Articles 16 to 19. With respect to all other tangible property the executor should endeavor to arrive at the sound and actual value at the day of death. Where such property is subsequently sold the sale price must be returned if the sale was a bona fide sale and for the best price obtainable. In the case of growing crops the executor should ascertain from expert opinion what the value of the growing crop was on the day of death, as evidenced by subsequent yield and crop prices. Where the crop is matured the value is the value of the crop unit on the day of death for the entire yield, less the cost of harvesting and marketing. Where the crop is not matured these factors should be considered; and the opinion of those expert in such matters should be ascertained as to what the crop was reasonably worth as a growing crop on the day of death. (Reg. 37, Art. 15.) When the value of the personalty involved is less than $2,000, the detailed lists may be prepared by the executor personally. A room by room appraisal is desirable; and all the articles should be named specifically, except those of small value, such as common bric-a-brac or cheap books. A separate value should be given for each article named, except that the values of a number of articles contained in the same room may be grouped. The value of an article worth more than $50 should be stated separately. Such an entry as the following would be acceptable : Dining room: Table, six chairs, three pictures (common prints), value $75; sideboard. $60; total, $135. (Reg. n, Art. 17.) 1448 MISCELLANEOUS TAXES Particular care is needed in arriving at the value of grow- ing crops. The knowledge of subsequent realization, most probably available by the time the executor is making up the return, may unduly influence the ultimate determination of the value of the growing crop at the time of decedent's death. Particularly is this the case should the market fall below anti- cipated figures and so make the valuation appear too high. The appraisal must be made and based entirely on conditions and estimates obtaining at the date of death and values fixed in accord therewith, or, if possible, on the basis of sales of similar standing crops efifected at that time. All charges nec- essary to the harvesting and marketing may be deducted from an appraisal based on an estimated worth. When the appraisal is made on comparative figures based on sales of similar stand- ing crops, these costs will not generally be deductible. Such a sale is usually conditional on the vendee removing and marketing the ultimate crop. If custom supports the procedure — as, for instance, in tobacco farming, where the aggregate cost of sowing, tending, harvesting, and depositing under cover (but not including picking and sorting) is considered the inventory figure of the year's crop — the value of the standing crop could very easily be estimated. The value at any given date would be the cost up to that date. In any case, and under whatever circum- stances the valuation of a ground crop is determined, such valuation should be supported by affidavits from responsible people in the same line of business testifying that the method employed is in accord with prevailing customs in the trade and that the result so obtained fairly represents the value of the crop included in the gross estate. Other regulations bearing on valuation follow : Regulations. Executors and administrators are required to have careful appraisal made of all household and personal effects of the decedent, and to furnish in duplicate detailed lists and affidavits in the manner directed below. No distribution of such effects may be made until the lists and affidavits have been filed with the collector, and, if deemed necessary, sufficient time afforded the Bureau to have FEDERAL ESTATE TAX 1449 personal inspection made by an official appraiser. Where it is desired to distribute or sell all the property in advance of the filing of the return, the lists and affidavits should be filed with the collector, to- gether v^rith a letter stating when it is desired to efifect distribution. If personal inspection by an internal-revenue officer is not deemed necessary, a waiver of such examination will be sent to the executor, who may thereupon proceed with distribution. (Reg. 37, Art. 16.) The foregoing regulation is not unreasonable if executors are not unduly hampered in making distributions. The law is silent on this point and no penalty is imposed. In practice distribution should be supervised in such a way as to satisfy the Treasury that the full value of the estate is reported for taxation. Regulations If there should be included in the lot, how- ever, jewelry or silverware of more than ordinary value, or articles having a marked artistic value, the executor must furnish an appraisal by persons thoroughly qualified by training and experience to judge of the value of such articles. In the case of effects having a total value of less than $2,000, the executor may furnish as an alternative requirement a sworn estimate in duplicate of the approximate total value of the property by a professional appraiser of recognized standing and ability, or by a dealer in the class of personalty involved. In addition to the lists or estimates described above, the executor must furnish in duplicate his affidavit as to the completeness of the lists and the qualification of the appraiser. (Reg. 37, Art. 17.) When the value of the effects is more than $2,000, detailed lists must be furnished, prepared by professional appraisers of recognized competence, or by dealers in the particular classes of personalty in- volved. The lists must be prepared in the same detail as that indicated above for the executor's list. Where the personalty includes jewelry, silverware, or like articles, except in cases where the value of these items is insignificant, the appraisal of a reputable dealer or appraiser of jewelry must be furnished. In the case of articles having marked artistic value, such as paintings, engravings, etchings, statuary, vases, oriental rugs, or antiques, the appraisals of experts will be required. The description of such articles should be fully given. Where paintings having artistic value are listed, the size, subject, and artist should be named. In the case of oriental rugs, the size, make, age, etc., should be given. The weight in ounces of each article of silverware should be stated. With the duplicate lists there must be filed the executor's affidavit as to the completeness of the list and the qualifications of the appraisers. (Reg. 37, Art. 18.) I450 MISCELLANEOUS TAXES (For Regulation ^yl, article 13, see page 1433.) The valuation of such miscellaneous property, in excess of $2,000, as may come under the last four articles quoted from the regulations is purely a matter of expert appraisal. A point that requires particular attention in the valuation of household effects is to differentiate between property of this description owned by a surviving husband or wife individually, and that owned by the decedent. Ruling. Household effects and like personalty used by husband and wife in the marriage relation are presumed to be the property of the husband, and, in the absence of sufiScient evidence to rebut this presumption, must be returned as portion of his gross estate.^* It is pointed out by the Commissioner that a bare state- ment from the wife claiming the property is not sufficient; the burden of establishing the claim is thrown upon her. When the wife owned articles of household furniture before mar- riage, purchased them out of her separate funds or received them as gifts from others, if her claim is supported by proven evidence, such effects need not be included in the gross estate of the husband. The Commissioner further says:" Ruling. The following proposition has been announced by the courts and is believed by this office to be sound. To constitute a valid gift there must be an absolute transfer of the property from donor to donee, taking effect immediately and fully executed by a delivery of the property to the donee, and the acceptance thereof by the donee. It is essential that the transaction should be fully executed by the delivery of the property to the donee, or to some person for him. In several States, statutes have been enacted providing that no gift, except by deed or will, shall be valid unless actual possession shall come to and remain with the donee, or his agent, and if the donee or donor reside together at the time of the gift, possession by the donee at their place of residence is not a sufficient possession within the meaning of statute. Community property and other property in which THERE ARE JOINT INTERESTS. — In applying the tax levied under this title, consideration must be given to decisions of state " T. D. 2529. " T. D. 2529. FEDERAL ESTATE TAX 145 1 courts construing local statutes. Particularly is this true in connection with community property. ^^ A test case, in so far as the California statutes are concerned, is found in the United States District Court, Northern District, Cahfornia.^'* The question before the court was as to there being a transfer of any estate, under the California law, when one-half of the community property became vested in the widow upon death of the husband. The court, in overruling a demurrer, in effect, held that a wife, under community property laws, no longer takes her interest in the community property as heir, and hence that her interest is not subject to the federal inheritance tax imposed on the transfer of a decedent's estate. The court said : The community property act of 1917 is valid as to community property acquired before its passage (Arnett v. Reade, 220 U. S. 311, 320, 31 Sup. Ct. 425, 426, 55 L. Ed. 477, 36 L. R. A. (N. S.) 1040), and if that act does not recognize in the wife a vaHd subsisting, vested interest and estate in the community property during the Ufe of the husband, language is without meaning and legislation without avail. When the husband had the management and control of the com- munity property, with the like absolute power of disposition as of his own separate estate, a decision that the wife had a mere expectancy was plausible, if unsound In all the community property states, from the necessity of the case, the agency of the husband as head of the family is much broader, and his control and dominion ^over personal property much greater, than in the case of real prop- erty; but it has never been supposed that this difference lessens the estate of the wife in community personal property, or calls for a different rule of succession. In so far as the life usufruct"" in favor of a widow under the Louisiana Civil Code is concerned, it has been decided that such value is not deductible from the gross estate in com- puting the federal estate tax.^^ "For a full discussion of community property in relation to the Rev- enue Act of 1921, see pages 395-400. " Blum V. Wardell, 270 Fed. 309. ^ "The right of enjoying things belonging to another and of drawing from them all the profit and advantage they will produce without destroying or wasting their substance." (Funk and Wagnall's N civ Standard Diction- ary.) "■ T. D. 3222. 1452 MISCELLANEOUS TAXES The matter of community property is dealt with generally and conclusively in the following : Ruling. In Washington, Arizona, Idaho, New Mexico, Louisiana and Nevada there should be included in gross estate, in computing the estate tax of a deceased spouse, one-half only of the community property of husband and wife domiciled therein; this is not based upon any statute enacted subsequent to March i, 1913 and applies under estate tax acts prior to the Revenue Act of 1918. ^^ Texas is included in the same category as the states enum- erated above. ^^ Valuation of annuities. — Regulation. Where the decedent was entitled to receive an annuity of a definite amount during the lifetime of another person, and the right constitutes an asset of his estate, the present worth of the annuity at the time of the decedent's death must be computed upon the basis of the expectancy of life of the other person. The table marked "A" [following] should be used for this computation. The amount of annual income should be multiplied by the figure in column 2 of the table opposite the number of years in column i nearest to the actual age of the other person. Example : The decedent received vmder the terms of his father's will an annuity of $10,000 for the life of his elder brother. The brother at the decedent's death was 40 years 8 months old. By refer- ence to the table the figure in column 2 opposite 41 years, the number nearest to the brother's age, is found to be 14.86102. The present worth of the annuity is therefore $148,610.20. Where the decedent was entitled to receive the annuity during a specified number of years, the table marked "B" [following] should be used. Example : The decedent received under the terms of his father's will an annuity of $10,000 for a period of 20 years, 15 of which had expired at the decedent's death. By reference to the table it is found that the figure in column 2 opposite 5 years, the unexpired portion of the 20-year period, is 4.45182. The present worth of the annuity is, therefore, $44,518.20 (4.45182 multiplied by 10,000). Where the decedent was entitled to receive the entire income of certain property during the life of another or for a term of years, and where the rate of income is fixed by the instrument creating the trust or is definitely determinable at the time of the decedent's death. "T. D. 3138. "T. D. 3071. FEDERAL ESTATE TAX 1453 the average annual income which the property actually yields should be determined, and its present worth computed, as explained above in the case of annuities. Example: The decedent's father placed $100,000 in trust, with directions that it be invested in state and municipal bonds and the entire income paid to the decedent during the life of his elder brother, who was 41 years old at the decedent's death. Before the decedent's death the money was invested in state and municipal bonds, and actually yielded a net return of $5,000 per annum. In this case the rate of income is definitely determinable. By reference to the table it is found that the present worth of an income of $5,000, dependent upon the life of a person 41 years of age, is $74,305.10 (14.86102 mul- tiplied by 5,000). Where the rate of annual -income is not determinable, or where the decedent was entitled merely to the personal use of nonincome- bearing property, a hypothetical annuity at a rate of 4 per cent of the value of the property should be made the basis of the calculation. Example: The decedent died before a fund of $100,000, of which he was entitled to receive the income during the life of a person 41 years old, had been invested by the trustees. The value of a hypothet- ical annuity of $4,000, dependent upon the life of such a person, is indicated by the table to be $59,444.08. Where the decedent possessed a remainder interest in property subject to the life estate of another, and such interest constituted an asset of his estate, the present worth of the remainder interest at the time of death should be obtained by multiplying the value of the property at the time of death by the figure in column 3 of Table A opposite the number of years nearest to the age of the life tenant. Where the remainder interest is subject to an estate for a term of years Table B should be used. Example: The decedent was entitled to receive property worth $50,000 upon the death of his elder brother, to whom the income for life had been bequeathed. The brother at the time of the de- cedent's death was 31 years old. By reference to the table it is found that the figure in column 3 opposite 31 years is 0.31262. The present worth of the remainder interest is, therefore, $15,631. (Reg. 37, Art. 20.) Where annual income is not determinable, the basis of 4 per cent to be used in calculating the annuity is too low. Resort to it should not be made until every other evidence as to possible income from the source in question has been re- viewed. For the last two years any "gilt edge" interest-bearing investment has yielded considerably more than 4 per cent. 1454 MISCELLANEOUS TAXES Unless proof can be established to the contrary, the benefit is distinctly to the government and not to the taxpayer. For instance, the present worth of an annuity of $i for twenty years at 4 per cent (Table B-2) is $13.59, whereas the same annuity at 8 per cent would show a present worth of $9,818. Granted that a straight annuity, providing as it does for the average rate of interest covering a period of years, can be estimated on a 4 per cent basis, nevertheless, in the hypo- thetical instance illustrated in the regulation, w^here $100,000 was at the disposal of the trustees for investment, it might well be that at the time of the- decedent's death this sum could be invested in bonds yielding 5^ per cent to 6 per cent. The value under such circumstances should be based on actual market conditions rather than on hypothetical rates which would not represent the actual value at the date of decedent's death, which is the value called for in the law. It is of interest to note that the first tables showing present worth of life inter- ests in personal property based on the same rate as those now in existence, 4 per cent, were promulgated by the Com- missioner of Internal Revenue as long ago as December 16, 1898, (Spanish War Revenue Act, 1898). The Supreme Court of the United States expressed the opinion that "at the time this tax was collected (1899) 4 per cent was very gen- erally assumed to be the fair value or earning power of money safely invested."'* Dower and Curtesy. — Law. Section 402. That the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated — (b) To the extent of any interest therein of the surviving spouse, existing at the time of the decedent's death as dower, curtesy, or by virtue of a statute creating an estate in lieu of dower or cur- tesy -\Siiiipson V. United States, 252 U. S. 547, 40 S. Ct. 367, 64 L. Ed. 700. FEDERAL ESTATE TAX 1455 Table "A." Table, single life, 4 per' cent, showing the present worth of an annuity, or life interest, and of a reversionary interest. 1 2 3 1 2 3 Annuity, or Reversion, or Annuity, or Reversion, or present value present value present value present value of $1 due at of $1 due at of $1 due at of $1 due at Age. the end of each the end of the Age. the end of each the end of the year during the year of death year du'ring the year of death life of a person of a person of life of a person of a person of of specified age. specified age. of specified age. Annuity. specified age. Annuity. Reversion, or Reversion. $14.72829 $0.39507 51 $12.17919 $0.49311 1 17.30771 .29586 52 11.88408 .50446 2 18.69578 .24247 53 11.58531 .51595 3 19.15901 .22465 54 11.28323 .52757 4 19.41226 .21491 55 10.97789 .53931 5 19.55301 .20950 56 10.60982 .55116 6 19.61731 .20703 57 10.35931 .56310 7 19.62502 .20673 58 10.04630 .57514 8 19.61097 .20727 59 9.73131 .58726 9 19.53413 .21022 60 9.41474 .59943 10 19.45359 .21332 61 9.09765 .61163 11 19.36943 .21656 62 8.78052 .62382 12 19.28184 .21993 63 8.46412 .63600 13 19.19065 .22344 64 8.14888 .64812 1 14 19.09590 .22708 65 7.83552 .66017 15 18.99764 .23086 66 7.52476 .67212 16 18.89569 .23478 67 7.21699 .68397 17 18.79010 .23884 68 6.91298 .69S6S 18 18.68070 .24305 69 6.61301 .70719 ly 18.56751 .24740 70 6.31716 .71857 20 18.45038 .25191 71 6.02612 .72976 21 18.32932 .25656 72 5.74003 .74077 22 18.20416 .26138 7i 5.45928 .75157 23 18.07471 1 .26636 74 5.18402 .76215 24 17.94097 .27150 75 4.91463 .77251 25 17.80274 .27682 76 4.65125 .78264 26 17.65984 .28231 77 4.39383 .79254 27 17.51224 .28799 78 4.14286 .80220 28 17.35968 .29386 79 3.89858 .81159 29 17.20225 .29991 80 3.66071 .82074 30 17.03961 .30617 81 3.42900 .82965 31 16.87176 .31262 82 3.20258 .83836 32 16.69846 .31929 83 2.98024 .84691 a 16.51964 .32617 84 2.76106 .85534 34 16.33503 .33327 85 2.54366 .86371 35 16.14437 .34060 86 2.32795 .87200 36 15.94755 .34817 87 2.11384 .88024 37 15.74427 .35599 88 1.90115 .88842 38 15.53421 .36407 89 1.69107 .89650 39 15.31722 .37241 90 1.48540 .90441 40 15.09295 .38104 91 1.28432 .91214 41 14.86102 .38996 92 1.09024 .91961 42 14.62122 .39918 93 .90647 .92667 43 14.37356 .40871 94 .73687 .93320 44 14.11860 .41852 95 .58435 .93906 45 13.85713 .42857 96 .46182 .94378 46 13.58958 .43886 97 .36698 .94742 47 13.31698 .44935 98 .24038 .95229 48 13.03942 .46002 99 .00000 .96154 49 12.75716 .47088 50 12.47032 .48191 1456 MISCELLANEOUS TAXES Table "B." 1 2 Present worth 3 1 2 Present worth 3 of an annuity Present worth of an annuity Present worth Number of $1, payable of $1, payable Number of $1, payable of $1, payable of years. at the end of each year, for at the end of a certain num- of years. at the end of each year, for at the end of a certain num- a certain num- ber of years. a certain num- ber of years. ber of years, i ber of years. Annuity. Reversion. Annuity. Reversion. 1 $0.96154 \ $0.961538 16 $11.65229 $0.533908 2 1.88609 .924556 17 12.16567 .513373 3 2.77509 I .888996 18 12.65929 .493628 4 3.62989 .854804 19 13.13394 .474642 5 4.45182 .821927 20 13.59032 .456387 6 5.24214 .790314 21 14.02916 .438834 7 6.00205 i .759918 22 14.45111 .421955 8 6.73274 .730690 23 14.85684 .405726 9 7.43533 .702587 24 15.24696 .390121 10 8.11089 .675564 25 15.62208 .375117 11 8.76047 .649581 26 15.98277 .360689 12 9.38507 .624597 27 16.32958 .346816 13 9.98565 .600574 28 16.66306 .333477 14 10.56312 .577475 29 16.98371 .320651 IS 11.11839 .555265 30 17.29203 .308319 Regulation. The provision includes dower and courtesy and all interests created by statute in lieu thereof, although the estate or interest so created is different in character. The effect of the provision is to require the inclusion of the full value of the property, without deduction of the value of the interest of the surviving hus- band or wife. This rule does not apply to the estate of any decedent dying after September 8, 1916, and prior to 6:55 p. m., February 24th, 1919 (the effective date of Title IV of the Revenue Act of 1918), unless the property has its situs in a jurisdiction wherein dower, courtesy, or the statutory interest in lieu thereof, is subject to the payment of charges against the estate, and the expenses of its admin- istration and is subject to distribution as part of the estate, or unless there has been an election to take property devised or bequeathed in lieu of dower, courtesy, or such statutory interest, and the property so taken has its situs in a jurisdiction by the laws of which it is subject to the payment of such charges and expenses, and to distribution as part of the estate. (Reg. 37, Art 21, as revised by T. D. 3165, May 18, 1921.) Transfers by decedent in his lifetime. — Under ordinary circumstances it is somewhat difficult to substantiate the fact that a transfer of property, either by means of a trust or otherwise, made without consideration and within two years of death, was not executed in contemplation of death. This dif- ficulty is not lessened by the burden of proof resting on the executor to show the contrary. FEDERAL ESTATE TAX 1457 Law. Section 402. That the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, where- ever situated (c) To the extent of any interest therein of which the decedent has at any time made a transfer, or vsrith respect to which he has at any time created a trust, in contemplation of or intended to take effect in possession or enjoyment at or after his death (whether such transfer or trust is made or created before or after the passage of this Act), ex- cept in case of a bona fide sale for a fair consideration in money or money's worth. Any transfer of a material part of his property in the nature of a final disposition or distribution thereof, made by the decedent within two years prior to his death without such a con- sideration, shall, unless shown to the contrary, be deemed to have been made in contemplation of death within the meaning of this title; .... Regulations. A transfer made by the decedent in his lifetime, if made by way of gift, is taxable when made in contemplation of death, or intended to take effect in possession or enjoyment at or after the death of the transferor. No distinction is made between ordinary transfers and transfers involving- the creation of a trust. Where a transfer, however, constitutes a bona fide sale for a fair consideration in money or money's worth, it is not taxable. In order to constitute such a bona fide sale, there must be a valuable consider- ation, as distinguished from love and affection. A sale implies the receipt of a price, in money or thing of value. The release of an existing claim, by way of accord and satisfaction, is not sufficient. The price must also be a fair equivalent for the property transferred. Where the price is not a fair one, the sale will not be considered to have been made bona fide. Such transfers are taxable whether made before or after September 8, 1916. (Reg. 37, Art. 22.) The words "in contemplation of death" do not refer to the gen- eral expectation of death which all persons entertain. A transfer, however, is made in contemplation of death wherever the person making it is influenced to do so by such an expectation of death, arising from bodily or mental conditions, as prompts persons to dis- pose of their property to those whom they deem proper objects of their bounty. The cause which induces such bodily or mental condi- tions is immaterial ; and it is not necessary that the decedent be in the immediate expectation of death. Such a transfer is taxable, although the decedent parts absolutely and immediately with his title to and possession of the property. Transfers made within two years of a decedent's death are presumed to be taxable if they are of a material part of his property and are in the nature of a final disposition thereof. Where a transfer is of this character, the executor must disclose the transfer in the return; but he may submit therewith evidence 1458 MISCELLANEOUS TAXES that it was not made in contemplation of death. The executor must also return transfers by the decedent of a material part of his property to relatives, though made more than two years before his death ; but he need not list them as taxable if he contends otherwise. All facts relating to the transfer should be stated, including the motive therefor, the decedent's state of health, and his anticipation of death. The pre- sumption of taxability may be rebutted by proof that the transfer was not induced by bodily or mental conditions leading the grantor to make a disposition of property testamentary in its nature. The fact that a gift was made as an advancement, to be taken into account upon the final distribution of the decedent's estate, is not enough, standing alone, to establish taxability: but it is a circumstance to be considered in determining whether the transfer was made in contem- plation of death. (Reg. 37, Art. 23.) The expression, "in contemplation of death," was held in the United States Circuit Court of Appeals^^ not to mean "on the one hand the general expectancy of death which is enter- tained by all persons, nor, on the other, is the meaning of the term necessarily limited to an expectancy of immediate death or dying conditions. Nor is it necessary, in order to constitute a transfer in contemplation of death, that the conveyance or transfer be made while death is imminent, or immediately impending by reason of ill health, disease, injury or like physi- cal condition. But a transfer may be said to be made in contemplation of death if the expectancy or anticipation of death in either the immediate or reasonably near future is the moving cause of the transfer." Generally speaking, the only argument in support of the contention that transfers within two years were not in con- templation of death, that can be urged with a measurable promise of success, arises where a sequence of events shows that the decedent, having had an eminently satisfactory busi- ness career, decides gradually to relinquish an active control of his interest and to enjoy the remainder of his life in w'ell- earned ease. In such a case, the decedent is not contemplating death but rather a new lease of enjoyable life. The material factor then is the ultimate cause of death. Should it be that ' Shzvab V. Doyle, 269 Fed. 321. FEDERAL ESTATE TAX 1459 the state of decedent's health at the time the transfer was effected showed symptoms of the disease or aihnent which was the uUimate cause of death, there is very httle hkeHhood that any proof, however strong in circumstantial evidence, would enable the executor to prove that the property transferred was not in contemplation of death within the meaning of the law. The last hope would center in affidavits from reputable doc- tors to the effect that although such symptoms must have ex- isted, decedent might be quite ignorant of their fatal signifi- cance — could such conceivably be the case. A widow, one year before death, conveyed by means of an absolute transfer a considerable amount of personal property. She died of apo- plexy primarily resulting from hardening of the arteries. Held, the trust was created in contemplation of death. ^^ The ultimate disposition of a transfer effected less than two years before death depends entirely upon the available evidence and arguments showing the intention of the decedent. It is important that all of the evidence be assembled in the brief, which should be filed in support of the claim. Due regard should be given to the contingencies discussed in the following regulations : Regulations. A transfer is taxable where the grantor reserves to himself during life the income of the property transferred. In such a case the transfer of the principal takes effect in possession and enjoyment after the death of the grantor, and the value of the entire property should be included in the gross estate. Where the grantor reserves a proportionate part of the income, only a corresponding proportion of the property should be included in the gross estate, unless the transfer was made in contemplation of death. If, for example, he reserves one-half of the income, the value of one-half of the property transferred should be included in the gross estate. If he reserves an annuity, so much of the property as is necessary to produce the annuity should be included in the gross estate. Where the property does not produce income, its value as of the date of the decedent's death should be ascertained, and so much of this sum as is necessary to produce the annuity should be included in the gross estate. A transfer is taxable in accordance with these principles whether the grantor makes a reservation of the annuity out of the '" Shzmb V. Doyle, 269 Fed. 321. 1460 MISCELLANEOUS TAXES property conveyed, or exacts from the grantee an agreement to pay the annuity. A gift of the principal of a trust fund which takes effect at or after the decedent's death is taxable, although the income during the decedent's life is payable to some one other than himself. Example : The decedent transfers property to his son, the latter agreeing to pay the income to his mother during the decedent's life. The transfer to the son is taxable. (Reg. 37, Art. 24.) Property held in trust under any instrument in which the grantor has reserved a power of revocation, or any power which has that effect, constitutes a part of the gross estate of such grantor for the purposes of this tax. For example, where a father places property in trust for the present benefit of his son, but reserves power to re- voke the trust at any time during his life, the value of the entire property transferred should be included in the gross estate. (Reg. 37, Art. 25.) Valuation of property transferred. — The rules of valuation already dealt with apply to property inckided under the caption of transfers. The value at the time of decedent's death includes only the original property transferred; any additions or betterments effected by the transferee, or portions of trust not originally contributed or owned by the decedent are excluded from inclusion in the gross estate. Regulation. The property to be valued is the interest owned and transferred by the decedent ; but the value of such property must be ascertained as of the date of the decedent's death. Where the transferee makes additions to the property, or betterments, the value of the additions or betterments at the time of death are not to be included. For example, a father makes a transfer to a son, in contemplation of death, of unimproved real estate valued at $20,000. The son erects buildings on the land at a cost of $10,000. The amount to be included in the gross estate of the father is the value of the entire property at the time of his death less the value of the buildings on that date. (Reg. ■^y, Art. 26.) Property held jointly. — The following section of the 192 1 law is considerably enlarged as compared with the same section in the 1918 law. In the latter any property which at any time had been in the possession of the decedent was to be included in the gross estate. The new provision allowing for the inclusion of what may have been acquired from the de- FEDERAL ESTATE TAX 1461 cedent for a fair consideration, or in any case up to the amount of such consideration, removes an obvious hardship to the taxpayer which resulted under the arbitrary provision of the 1918 law. Gifts or bequests common to both spouses, also now for the first time included in this section, are placed on an equitable basis by law. Law. Section 402. That the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated (d) To the extent of the interest therein held jointly or as tenants in the entirety by the decedent and any other person, or deposited in banks or other institutions in their joint names and payable to either or the survivor, except such part thereof as may be shown to have originally belonged to such other person and never to have been received or acquired by the latter from the decedent for less than a fair consideration in money or money's worth: Provided, That where such property or any part thereof, or part of the consideration with which such property was acquired, is shown to have been at any time acquired by such other person from the decedent for less than a fair consideration in money or money's worth, there shall be excepted only such part of the value of such property as is proportionate to the con- sideration furnished by such other person: Provided further, That where any property has been acquired by gift, bequest, devise, or in- heritance, as a tenancy in the entirety by the decedent and spouse, or where so acquired by the decedent and any other person as joint tenants and their interests are not otherwise specified or fixed by law, than to the extent of one-half of the value thereof; . . . .-^ Regulation. The statute prorvides for the taxation of interests held jointly, or as tenants in the entirety, by the decedent and any other person or persons. This class of property includes all interests, whether in real or personal property, in which the survivor takes the entire property by right of survivorship, and it consequently does not form part of the decedent's estate for purposes of administration. It does not include interests held as tenants in common, where the interest of each tenant passes to his estate, free from any right of survivorship. '-'' [Former Procedure] 1918 Law. Section 402 (d) To the » extent of the interest therein held jointly or as tenants in the entirety by the decedent and any other person, or deposited in banks or other insti- tutions in their joint names and payable to either or the survivor, except such part thereof as may be shown to have originally belonged to such other person and never to have belonged to the decedent; .... 1462 MISCELLANEOUS TAXES The following are examples of this class of property : Real estate held jointly; real estate held by husband and wife (known as an estate in the entirety) ; money deposited in a bank or trust company in the joint names of the decedent and another and payable to either or the survivor ; joint trading accounts with brokers ; stocks and bonds held in the joint names of several owners. (Reg. 37, Art. 27.) The regulations which govern the corresponding section of the 1 9 18 law^* interpreted that section in accord with what is now included in the law itself. The expression "originally belonged" has been interpreted (T. D. 3225) as referring, not to the time of death, but to the time a joint interest was created. The act does not become retroactive because it measures a transfer tax on pro- perty which decedent has given away in his lifetime. In other words, the passing of property has, generally speaking, to be taxed under the estate tax law sooner or later, and the establishment of trusts or joint interests does not automatic- ally release property of the decedent therein included from the application of the law. A surviving tenant's original half interest in a joint tenancy created prior to the enactment of the statute has been held to form part of the decedent's gross estate.^® Property passing under power of appointment. — The in- tention of the law is to reach all the property which a decedent had enjoyed during his lifetime. This includes not only such as he owned but also property of which he had merely the right to direct the disposition b}' his will or by a deed. Law. Section 402;. That the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, where- ever situated — (e) To the extent of any property passing under a general power of appointment exercised by the decedent (i) by will, or (2) by deed executed in contemplation of, or intended to take effect in possession "'Reg. 37, 1918, Arts. 28 and 2g. " McElligott V. Kissam et al., U. S. Circuit Court of Appeals, Second Circuit, June 30, 1921, Advance Opinions, 275 Fed. 545. FEDERAL ESTATE TAX 1463 or enjoyment at or after, his death, except in case of a bona fide sale for a fair consideration in money or money's worth; .... The provision made in this section, which is the same in the 19 18 law, was included in that law in order specifically to embrace property transferred by a power of appointment. Section 202 (c) of the Revenue Act of 191 6 served as a general provision which was intended to include such property in its provisions. This intent was more or less obscure. The 1916 law relied upon the rule generally followed, that equity will regard the property appointed under a power of appoint- ment, either by deed or will, as part of the assets of the ap- pointor. Nevertheless, it was held that, "The Revenue Act of 191 6 did not impose an estate tax upon property passing under a testamentary execution of a general power of appointment."^" Hence the direct provision in the statutes subsequent to 1916. By "a general power of appointment" is meant the power which is often given by a will to the life beneficiary of a trust fund to name or appoint the persons who shall receive the prin- cipal after his life estate shall have terminated. Such prin- cipal, under the estate tax law, is taxable as the property of the life beneficiary at his death if he exercises the power of appointment by his will or by a deed made in contemplation of death or intended to take effect at or after his death (except in the case of a bona fide sale for a fair consideration). The principal is therefore to be included in the appointor's gross estate. Regulation. As a general rule, property passing under a gen- eral power of appointment must be included in the gross estate of the person exercising the power (known as the donee, or appointor) where the power is exercised by will, or by deed executed in contempla- tion of death, or intended to take effect at or after death. This gen- eral rule applies wherever the decedent died after September 8, 1916, although the power was created prior to that date. In certain cases, however, the transfer is taxable under the Revenue Act of 1918 when it would not be taxable under the Revenue Act of 1916 (See Art. 31). Only property passing under a general power should be included. '"' U. S. V. Field, 255 U. S. 257, 65 L. Ed. 355, 4i Sup. Ct. 256, October Term, 1920. 1464 MISCELLANEOUS TAXES A general power is one to appoint to any person or persons in the dis- cretion of the donee. Where the donee is required to appoint to a specified person or class of persons, the property should not be included in his gross estate. Property appointed under a general power should be included in the estate of the appointor, although the persons to whom the appointment was made would have taken the property had the power not been exercised. A copy of the instru- ment granting the power should be filed with Form 706 in all cases in order that the Bureau may determine whether the power is general or special. Example : The income of property is left to a person for life, with the right to name in his will the person who shall receive it upon his death. He exercises this pow-er in his will. Upon his death, if occurring after September 8, 1916, the property so appointed should be included in his gross estate. (Reg. 37, Art. 30.) Regulation. The Revenue Act of 1918 taxes all transfers ef- fected by the exercise of a general power of appointment, provided the exercise was by will, or by deed made in contemplation of death, or intended to take effect at or after death. It follows that all trans- fers of this character, where the decedent died after February 24, 1919, are taxable, and the property must be included in the gross estate. Where the decedent died between September 8, 191 6, and Feb- ruary 25, 1919, the taxability of the transfer depends upon whether the property was subject to the claims of the creditors of the ap- pointor, in preference to the person or persons in whose favor the power was exercised. The general rule is, that the property is so subject; and it should consequently be included in the gross estate unless this rule has been abrogated in the State whose laws determine the nature and effect of the transfer. All such transfers should be disclosed to the Bureau in order that it may pass upon the question of taxability. (Reg. 37, Art. 31.) The right to tax property passing under a power of appoint- ment does not solely depend on whether or not the property is subject to the claims of the creditors of the appointor. Such property to be subject to the estate tax involved must also be property subject to distribution as* a part of the dece- dent's estate. "It is the general rule of the common law sub- ject to certain exceptions, that the appointee of an estate takes from the original donor and not from the donee of the power."^^ Ebersok v. McGrath, 271 Fed. 995. FEDERAL ESTATE TAX 1465 Insurance.— It is recognized that a reasonable amount of life insurance should pass to beneficiaries free from tax. The amount exempted in the 1921 law is $40,000, just as under the 1918 law. Law. Section 402. That the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated — .... (f) To the extent of the amount receivable by the executor as in- surance under policies taken out by the decedent upon his ov^n life; and to the extent of the excess over $40,000 of the amount receivable by all other beneficiaries as insurance under policies taken out by the decedent upon his own life. Regulation. The statute provides for the inclusion in the gross estate of certain forms of insurance taken out by the decedent upon his own life. Two kinds of insurance are taxable: (a) all insurance payable to the estate; (b) insurance payable to individual beneficiaries to the extent that it exceeds $40,000. The term "insurance" refers to life insurance of every description, including death benefits paid by fraternal beneficial societies, operating under the lodge system. Insurance is deemed to be taken out by the decedent in all cases where he pays the premiums, either directly or indirectly, whether or not he inakes the application. On the other hand^ the insurance should not be included in the gross estate, even though the application is made by the decedent, where the premiums are actually paid by some other person or corporation, and not out of funds belonging to, or advanced by, the decedent. Where the decedent takes out insurance in favor of another person or corporation, as collateral security for a loan or another accommodation, and the decedent, either directly or indirectly, pays the premiums thereon, the insurance must be con- sidered in determining whether there is an excess over $40,000. Where the decedent assigns a policy, and retains no interest therein, and thereafter pays no part of the premiums, the insurance will not be considered in determining whether there is such a taxable excess. (Reg. ^7, Art. 32.) When premiums are paid by other persons and the executor is not required to include the proceeds of the insurance in the gross estate of the decedent, care must be exercised to see that such payments were not constructive payments by the deceased; as, for instance, where premiums are paid by a corporation on behalf of an official as part of the latter' s compensation for services, the benefit of such insurance accruing to the 1466 MISCELLANEOUS TAXES official's heirs or assigns. This benefit would form part of the gross estate in so far as it, or any portion of it, was in excess of $40,000. All insurance coming under the provisions of this section must be included in detail in schedule C of form 706. The amounts of insurance payable to beneficiaries, other than the executor, not in excess of $40,000, are not extended. The balance, if any, is extended and so comprised in the total gross estate reported in this schedule. The inclusion of insur- ance eftected as security for indebtedness is obviously correct, the indebtedness itself being an offset for inclusion in deduc- tions from gross estate in schedule I. The constitutionality of taxing the proceeds from life insurance policies payable to beneficiaries other than the es- tates of decedents is open to question. The estate tax is "imposed upon the transfer of the net estate of every dece- dent."^^ The estate of the decedent consists of all property of which the decedent dies seized and possessed, and which can be devised by him; or, if he dies intestate, is distributed according to the statutes of descent and distribution as pro- vided by law. The property is of such a nature as to be liable for his debts. The proceeds of life insurance which do not go to a decedent's estate never formed any part of the dece- dent's estate, nor were they liable for his debts. Where en- dorsed to a third party, no reversionary interest or equity entered into the value of the decedent's estate prior to his death. In this connection the following dissenting opinion of Mr. Justice Holmes is pertinent : Decision If the succession has fully vested, or has passed beyond dependence upon the continuing of the state's permis- sion or grant, an attempt to levy a tax under the power to regulate succession would be an attempt to appropriate property in a way which the 14th Amendment has been construed to forbid. ^^ A test as to the taxability of this form of insurance is '"^ Section 401. '' Chanler v. Kclscy, 205 U. S. 466, 479, 51 L. Ed. 882, 27 Sup. Ct. 550. FEDERAL ESTATE TAX 1467 furnished in a case before the United States District Court of Maryland.^* The testator, two months before his death, had caused three insurance poHcies to be made payable to his son and daughter. He reserved no interest to himself nor to his personal representatives. The transfers were made without consideration and within two years of his death. The court decided : Decision. Under the circumstances, I do not feel justified in holding that the three policies, which were absolutely assigned, were within the statutory meaning of the phrase "transferred in contempla- tion of death." These three policies, therefore, did not remain a part of the decedent's estate, so as to be subject to the estate tax. The above decision is conclusive in its expression. If, even within two months of death, these insurance policies were not considered as "made in contemplation of death" within the meaning of the statute, it would seem that any absolute transfer effected in such a manner could be reasonably held to be without the power of the estate tax law. Regulations. The provision requiring the inclusion in the gross estate of all insurance receivable by the executor, without any de- duction, applies to policies made payable to the decedent's estate or his executor or administrator, and all insurance, regardless of the manner of execution, which is in fact receivable by the estate, or which must be used to pay charges against the estate or the expenses of administration. This provision includes insurance taken out to provide funds to meet the estate tax, state inheritance taxes, or any other legal charge upon the estate. The manner in which the policy is drawn is immaterial so long as there is an obligation, legally bind- ing upon the beneficiary, to use the proceeds in payment of the charge. (Reg. 37, Art. 33.) The estate is entitled to only one exemption of $40,000 upon insurance payable to beneficiaries other than the executor. For ex- ample, if the decedent left life insurance payable to three persons in amounts of $10,000, $40,000 and $50,000 (total $100,000), the amount of $60,000 should be returned for taxation, which is the excess of the sum of the three policies over the exempted amount. The word " Gaither v. Miles, 268 Fed. 692. 1468 MISCELLANEOUS TAXES "beneficiary," as used in reference to the $40,000 exemption, means a person entitled to tiie actual enjoyment of the insurance money. (Reg. 37, Art. 34.) Insurance receivable by the executor must be included in the gross estate of all decedents who died after September 8, 1916. In- surance payable to beneficiaries other than the executor, however, need not be included in the gross estate of decedents who died before February 25, 19 19, the effective date of the Revenue Act of 1918, unless the insurance was originally payable to the estate, and was transferred by the decedent to specific beneficiaries in contempla- tion of death." (Reg. 37, Art. 35.) The amount to be returned in the case of any policy is the amount actually receivable by the executor or beneficiary. In cases where the proceeds of a policy are made payable to the beneficiary in the form of an annuity for life or for a term of years, the present worth of the annuity at the time of death should be included in the gross estate. For the method of computing the value of such an annuity, see Article 20."^ Where the insurance contract gives an option to receive a fixed sum of money in lieu of an annuity, this sum, if ac- cepted, represents the value of the insurance for the purpose of the tax. If such sum is not accepted the value of the annuity is to be included in the gross estate. Where there is more than one option, and none of them is convertible, the value of the insurance should be determined in accordance with the option actually exercised. (Reg. i7, Art. 36.) The foregoing regulations merely explain the principle under which the proceeds of life insurance are included in tlie gross estate. Deductions from Gross Estate Deductions allowed resident estates. — Having computed the amount of the gross estate, the next step is to ascertain the allowable deductions. Law. Section 403. That for the purpose of the tax the value of the net estate shall be determined — (a) In the case of a resident, by deducting from the value of the gross estate — (i) Such amounts for funeral expenses, administration expenses, claims against the estate, unpaid mortgages upon, or any indebtedness in respect to, property (except, in the case of a resident decedent, ■"■' See page 1453. FEDERAL ESTATE TAX 1469 where such property is not situated in the United States), losses in- curred during the settlement of the estate arising from fires, storms, shipwreck, or other casualty, or from theft, when such losses are not compensated for by insurance or otherwise, and such amounts reason- ably required and actually expended for the support during the set- tlement of the estate of those dependent upon the decedent, as are al- lowed by the laws of the jurisdiction, whether within or without the United States, under which the estate is being administered, but not in- cluding any income taxes upon income received after the death of the decedent, or any estate, succession, legacy, or inheritance taxes. Regulations. In the case of the estates of residents, the de- ductions are made from the value of the entire gross estate, wherever situated. The deductions specified in the above provisions, contained in the Revenue Act of 1918, are proper in all cases where the decedent died on or after February 25, 1919. Where the decedent died prior to February 25. 1919, the case is governed by the provisions of the Revenue Act of 1916, which permits the following deductions : (i) Funeral expenses. (2) Administration expenses. (3) Claims against the estate. (4) Unpaid mortgages. (5) Losses from casualty or theft. (6) Support of decedent's dependents. (7) Other charges against the estate. (8) Specific exemption of $50,000. (9) In the case of decedents dying after December 31, 1917, public, religious, charitable, scientific, literary, and educational be- quests. The provision in the Revenue Act of 1916 for the deduction of "such other charges" than those previously specified as may be al- lowed by the laws of the jurisdiction is omitted in the Revenue Act of 1918. Consequently, in the case of estates of all persons dying after February 24, 1919, the executor, in order to obtain a deduction, must bring the item within one of the classes specifically described. (Reg. 37, Art. 37.) In order to be deductible, the item must be of the character de- scribed in the statute; and it must also be one the payment of which out of the estate is allowed by the law of the jurisdiction administer- ing it. Where the item is not one of those described, it is not de- ductible merely because payment is allowed by the local law. On the other hand, no item is deductible unless its payment is so allowed. It must appear in every case either that payment of the item has been made, or that such payment is clearly contemplated. Where the amount which may be expended for the particular purpose is limited by the local law, no deduction in excess of such limitation is per- missible. Where the local courts have approved the expenditure it 1 4/0 MISCELLANEOUS TAXES will ordinarily be allowed for deduction. (See Art. 39.) Where the disbursement has not been made, the item may be entered for de- duction where the amount is certain, and it appears satisfactorily that it will be paid. No deduction may be taken upon the basis of a vague or uncertain estimate. Where an uncertain or contingent lia- bility, not allowed as a deduction, becomes fixed, and payment is made, the remedy is a claim for a refund of the excess tax. (Reg. 37, Art. 38.) Effect of court decree on deductibility. — Regulation. The decision of a local court as to the amount of a claim or administration expense will ordinarily be accepted where the court passes upon the fact upon which deductibility depends. Where the court does not pass upon such fact its decree will, of course, not be followed. For example, where the question before the court is whether a claim should be allowed, the decree allowing it will ordinarily be accepted as establishing that the claim is valid and the amount of it. Where, however, a legacy is left to an executor in lieu of commissions, the allowance of the legacy does not estab- lish that the executor's claim for commissions is equal to the amount bequeathed, and that this amount is consequently deductible. (See Art. 42.) Nor will the decree necessarily be accepted even where it purports to decide the fact upon which deductibility depends. It must appear that the court actually passed upon the merits of the case. This will be presumed in all cases where there is an active and genuine contest. Where the result reached appears to be unreasonable, this is some evidence that there was not such a contest, but it may be rebutted by proof to the contrary. Where the decree was rendered by consent, it will be accepted, provided the consent was a bona fide recognition of the validity of the claim — not a mere cloak for a gift — and was accepted by the court as satisfactory evidence upon the merits. It will be presumed that the consent was of this character, and was so accepted, where it is made by all parties having an interest adverse to the claim, when all aspects of the matter, including its effect upon taxation, are considered. The decree will not be accepted . where it appears to be at variance with the law of the State ; as, for example, if an allowance is made to an executor in excess of the rate prescribed by statute. (Reg. 37, Art. 39.) Funeral expenses. — Regulation. An executor may deduct such amounts for funeral expenses as are actually expended by him, provided expenditures of this nature are a liability of the estate under the laws of the local jurisdiction. A reasonable expenditure by the executor for a tomb- stone, monument or mausoleum, or for a burial lot, either for the de- FEDERAL ESTATE TAX 1471 cedent or his family, may be deducted under this heading, provided such an expenditure is made a charge upon the estate by the local law. Included in funeral expenses is the transportation of the person bringing the body to the place of burial. (Reg. 37, Art. 40.) Administration expenses. — Regulation. The amounts deductible from the gross estate as "administration expenses" are such expenses as are actually and necessarily incurred in the administration of the estate; that is, in the collection of assets, payment of debts, and distribution among the persons entitled. The expenses contemplated in the law are such only as attend the settlement of an estate by the legal representative pre- liminary to the transfer of the property to individual beneficiaries or to a trustee, whether such trustee is the executor or some other person. Expenditures not essential to the proper settlement of the estate, but incurred for the individual benefit of the heirs, legatees, or de- visees, may not be taken as deductions. Administration expenses include (i) executor's commissions; (2) attorney's fees; (3) mis- cellaneous expenses. Each of these classes is considered separately. (See Arts 42 to 44.) (Reg. 37, Art. 41.) Executor's commissions. — Regulation. No amount may be deducted as executor's com- missions in excess of that actually paid or to be paid, and in no case in excess of the amount allowable by the law of the jurisdiction wherein the estate is being administered. If at the time of filing the return the commissions of the executor have not been allowed or awarded by the court or tribunal having jurisdiction in the premises, the commissions may nevertheless be entered on the return and claimed as a deduction, subject to future allowance or disallowance by the Commissioner, provided: (i) That the amount entered and claimed is within the amount allowable by the laws of the jurisdiction wherein the estate is being administered; (2) that such amount is in accordance with the usually accepted practice in such cases within said jurisdiction; and (3) that it may reasonably be expected that the said amount will be paid within one year and 180 days after the decedent's death. Except in those cases in which the commis- sions have been both awarded and paid, the Commissioner may at any time require the executor to furnish satisfactory evidence of his right to take or claim the deduction. Whenever it shall appear to the Commissioner that the commissions claimed but not awarded, whether paid or unpaid, exceed the amount allowed by law or exceed the amount usually allowed within the commonly accepted practice of the jurisdiction wherein the estate is being administered, or where in any case the Commissioner finds after the lapse of i year and 180 T472 MISCELLANEOUS TAXES days after the decedent's death that the commissions have not been paid, the deduction will be disallowed, subject to the right of the executor thereafter in a proper case to file a claim for abatement or refund as he may be advised, when the commissions shall have been actually awarded and paid. Where the executor does not intend to make any charg-e upon the estate for his services, no deduction may be claimed. No deduction may be made for trustees' commissions, and an executor who acts as trustee is not entitled to deduct the commission he receives for his services in the latter capacity. The executor's duties are complete when he has turned over the estate or the proceeds to the persons entitled thereto. Such persons may be beneficiaries entitled to receive the property in their own right, or trustees entitled to receive it in the right of their cestuis que trustent. The services of the trustees are distinct from, and additional to, the ordinary duties of an executor in the settlement of estates; and commissions for such trustees' services do not constitute an expense of administration. Where a bequest is made to an executor in lieu of commissions it may be deducted as an administration expense only to an amount thereof not in excess of the amount allowable as commissions by the law of the jurisdiction wherein the estate is being administered. If the legacy is in excess of such allowable commissions, the excess may not be deducted. (Reg. 37, Art. 42.) Attorney's fees. — Regulation. No amount may be deducted in any case as at- torney's fees in excess of that actually paid or to be paid. If at the time of filing the return the attorney's fees have not been allowed or awarded by the court or tribunal having jurisdiction in the premises, they may nevertheless be entered on the return and claimed as a deduction, subject to future allowance or disallowance by the Com- missioner, provided: (i) That the amount so entered and claimed is reasonable in consideration of the services performed and the value of the estate; and (2) that it may reasonably be expected that such amount will be paid within i year and 180 days after the decedent's death. Except in those cases in which the attorney's fees have been both awarded and paid, the Commissioner may at any time require the executor to furnish satisfactory evidence of his right to take or claim this deduction. Whenever it shall appear to the Commissioner that the fees claimed were not awarded, and whether paid or unpaid, ex- ceed a reasonable amount in the discretion of the Commissioner, or where in any case the Commissioner finds after the lapse of i year and 180 days after the decedent's death that the fees have not been paid, the deduction will be disallowed, subject to the right of the executor thereafter, in a proper case to file a claim for abatement or refund as he may be advised, when the fees have actually been awarded and FEDERAL ESTATE TAX 1473 paid. The cost of litigation insLitutcd by the beneficiaries as to the amount of their respective interests may not be deducted, since ex- penses of this character are properly charges against the beneficiaries personally, rather than against the general estate. (Reg. 37, Art. 43.) Miscellaneous administration expenses. — Regulation. This item includes expenses incident to court pro- ceedings, or the administration of the estate, such as court costs, sur- rogates' fees, accountants' fees, appraisers' fees, clerk hire, etc. Ex- penses necessarily incurred in distributing the estate are deductible. This includes the cost of storing or maintaining property of the es- tate, where it is impossible to effect immediate distribution to the beneficiaries. Expenses for preserving and caring for the property may be deducted, but do not include additions or improvements; nor will such expenses be allowed for a longer period than the executor is required to retain the property. A brokerage fee for selling prop- erty of the estate is deductible where the sale is necessary in order to pay the decedent's debts, or the expenses of administration, or to ef- fect distribution. Other expenses attending the sale are deductible, such as the fees of an auctioneer, where it is reasonably necessary to employ one. (Reg. 37, Art. 44.) Claims against the estate. — Regulation. The amounts that may be deducted under this head- ing are such only as represent personal obligations of the decedent existing at the time of his death, whether then matured or not. Obli- gations contracted by the executor are not deductible. Only such claims as are actually enforceable against the estate may be deducted. (Reg. 37, Art. 45.) Taxes. — Regulation. Taxes upon real property should be accrued to the date of death. This is done by ascertaining the time between the first day of the taxable period wherein the death occurs and the date of death, and computing the proportion of the entire tax which this period bears to the entire taxable period. Such proportion of the tax has accrued upon the date of death, and is deductible. Taxes upon personal property are either wholly deductible, or are not deductible at all, depending upon whether the tax did, or did not, become the personal obligation of the taxpayer in his lifetime. If the tax became his personal obligation during his life, the whole amount is deductible as a claim against his estate. If it did not become such personal obligation in his lifetime, no part of it is de- ductible. The question when the tax became the personal obligation of the taxpayer depends upon the law of the jurisdiction where the 1474 MISCELLANEOUS TAXES decedent was domiciled at the time of his death. Prima facie, the date when the tax became the personal obligation of the taxpayer is the date when the assessment was laid. In the case of federal taxes upon income, the tax upon income re- ceived or accrued during the decedent's lifetime constitutes the per- sonal obligation of the decedent, and is deductible. Taxes upon in- come received after the decedent's death are not deductible. No es- tate, succession, legacy, or inheritance tax is deductible. (Reg. 37, Art. 46.) Unpaid mortgages. — Regulation. The full amount of unpaid mortgages on property included in the gross estate should be deducted under this heading, including interest which had accrued at the time of death, whether payable at that time or not. Interest should be computed upon the basis of 365 days to the year. The full value of the real estate, with- out any deduction for mortgages, must be returned as part of the gross estate. As real property situated outside of the United States is not part of the gross estate, the amount of mortgages upon such property should be deducted only where the decedent was personally liable for the mortgage debt. (Reg. 37, Art. 47.) Losses fro:m casualty or theft. — Regulation. There may be deducted under this heading losses incurred during the settlement of the estate arising from fires, storms, shipwreck, or other casualty, or from theft, when such losses are not compensated by insurance or otherwise. If the loss is partly com- pensated, the excess of the loss over such compensation may be de- ducted. Losses not of the nature described are not deductible. Losses sustained by reason of depreciation in the value of the assets of the estate subsequent to the decedent's death are not deductible. The term "casualty" includes only losses of a fortuitous and unusual character, such as result from violence, or from a disaster which could not be foreseen or prevented by the e.xercise of reasonable care. Losses due to the death of animals from disease are deductible. In order to be deductible a loss must occur during the settlement of the estate. Where property has been delivered to the beneficiary, settlement has. been effected, and no deduction may be had for loss of the property. (Reg. 2i7^ -^^^- A^-) Support of dependents. — Regulation. The support during the settlement of the estate of dependents of the decedent should be deducted, but pursuant to the following rules : FEDERAL ESTATE TAX 1475 (i) In order to be deductible, the allowance must be authorized by the laws of the jurisdiction in which the etsate is being adminis- tered, and not in excess of what is reasonably required. (2) The allowance for which deduction may be made is limited to support during the settlement of the estate. Any allowance for a more extended period is not deductible. (3) There must be an actual disbursement from the estate to the dependents, but after payment has been made the right of deduc- tion is not affected by the fact that the dependents do not expend the entire amount for their support during the settlement of the estate. (Reg. 37, Art. 49.) The governing factor in determining the deductibility of expenses is their allowance as such under local statutes. Care- ful study of such statutes is therefore necessary, since under some jurisdictions a deduction for the support of dependents is not permitted. Nevertheless, expenses, to be deductible from the gross estate, must come distinctly under some one of the descriptions enumerated in section 403 (a) of the act. Par- ticular attention is drawn to the treatment of the executor's commission where a specific sum has been willed by the dece- dent for this remuneration. Any such amount in excess of the total commission permitted by the local court is disallowed. The exclusion of mortgages on property of a resident de- cedent which is situated outside the United States is a new provision. Under the 1918 regulations, mortgages on prop- erty owned outside the United States were deductible when the decedent was personally liable for the mortgage debt.^*^ The latter would seem to be the more equitable treatment. Where the indebtedness of the decedent includes notes pay- able, care should be taken to ascertain whether such notes are secured by collateral. The value of such collateral would, of course, have to be included in the gross estate. In connection with the deductibility of estate, succession, legacy or inheritance taxes from the gross estate, despite the fact that estate taxes are included in those not deductible under the law," the government contended, in a court case. " Reg. 37, 1918, Art. 47. " Sec. 403 (a-i). 1476 MISCELLANEOUS TAXES that estate taxes were deductible because levied against the estate itself, but that "legacy"' taxes are not deductible, because levied against the legatee.^* In this particular case the deci- sion was that the ^Massachusetts tax should have been deducted before the estate tax was computed. The court also stated it to be "unjust to hold that under this Federal Statute (Reve- nue Act of 1 91 6) the State tax was deductible in one state and not deductible in another, upon a subtle legalism without .practical value." On the other hand, a contrary opinion has been handed down by the Supreme Court of the United States f^ " 'Charges against the estate' as pointed out by the Court below, are only charges that affect the estate as a whole, and therefore do not include taxes on the right of individual beneficiaries. This reasoning excludes not only the New York- succession tax, but those paid to other states, which can stand no better than that paid in New York." And again, in the United States District Court, Northern District, New York,*" it was held that the New York transfer tax was a proper de- duction to be made in the tax due the United States. As to the Pennsylvania collateral inheritance tax, the court decided *^ that it is an estate tax, not a legacy tax, and that as such it is levied upon and made a charge against the estate. For this reason the court held that the tax was deductible from the gross estate before the imposition of the federal estate tax. With these conflicting decisions given, it can only be said that the question of deductibility of state estate or inheritance taxes is entirely dependent upon the exact nature of the tax imposed by a particular state. Deduction for property previously taxed. — Law. Section 403. That for the purpose of the tax the value of the net estate shall be determined — ^ Thayer et al. v. Mallcy, U. S. District Court, Mass., March 28, 1921 (case not reported). "" N. }'. Trust Co. et al. v. Eisner. U. S. Sun. Ct., October term. 1920. Advance Opinions 620. *" Say re et al. 7: Breivsler, 268 Fed. 533. *^ Northern Trust Co. v. Lederer. 262 Fed. 52; certiorari denied, 252 U. S. 487, 64 L. Ed. 1025, 40 Sup. Ct. 483. FEDERAL ESTATE TAX- 1477 (a) In the case of a resident, by deducting from the value of the gross estate — .... (2) An amount equal to the value of any property forming a part of the gross estate situated in the United States of any person who died within five years prior to the death of the decedent where such property can be identified as having been received by the decedent from such prior decedent by gift, bequest, devise, or inheritance, or which can be identified as having been acquired in exchange for prop- erty so received: Provided, That this deduction shall be allowed only where an estate tax under this or any prior Act of Congress was paid by or on behalf of the estate of such prior decedent, and only in the amount of the value placed by the Commissioner on such property in determining the value of the gross estate of such prior decedent, and only to the extent that the value of such property is included in the decedent's gross estate and not deducted under paragraphs (i) or (3) of subdivision (a) of this section. This deduction shall be made in case of the estates of all decedents who have died since September 8, 1916; .... While in general accord with the corresponding section of the 1918 law,*^ this section also includes some provisions pre- viously covered merely by regulation. The intent is perfectly clear, in that where an estate tax has l)een paid on the transfer of any portion of the decedent's estate within five years prior to the date of death, no further federal tax need be paid in respect of that particular property.*^ Only the value accepted by the Commissioner in the return of the prior decedent may be deducted from the gross estate under this section. If the actual value at date of decedent's death exceeds the original value the excess must be included in the gross estate. Property owned by a resident or non-resident decedent which formed part of the estate of anyone dying after Sep- temljer 8, 19 16, and upon which an estate tax had been paid, may be deducted from the gross estate. The rules for such deduction may be summarized as follows : I. The two deaths must have occurred within five years of each other. *-Reg. 37, 1918, Art. 50. "As to the effect of the change of the effective dale on refunds of tax, see page 15 13. T478 MISCELLANEOUS TAXES 2. The first decedent must have died after September 8, 191 6, and the second after November 23, 1921. 3. Tax must have been paid on the first decedent's prop- erty. 4. The value exempt from taxation in the case of the last decedent is the value at which such property was included in the gross estate of the prior decedent. 5. The property shall be situated in the United States at the time of the last decedent's death. The third condition above paves the way for possibility of an injustice in certain cases. It is specifically stated that the filing of a return is not a sufficient cause for deduction ** but that the tax itself must have been paid. The inevitable construction to be placed on this condition is that the net estate of the first decedent must have exceeded the $50,(X)0 specific exemption; otherwise there would have been no tax- able estate and, consequently, no tax paid. Any benefit accru- ing to the estate of the last decedent, under these circumstances, is entirely dependent on the fact as to whether or not the gross estate of the prior decedent exceeded $50,000. If the gross estate of the prior decedent exceeded $50,000, then bequests to the second decedent will be deductible from the latter's gross estate. This is true, in spite of the fact that the estate of the prior decedent (if a resident) was only sub- ject to tax on the amount in excess of $50,000. Where the gross estate of the prior decedent was less than $50,000, no tax was payable (by a resident), and therefore the estate of the second decedent will be unable to deduct any bequests received from the prior decedent. To illustrate : (i) Assume A (a resident) had a gross estate of $100,000 Deduct: Specific exemption 50,000 Tax paid by A's estate on $ 50,000 Reg. 37, 1918, Art. 62. FEDERAL ESTATE TAX 1479 B (a resident) has a personal estate excluding payment from A of $ 40,000 Bequest from A 100,000 Gross estate of B $140,000 Deduct: A's bequest $100,000 Specific exemption 50,000 150,000 Excess of deductions $ 10,000 No tax due on B's estate. The Treasury receives in total from the estates of A and B tax on $ 50,000 (2) Assume A (a resident) had a gross estate of $ 40,000 No tax is payable by the estate of A. B (a resident) has a personal estate excluding bequest from A of $100,000 Bequest from A 40,000 Gross estate of B $140,000 Only the specific exemption can be deducted 50,000 Total paid by A's estate on $ 90,000 The Treasury receives in total from the estates of A and B tax on $ 90,000 It follows that the discrimination referred to above results in the collection by the Treasury of a tax on $40,000 more in the second case than in the first although the total personal estates (excluding the transfer) of A and B are identical in the two examples, namely, $140,000. The discrimination is unfair. The Treasury should permit in the second case the deduction of $40,000 from the estate of B, which is the intention of Congress. Deduction for propekty acquired in exchange. — ■ Regulations. The deduction for substituted property is lim- ited to property acquired in exchange for the identical property re- ceived from the estate of the prior decedent. Where there is a sub- sequent exchange, the right to deduction is lost. Where, however, property is sold, and the proceeds immediately invested in other prop- erty, the property purchased is deemed to be taken in exchange, and its value is deductible. In the case of an exchange the executor must describe and identify fully both the property originally received from the prior e.state and the property acquired in exchange therefor. lie must also state the 1480 MISCELLANEOUS TAXES date and nature of the transaction by which the exchange was effected, the name and address of the transferee, and the consideration, if any, given or received by the decedent in addition to the property received from the prior estate. If the exchange was made by written instrument of pubHc record, a precise reference must be made to the record containing the instrument, and if by instrument not of record a copy of the instrument must be supplied. If there was no written instrument, an affidavit as to the facts of the exchange by one or more persons having personal knowledge of the matter must be furnished. If at the time of exchange the decedent gave a consideration in addition to the property received from the prior estate, and acquired property of greater value than the property so received, there may be deducted the proportion of the value of the property received in exchange which the value of the original property bears thereto. (Reg. 37, Art. 52.) If the property originally received from the prior estate is in- cluded in the decedent's gross estate, the executor must describe it fully, and prove its identity with the property received from the prior estate. The value to be deducted is the value at the time of the second decedent's death. (Reg. 37, Art. 51.) Since the amount of property originally received under the conditions mentioned will have been included (on schedule G of form 706) at its value at the time of decedent's death, the deduction made (on schedule K of form 706) will be at the same figure. Deduction for charitable and similar bequests.*^ — Law. Section 403. That for the purpose of the tax the value of the net estate shall be determined — (a) In the case of a resident, by deducting from the value of the gross estate — .... (3) The amount of all bequests, legacies, devises, or transfers, except bona fide sales for a fair consideration in money or money's worth, in contemplation of or intended to take effect in possession or enjoyment at or after the decedent's death, to or for the use of the United States, any State, Territory, any political subdivision thereof, or the District of Columbia, for exclusively public purposes, or to or for the use of any corporation organized and operated exclusively " [Former Procedure] Frovisiun for the deduction of charitable and similar bequests was first instituted in the 1918 law. That law provided for deductions similar to those which are allowed under the 1921 law. Prior laws made no allusion to this form of deduction from gross estate. FEDERAL ESTATE TAX 1481 for religious, charitable, scientific, literary, or educational purposes, in- cluding the encouragement of art and the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual, or to a trustee or trustees exclusively for such religious, charitable, scientific, literary, or educational purposes. This deduction shall be made in case of the estates of all decedents who have died since December 31, 1917; .... Regulations. Bequests to religious, charitable, scientific, literary, or educational corporations are deductible only if the corporation is organized or operated exclusively for one of the purposes specified (see Art. 54). Similarly, in the case of a trust, the trust must be exclusively for such purposes. It does not prevent deduction, hovi'- ever, that the property placed in trust is also subject to another trust for a private purpose. Thus, where money or property is placed in trust to pay the income to an individual during life, and then to pay or deliver the same to a charitable corporation, or apply the principal to a charitable purpose, the charitable bequest or devise forms the basis for a deduction. The amount of the deduction, in such case, is the value, at the date of the decedent's death, of the remainder in- terest in the money or property which is devised or bequeathed to charity. For the manner of determining the value of such remainder interest, see Article 20. Gifts made in the decedent's lifetime are deductible only if made in contemplation of death ,or intended to take effect at or after death, and the property is consequently included in the gross estate. Gifts made in satisfaction of a legacy are also de- ductible. The deduction is not limited in the case of the estates of residents to bequests to domestic corporations or to trustees for use within the United States. (Reg. 37, Art. 53.) In order to be exempt the corporation or association must meet three tests : ( i ) it must be organized and operated for one or more of the specified purposes; (2) it must be organized and operated exclusively for such purposes; and (3) no part of its income must inure to the benefit of private stockholders or individuals. (i) Charitable corporations include an association for the relief of the families of clergymen, even though the latter make a contribu- tion to the fund established for this purpose; or for furnishing the services of trained nurses to persons unable to pay for them ; or for aiding the general body of litigants by improving the efficient adminis- tration of justice. Educational corporations include an association whose sole purpose is the instruction of the public, even if it merely disseminates propaganda on a single question. Thus an association inculcating prohibition or protectionist principles is exempt. The same is true of an association to promote acquaintance with the Spanish language and literature, although it has incidental amusement 1482 MISCELLANEOUS TAXES features; of an association to increase knowledge of the civilization of another country ; and of a Chautauqua association whose primary purpose is to give lectures on subjects useful to the individual and beneficial to the community, and whose amusement features are in- cidental to this purpose. Societies designed to encourage the per- formance of first-class orchestral music are not exempt, the purpose being merely to provide a high grade of entertainment. Scientific corporations include an association for the scientific study of law, to the end of improvement in its administration. (2) Where a religious corporation owns a large quantity of farm land and works it, and also manufactures and sells clothing and other articles for profit, it is not operated exclusively for religious purposes and is not exempt, even though its property is held in com- mon and its profits do not inure to the benefit of individual members of the society. (3) It does not prevent exemption that private individuals, for whose benefit a charity is organized, received the income of the cor- poration or association. The statute refers to individuals having a personal and private interest in the activities of the corporation, such as stockholders. If, however, a corporation issues "voting shares,'" which entitle the holders upon the dissolution of the corpora- tion to receive the proceeds of its property, including accumulated income, the right to exemption does not exist, even though the by- laws provide that the shareholders shall not receive any dividend or other return upon their shares. (Reg. 37, Art. 54.) The foregoing regulations in most respects properly inter- pret the law. When the intention of the law is to exempt certain gifts from taxation, gifts falling reasonably within the exempt class should be tax-free. The regulations are too dras- tic in such cases as a religious corporation which operates a farm, a factory, a hotel, and a theatre, the profits, if any, from these varied operations being entirely devoted to the religious objects for which the corporation was formed. Surely it can- not be maintained that such bequests were other than for the specific furtherance of those religious objects. The test in such a case is the object of the pursuits followed, not the fonn which those pursuits may take. Should any of the profits inure to the stockholders (which it is expressly stated that they do not), then the exclusively religious purpose of the organization would cease and the bequest would autoinatically be deprived of any claim as a deductible item. FEDERAL ESTATE TAX 1483 A decedent may bequeath a farm to a religious institution. The gift is tax-free. The institution is unable to sell the farm and operates it to the best advantage. Another decedent makes a money bequest to the same institution. If the farm has been neglected the second bequest is tax-free; if proper care has been taken of the farm the second bec|uest is not tax-free ! It is impossible to read into the law any such rediictio ad ab- surdnni. Yet the regulations appear to so hold. It is difficult to see for what reason contributions to com- munity chests, funds, or foundations are not included in the deductions under this title. For income tax purposes ""^ they are specifically enumerated among the deductions allowed to individuals. This is an invidious distinction as between the treatment of contributions donated by an individual himself and those donated by his executor in accord with his expressed desires before his death. The anomaly is further instanced by the fact that contributions by a living individual to the National Dry Federation are not allowable deductions from gross income, while a bequest to an association established for the purpose of inculcating prohibition principles is deductible from the gross estate under this section.^' In claiming the deduction for charitable and similar be- quests, the executor is required to submit certain documentary evidence as indicated in the following article : Regulations. In order to prove his right to this deduction the executor must submit : (i) Certified copy of the will of the decedent or the instrument of gift in the case of a transfer of property in contemplation of death. (2) A receipt, statement, or other documentary evidence to show the beneficiary's receipt of, or intention to accept, the legacy, devise, or gift. (3) Affidavit of the executor stating whether any action has been instituted to contest the will, or whether, according to his information and belief, any such action is contemplated. (4) Such other document or evidence as may be specified by the I'ureau. (Reg. 37, Art. 55.) "Title II, section 214 (a-ii). " Reg. 37, 1918, Art. 54. 1484 MISCELLANEOUS TAXES Where llie bequest, legacy, devise, or gife is dependent upon tlic performance of some act, or the happening of some event, in order to become effective, it is necessary that the performance of the act or the occurrence of the event shall have taken place before the deduction can be allowed. Where the legatee, devisee, donee, or trustee is empowered to divert the property or fund, in whole or in part, to a use or purpose which would have rendered '\t, to the extent that it is subject to such power, not deductible had it been directly so bequeathed, devised, or given by the decedent, deduction will be limited to that portion, if any, of the property or fund which is exempt from an exercise of such power. (Reg. 37, Art 56, as amended by T. D. 3241, dated November i, 1921.) The deduction may be claimed by the estates of all decedents dying after December 31, 1917. Where the tax has been paid without taking the deduction a claim for refund may be made, as provided by Article no. (Reg. 37, Art. 57.) Specific exemption. — The 1921 law makes no change in the specific exemption of $50,000 allowed in the case of resi- dent estates. This exemption has been allowed in all laws from 191 6. Law. Section 403. That for the purpose of the tax the value of the net estate shall be determined — (a) In the case of a resident, by deducting from the value of the gross estate — .... (4) An exemption of $50,000; .... Regulation. There may be deducted from the gross estate of all resident decedents a specific exemption of $50,000. No part of this exemption is allowed in the case of nonresident decedents. (See Art. 59.) If more than one return is made for purposes of the tax, the exemption may be taken only once. (Reg. 37, Art. 58.) Method of determination of net estate of non-residents. — In computing the net estate of a non-resident which is subject to tax, there are two important differences from the procedure in the case of resident estates : 1. There is no especific exemption of $50,000. 2. Only the amount of the gross estate which is deemed to be situated in the United States is considered, and from this amount the statutory deductions (limited to 10 per cent of the gross estate ^^) are subtracted. Section 403 (b-i). FEDERAL ESTATE TAX 1485 Status of certain itujimcrty of non-resident es- tates. — Law. Section 403 (b) ... (3) For the purpose of this title stock in a domestic corporation owned and held by a nonresi- dent decedent shall be deemed property within the United States, and any property of which the decedent has made a transfer or with respect to which he has created a trust, within the meaning of subdivision (c) of section 402,^'-' shall be deemed to be situated in the United States, if so situated either at the time of the transfer or the creation of the trust, or at the time of the decedent's death. The amount receivable as insurance upon the life of a nonresident decedent, and any moneys deposited with any person carrying on the banking business, by or for a nonresident decedent who was not en- gaged in business in the United States at the time of his death, shall not, for the purpose of this title, be deemed property within the United States. The exclusion of the proceeds of hfe insurance, or bank deposits, is an exemption granted to non-residents for the first time in this law. Heretofore, when the insurer was a domestic corporation, insurance receivable from such a source was deemed to be property within the United States, and, as such, subject to inclusion in the taxable gross estate. Neither of these exemptions apply to non-residents engaged in business in the United States. Missionaries classed as residents. — Law. Section 403 (b) .... (3) Missionaries duly commissioned and serving under boards of foreign missions of the vari- our religious denominations in the United States, dying while in a foreign missionary service of such boards, shall not, by reason merely of their intention to permanently remain in such foreign service, be deemed nonresidents of the United States, but shall be presumed to be resi- dents of the State, the District of Columbia, or the Territories of Alaska or Hawaii wherein they respectively resided at the time of their commission and their departure for such foreign service. The foregoing paragraph applying to missionaries and, in effect, placing them in the same plane, as far as deductions and exemptions are concerned, as residents, is a new and equitable feature of the 192 1 law. 'A trust created in contemplation of death. I486" MISCELLANEOUS TAXES Deductions allowed non-resident estates. — Law. Section 403. That for the purpose of the tax the value of the net estate shall be determined — .... (b) In the case of a nonresident, by deducting from the value of that part of his gross estate which at the time of his death is situated in the United States — (i) That proportion of the deductions specified in paragraph (i) of subdivision (a) of this section •" w^hich the value of such part bears to the value of his entire gross estate, wherever situated, but in no case shall the amount so deducted exceed 10 per centum of the value of that part of his gross estate which at the time of his death is situated in the United States; .... (2) An amount equal to the value of any property forming a part of the gross estate situated in the United States of any person who died within five years prior to the death of the decedent where such property can be identified as having been received by the decedent from such prior decedent by gift, bequest, devise, or inheritance, or which can be identified as having been acquired in exchange for prop- erty so received: Provided, That this deduction shall be allowed only where an estate tax under this or any prior Act of Congress was paid by or on behalf of the estate of such prior decedent, and only in the amount of the value placed by the Commissioner on such property in determining the value of the gross estate of such prior decedent, and only to the extent that the value of such property is included in that part of the decedent's gross estate which at the time of his death is situated in the United States and not deducted under paragraphs (i) or (3) of subdivision (b) of this section. This deduction shall be made in case of the estates of all decedents who have died since Sep- tember 8, 1916;°^ and (3) The amount of all bequests, legacies, devises, or transfers, except bona fide sales for a fair consideration, in money or money's worth, in contemplation of or intended to take effect in possession or enjoyment at or after the decedent's death, to or for the use of the United States, any State, Territory, any political subdivision thereof, or the District of Columbia, for exclusively public purposes, or to or for the use of any domestic corporation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, including the encouragement of art and the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual, or to a trustee or trustees exclusively for such religious, charitable, scientific, literary, or educational purposes within the United States. This de- " See page 1468. "This subsection is identical with section 403 (a-2). cussion, see page 1477. For a full dis- FEDERAL ESTATE TAX 1487 duction shall be made in case of the estates of all decedents who have died since December 31, 1917. No deduction shall be allowed in the case of a nonresident unless the executor includes in the return required to be filed under section 404 the value at the time of his death of that part of the gross estate of the nonresident not situated in the United States. Except for the 10 per cent limitation included in paragraph ( I ) above, the section quoted provides the same general de- ductions for non-residents as in the case of resident estates. The specific exemption of $50,000 does not, hoivever, apply as far as non-resident estates are concerned. Regulation. The gross estate of a resident and of a nonresident are made up in the same way. In ascertaining the net estate, how- ever, which is subject to tax, there is a radical difference between the two cases. Whereas the net estate in the case of a resident is de- termined by making the specified deductions from the entire gross estate, the net estate in the case of a nonresident is determined by making the deductions from the value of so much of the gross estate as is situated in the United States.^- Thus, in substance, the statute attempts to tax only the transfer of so much of the estate of a non- resident as is situated in the United States. On the other hand, nonresident estates are not entitled to the specific exemption of $50,000. (Reg. 37, Art. 59.) Deduction for claims and expenses of non-resi- dents. — Regulation. The character of the deduction is the same as in the case of resident estates (see Arts ^y to 49). It is immaterial whether the expenditures are incurred or paid in this country or else- where. The deduction, however, is subject to limitations which do not apply in the case of a resident estate. Only that proportion of the claims and expenses is deductible which the value of the property situated in the United States bears to the value of the entire gross estate, wherever situated; and in no event may a sum be deducted in excess of 10 per cent of the value of the property situated in the United States. This 10 per cent limitation does not apply to the de- ductions subsequently considered. (See Arts. 62, 63.) (Reg. 37, Art. 61.) Deductions for public, charitable, or similar gifts BY non-residents. Regulation. Where the bequest is to a corporation, it is limited to a domestic corporation ; tluit is, one created or organized in the 'But not in excess of 10 per cent thereof. Act. section 403 (i). 1488 MI-SCELLANEOUS TAXES United States. Where the bequest is to a trustee, it must be for use exclusively within the United States. The requirements are dif- ferent and should not be confused. The first relates to the character of the donee ; the second to the character of the use of the gift. With these exceptions the rules for deduction are the same as in the case of resident estates (see Arts. 53, 54). This deduction applies to the estates of all decedents dying after December 31, 1917. In the case of any estate entitled to the deduc- tion which paid the tax without receiving the benefit of the right, the excess tax will be refunded upon filing of claim for refund. (Reg. 37, Art. 63.) Example of determination of net estate of non-residents. — Regulation. The following example will show the manner of de- termining the net estate, subject to tax, of a nonresident decedent. The gross estate of the decedent, wherever situated, amounts to $1,- 000,000, of which the property in the United States, Hawaii, and Alaska amounts to $200,000. The total legal deduction for claims and ex- penses (see Art. 61) amounts to $75,000; and there are charitable bequests, for use within the United States, amounting to $25,000. In- asmuch as the property in the United States, Hawaii, and Alaska con- stitutes 20 per cent of the entire gross estate, one-fifth of the total deductions for claims and expenses is the proportionate share corres- ponding to this property. This proportion amounts to $15,000; and as this amount does not exceed ten per cent of the property situated in the United States. Hawaii, and Alaska, the entire amount is de- ductible. The following result is accordingly obtained : Gross estate within the United States--- $200,000 Proportion of deductions for claims and expenses under subdivision i --- $15,000 Charitable bequests in United States -- 25,000 40,000 Net estate subject to tax - 160, 000 The tax on this amount should be computed in the manner previ- ously provided for estates of residents. fSee Art. 8.) In the example given, if the total legal deductions for claims and expenses had amounted to $150,000, the proportionate amount of de- ductions, $30,000, would not have been deductible, inasmuch as this would have exceeded ten per cent of the property in the United States, Hawaii and Alaska. In such case the total amount of the deductions allowable for claims and expenses would have been ten per cent of the gross estate within the United States, or $20,000, making, with the charitable bequests of $25,000, a total deduction of $45,000. The net estate subject to tax would accordingly have been $155,000, instead of the amount given in the example. (Reg. 37, Art. 64.) FEDERAL ESTATE TAX 1489 It is presumed that insurance payable to individuals other than the executor in excess of $40,000 has been included in the gross estate in arriving at the $200,000.^^ Payment of tax — non-residents. — Regulation. The regulations with reference to rates of tax and pa3^ment are the same in the case of estates of nonresidents as of residents. The statute provides that the executor shall pay the tax. If no executor or administrator has been appointed in the United States, every person in the United States in possession of any part of the decedent's gross estate is constituted an executor for the purpose of tax payment, and is liable for the tax upon the trans- fer of the portion of the gross estate in his possession. All checks, drafts, or money orders should be made payable to the order of Col- lector of Internal Revenue. Payment so made of an amount indi- cated to be due upon the return discharges the tax only in case sub- sequent investigation and audit disclose that the correct amount has been paid. (See Art. 90.) (Reg. 2^^, Art. 65.) Sixty-Day Notice Resident estates.^* — In the case of a resident decedent, action is required on the part of the executor before the regu- lar return is filed. It is necessary that he give written notice to the collector in the district wherein the decedent died of such death, of the approximate amount of the gross estate and of his appointment by the court or of his coming into possession of the property. This notice must be filed within two months (sixty days) after the executor has had his ap- pointment confirmed by the courts. Law. Section 404. That the executor, within two months"'"' after the decedent's death, or within a like period after qualifying as such, shall give written notice thereof to the collector Regulations. A preliminary notice, called the 60-day notice, is required to be filed in the case of every resident decedent who died on or after February 25, 1919, the gross amount of whose estate "■' See Art. 60. '^ For non-residents, see page 1493. '"The term "month" means calendar month (law, section 400). I490 MISCELLANEOUS TAXES exceeds $50,000. This notice must be filed in duplicate with the col- lector in whose district the decedent had his domicile at the time of death. Where there is doubt as to whether the gross estate exceeds $50,000, the notice should be filed, as matter of precaution, in order to avoid penalties. Prior to February 25, 1919, the notice was required if the gross estate exceeded $60,000, or if there was any net estate after the deductions allowed by law, including the $50,000 exemption, had been taken. These provisions are not now in effect except to determine delinquency under previous acts. In the case of the estates of nonresident decedents, notice is re- quired if there is any property situated in the United States, without reference to its value. (Reg. 37, Art. 66.) The executor or administrator of an estate is required to file notice on Form 704 within 60 days of his appointment by the court, or of coming into possession of any property of the estate, whichever event occurs first. The primary purpose of the notice is to advise the Government of the existence of taxable estates, and filing should not be delayed beyond the 60-day period because of uncertainty as to the exact value of the assets. Since the filing of the notice within the prescribed period is mandatory, the estimate of the gross estate called for by the notice is merely the best approximation of value which can be made within the time allowed. The instructions upon the back of the form should be read carefully before executing the notice. The signature of one executor or administrator upon Form 704 is sufiEicient. For penalties for delinquency in filing notice, or filing of false or fraudulent notice, see Articles 103 and 104. (Reg. 37, Art. ^y.) A detailed explanation under oath must accompany form 704 in the event of failure to file same within the time set by law. Notice by other.s than the executor or adminis- trator. — Regulation. The notice upon Form 704 must be filed by others than the executor or administrator if either of the following situa- tions exists: (i) No executor or administrator has been appointed. (2) There is property included in the gross estate, as defined by -Statute, which has not, and will not, come into the custody and con- trol of the executor. In these cases, the persons in possession of the property included in the gross estate are executors, within the meaning of the statute, for the purpose of filing the notice. (Reg. 37, Art. 68.) FEDERAL ESTATE TAX Notice wken no executor appointed. 1491 Regulation. Where no executor or administratur has been ap- pointed, the person taking possession of property at the time of death is required to file notice within 60 days of the date of death. The notice must be filed whether possession of the property was held at the date of death, or was acquired thereafter. The notice on Form 704 must be filed by such persons in any case where an executor or administrator has not been appointed within 60 days of the decedent's death, although one is appointed subsequently. Where an executor or administrator is appointed within the 60-day period, the duty of filing the notice devolves upon him; and all other persons are relieved from liability to file with respect to property coming into the custody and control of the executor or administrator. (Reg. 37, Art. 69.) Notice where property not within executor's con- trol. — Regulation. Where there is property that will not come into the custody and control of the executor, but which is included in the gross estate as defined by the statute, the notice on Form 704 must be filed within 60 days of the date of death by the person in possession or control of the property at the time of death. The persons required to file Form 704, in compliance with this requirement, include the following: (i) The surviving husband or wife in the case of property owned as tenants in the entirety. (2) Donees who have received within two years prior to the de- cedent's death any gift of material value from the decedent, or who have received at any time whatever gifts made by the decedent in contemplation of death or intended to take effect at or after death. (3) Trustees holding property conveyed during lifetime by de- cedent in contemplation of death, or with intent to provide for others at or after the decedent's death, regardless of the date of execution of the instrument making the conveyance. (4) Fiduciaries holding property of any kind jointly for the de- cedent and another or others. Example : A savings bank holding a joint account in the name of the decedent and another, payable to either or to the survivor, must file Form 704 for the full amount of the account. (5) Trustees having in charge property over which the decedent exercised a general power of appointment, and which will not come into the possession and control of the executor or administrator. (6) Beneficiaries other than the executor who receive insurance upon the decedent's life, provided the total amount of the insurance receivable by all such beneficiaries exceeds $40,000. The primary duty of filing notice with respect to property which 1492 MISCELLANEOUS TAXES will not come into the executor's control rests upon the person actu- ally in possession at the time of death. It is the duty of the succeed- ing owner, however, where property of this character is held at the tmie of death by an agent or fiduciary, to give notice w^ithin 60 days of the date of taking possession, unless he finds that notice has already been filed. For example, the appointee of property, under a general power of appointment exercised by the decedent, should file notice within 60 days of receiving possession, unless the notice has already been filed. (Reg. 37, Art. 70,) Insurance companies' sixty-day notice. — Regulation. Sixty-day notice upon Form 787 must be filed by every insurance company which pays insurance upon the life of a resident decedent to beneficiaries other than the executor or adminis- trator in amounts aggregating more than $40,000, or which has knowl- edge of insurance payable to such beneficiaries by other insurance companies, aggregating, with amounts payable by the company it- self, more than $40,000. If the proceeds of any policy are payable in the form of an annuity, the present worth of such annuity, for the purpose of deducting the $40,000 exemption, should be computed in accordance w'ith the provision of Article 20. Notice should be filed with the collector of the district in which the decedent had his domicile within 60 days of receipt by the company of notification of death. If the insurance company is in doubt as to its liability to give notice, the notice should be filed. Where insurance is taken out with a foreign branch of a domestic insurance company, the notice should be given by the home office of the company within 60 days of the receipt by the foreign branch of information of the decedent's death. (Reg. 37, Art. 71.) Where military exemption claimed sixty-day notice required. — Regulation. The executors of estates exempted from the tax (see Art. 9) are required to file the 60-day notice with the proper collector in the same manner as the executors of taxable estates. The executor should, in addition, write across the face of the form the words "Military exemption claimed.'" (Reg. 37, Art. 72.) Under the provision covering military exemptions (section 401 ) the regulations demand that a formal claim for such exemption be submitted with the sixty-day notice, or as soon as possible thereafter, on form 793.^** '°Reg. ZT, Art. 10, FEDERAL ESTATE TAX 1493 Non-resident estates. — Regulation. A 60-day notice on Form 705 should be filed with the Commissioner of Internal Revenue, Washington, D. C, by every executor or administrator appointed in the United States. The notice is necessary if any part of the decedent's gross estate was situated in the United States at the time of death, regardless of the value of that part or of the entire gross estate. If no executor or adminis- trator has been appointed in this country, notice must be filed within 60 days of the date of death by every person in possession of any part of the gross estate in the United States. If such person has no knowledge of the decedent's death within 60 days of its occurrence, he should file this notice immediately upon obtaining such knowledge. The filing of notice by a foreign executor or administrator does not relieve persons in possession from the duty of filing notice. If there is a delay in the appointment of a local executor or administrator of more than 60 days after the death, persons in possession should file notice. The term "person in possession of property of the decedent" includes the decedent's agents or representatives, donees and trans- ferees or trustees of property transferred in contemplation of death ; the surviving owner of property held jointly; safe-deposit companies, warehouse companies, and similar custodians of property in this country of a nonresident decedent; brokers holding as collateral securities belonging to the decedent or investment funds owned by the decedent ; banking institutions holding money on deposit or for any specific purpose, such as purchase of goods, if the title rests in the decedent; and debtors of the decedent in this country. (Reg. 37, Art. 73.) Transfer agents' sixty-day notice. — Regulations. A 60-day notice upon Form 714 is required to be filed whenever a corporation, its transfer agent, register, or paying agent, is called upon to make a transfer of stocks or bonds, or to pay interest or dividends, to any successor in interest of any nonresident stockholder or bondholder who died after September 8, 1916, unless the transfer is made upon the order of an executor or administrator appointed in the United .States. The notice is required for dividends declared prior to the day of death, and for interest which had ac- crued on bonds prior to the death of the decedent although payable thereafter. Notice should be filed with the Commissioner of Internal Revenue at Washington, D. C, within 60 days of the date of death, or immediately upon receipt of the order of transfer or payment. A transfer agent should be vigilant to report all cases in which the fact of the death of a nonresident appears. Where the securities are re- ceived without the personal assignment of the decedent, but with the transfer order of the foreign executor, it is clear that the case should 1494 MISCELLANEOUS TAXES be reported. Where the securities bear the personal assignment of the decedent, the transfer should be reported if made upon the order of a foreign executor, or if information is received in any other manner that the record owner has died a nonresident of the United States. (Reg. 37, Art. 74.) In order to prevent loss of the tax upon nonresident estates, it is essential that transfer agents should exercise great care in reporting all transfers of the kind described. Their records will be examined from time to time by internal-revenue ofificers to determine whether this regulation is being strictly complied with. Failure to file notice in the manner prescribed will render the transfer agent liable to a fine. (Reg. 37, Art. 75.) Transfer of stock of non-resident decedent, how MADE. Regulation. Wherever a transfer agent is required to file 60-day notice as provided in Article 74, he shall not make transfer of the stock standing in the name of the decedent until there has been de- livered to such collector of internal revenue as may be designated by the Commissioner the bond of the party to whom the stock is to be transferred with corporate surety in an amount to be fixed by the Commissioner, conditioned for the payment of the tax upon the trans- fer of the decedent's estate, not exceeding in amount the value of the stock to be transferred. Upon receipt of the 60-day notice the Com- missioner will at once, upon request, fix the amount for which the bond is to be given. In lieu of the bond a deposit of the amount so fixed may be made with such collector of internal revenue as the Commissioner may designate. Where a sum of money is deposited in lieu of the bond, and it exceeds the amount of the tax as finally determined, the excess will be refunded to the person making deposit. In lieu of the provisions and restrictions hereinbefore set forth, transfer agents are authorized to make a transfer of stock standing in the name of a nonresident decedent to the duly qualified ancillary executor or administrator within the United States, who shall make a return on Form 706, as any other executor is required by law to do, provided that such transfer agent at the time of making such trans- fer gives notice thereof in writing to the Commissioner of Internal Revenue. (Reg. 37, Art. 75 A.) Insurance companies' .sixty-day notice. — Regulation. The 60-day notice upon Form 788 must be filed by every domestic insurance company which pays insurance upon the life of the nonresident decedent in any amount either to a foreign executor or administrator, or to individual beneficiaries. The notice should be filed with the Commissioner of Interna] Revenue, Wash- FEDERAL ESTATE TAX 1495 ington, D. C, within 60 days of receipt of proof of claim. No notice is required to be filed, if the only insurance paid is receivable by an executor appointed in the United States. If, however, the company is liable to give notice, it is required to report insurance of all classes in order that its statement may be complete. (Reg. 37, Art. y6.) Payment of life insurance policy. — Regulation. Wherever an insurance company is required to file a 60-day notice, as provided in Article 76, where the insured was a nonresident it shall not make payment of any policy or policies to a foreign executor or administrator, or to an individual beneficiary, until there has been delivered to such collector of internal revenue as may be designated by the Commissioner the bond of the party to whom the insurance is to be paid, with corporate surety in an amount to be fixed by the Commissioner, conditioned for the payment of the tax upon the transfer of the decedent's estate, not exceeding the amount of insurance payable under such policy to the executor, and the excess over $40,000 of the aggregate insurance payable to specific beneficiaries other than the executor or the estate of the decedent. Upon receipt of the 60-day notice the Commissioner will at once, upon request, fix the amount of the bond to be given. In lieu of such bond a deposit of the amount fixed may be made with such collector of in- ternal revenue as the Commissioner may designate. If in lieu of the bond a sum of money is deposited, and such sum exceeds the amount of tax as finally determined, the excess will be refunded to the person making the deposit. In lieu of the bond or a deposit of money, where insurance is payable to a foreign executor or administrator, the insurance may be paid to ancillary executor or administrator ap- pointed within the United States, provided that such ancillary exe- cutor or administrator shall have given bond with corporate surety in an amount sufiicient, in the opinion of the Commissioner, to dis- charge the tax liability of the estate, not exceeding the amount of insurance subject to be included within the gross estate of the de- cedent. Wherever insurance companies are required to file a 60-day notice, as provided in Article 71, where the decedent is a resident and there is subject to be included within the decedent's gross estate any excess over $40,000 in the aggregate of insurance payable to specific beneficiaries other than the executor or the estate of the decedent, the same provisions and restrictions in regard to payment of insur- ance shall apply and govern insurance companies as are set forth in this article in the case of nonresidents. Where insurance companies are required to file a 60-day notice, as provided in Article 71 or in Article 76, if the decedent is a resi- dent or nonresident, and there is an excess over $40,000 in the aggre- 1496 MISCELLANEOUS TAXES gate of all insurance payable to specific beneficiaries other than the executor or the estate of the decedent, insurance companies are authorized, in lieu of the provisions and restrictions hereinbefore set forth, upon consent of the beneficiaries to make payment of such insurance to such beneficiaries through the duly qualified executor or administrator within the United States or through the duly qual- ified ancillary executor or administrator in the United States who shall make return on Form 706 of the excess over $40,000 of such insurance, if the estate be that of a nonresident, or that of a resident if there be a net estate subject to tax. (Reg. 37, Art. 76A.) Returns Returns for resident estates. — As with returns called for under the income tax laws, the returns under this title literally impose upon the executor the duty of assessing the amount of tax due. The correctness of this assessment is subject to final determination by the Commissioner. The form of the return is practically a series of information schedules which may be summarized as follows : 1. General information sheet in regard to decedent, heirs, legatees, and beneficiaries. 2. Items under separate captions, going to make up the gross estate (schedules A to D). 3. Transfers, property passing under power of appoint- ment, and property taxed within five years (sched- ules E to G). 4. Deductions classified (schedules H to K). 5. Recapitulation (schedule L). 6. Rates and tax due (schedule AI). 7. Jurat for executors, etc. Schedule AI also calls for details to be supplied by non- residents as to gross estate situated outside the United States. Explicit and concise instructions are given regarding the information required, and these instructions should be fol- lowed in every particular. Law. Section 404 The executor shall also, at such times and in such manner as may be required by regulations made FEDERAL ESTATE TAX 1497 pursuant to law, file with the collector a return under oath in dupli- cate, setting forth (a) the value of the gross estate of the decedent at the time of his death, or, in case of a nonresident, of that part of his gross estate situated in the United States; (b) the deductions allowed under section 403; (c) the value of the net estate of the de- cedent as defined in section 403; and (d) the tax paid or payable there- on; or such part of such information as may at the time be ascer- tainable and such supplemental data as may be necessary to establish the correct tax. Return shall be made in all cases where the gross estate at the death of the decedent exceeds $50,000, and in the case of the estate of every nonresident any part of whose gross estate is situated in the United States. If the executor is unable to make a complete re- turn as to any part of the gross estate of the decedent, he shall include in his return a description of such part and the name of every person hold- ing a legal or beneficial interest therein, and upon notice from the collec- tor such person shall in like manner make a return as to such part of the gross estate. The commissioner shall make all assessments of the tax under the authority of existing administrative special and general provisions of law relating to the assessment and collection of taxes. Date of filing return. — Regulation. A return on Form 706 is required in the case of every resident decedent who died on or after February 25, 1919, leaving a gross estate exceeding $50,000 in value. This return must be filed with the collector in whose district the decedent resided. It must be filed within one year after the date of death, unless an extension is granted, and must be in duplicate. In the case of decedents who died before February 25, 1919, the effective date of the Revenue Act of 1918, the return is required if the gross estate exceeds $60,000, or if there is any net estate after the legal deductions, including the $50,000 exemption, have been taken. In the case of estates of non- residents return is required if the decedent owned any property in the United States regardless of value. (See Art 88.) (Reg. 37, Art. 77.) Procedure where no return has been made. — Regulation. The statute provides that if no return is filed for the estate of a decedent, or if a return contains a false or incor- rect statement of a material fact, the collector or deputy collector shall make a return. The Commissioner may amend this return from such knowledge or information as he can obtain, through testimony or otherwise. A return so made by the Commissioner, or made by the collector and approved by the Commissioner, is a sufficient basis for assessing the tax. Where a tax is found to be due upon such 1498 MISCELLANEOUS TAXES a return, the estate will be liable for penalties as well as for the tax. {Reg. 37, Art. 78.) Investigation where return has been filed. — Regulation. An investigation of every return for estate tax will be conducted to verify the accuracy of the return. The investi- gation will be made by special officers of the Bureau. The fact that an investigation is made does not reflect upon the competence or good faith of the executor, since investigations are required in all cases as a matter of administrative procedure. The executor should cooper- ate with the examining officer in order that the full tax liability may be definitely determined and the case closed. During the course of the investigation the examining officer will inspect the books and records of the estate, interview the executor and other persons hav- ing knowledge of the decedent's affairs, verify the value of the assets and the amounts of debts and administration expenses, and take such other steps as may be necessary to determine the correct tax. It is the purpose of the Bureau to make these investigations as soon as practicable after the filing of the return. Whenever there are special and urgent reasons for an early investigation, the col- lector should be notified in order that the case may be given special attention. Upon completion of the investigation the executor will be apprised by the examining officer of his findings, and will be given an opportunity to discuss the case and present such data as he may desire, to be considered by the Bureau in connection with the ex- amining officer's report. Upon the completion of the review and audit by the Bureau of the return and the examining officer's report, the executor will be informed by letter from the Commissioner of the result of the audit. If the letter contains notification of an unpaid balance of tax, the executor should make payment to the col- lector. After the expiration of 30 days from receipt of the notification interest will accrue upon the excess tax at the rate of ten per centum per annum. If the executor wishes to file claim for abate- ment of any part of the excess tax, such claim must be filed within 30 days of receipt of notification, or he may pay the tax in order to prevent the running of interest, and submit claim for refund. (Reg. 37, Art. 79.) The foregoing regulation is in the nature of an outHne of procedure which the Treasury follows after the executor has performed the requirements of the law in fihng form 706. It is unfortunate that the Treasury is not subjected to a Hmi- tation of titne as is tlie exectitor. In many cases there are '^special and tirgent reasons" why estates should l)e settled FEDERAL ESTATE TAX 1499 with despatch. Particularly may this be said of an estate which must remain under the administration of an executor, with consequent cost and inconvenience to the legatees. While section 407 provides that the Commissioner, on written appli- cation of the executor, shall make a final settlement of the tax within one year from the receipt of such application, there seems to be no reason why the Treasury should not be com- pelled by law to do its business with ordinary despatch without a special application for settlement being necessary. A maxi- mum time should be established, within which time the inves- tigation must be completed and a final assessment agreed upon. Promise of more speedy operation on the part of the sec- tions responsible for audit and examination of estate tax re- turns is reflected in the statement that ''changes in procedure and personnel have resulted in bringing work to a current basis and increased efficiency." ' There were 11,833 estate tax returns filed during the year ended June 30, 192 1, which produced just over $103,000,000. Examinations of these re- turns disclosed additional taxes due to the government amount- ing to over $13,000,000, or 12.9 per cent, an indication of the necessity for prompt audit so that executors may close estates within a reasonable time. Who shall make the return. — Regulation. The statute provides that the executor or admin- istrator shall file the return. If there is more than one executor or administrator, the return must be made jointly by all. Where no executor or administrator has been appointed, every person in pos- session of any part of the gross estate is considered to be an executor for the purposes of the tax, and is liable for a return as to the property in his possession. The executor or administrator is required to make a return of the entire gross estate of the decedent, including property which will not come into his possession, such as property transferred by the decedent before death, and property owned by tenants in the entirety. If the executor is unable to make a complete return as to any part of the gross estate, he is required to give all the in- formation he has as to such property, including a full description, Report of Commissioner of Internal Revenue, 1921. I500 MISCELLANEOUS TAXES and the name of every person holding a legal or beneficial interest in the property. Where the execntor is unable to make a return as to any property, the statute requires every person holding a legal or beneficial interest therein, upon notice from the collector, to make return as to such part of 'the gross estate. For penalties for delin- quency in filing return, or filing of false or fraudulent return, see Articles 103 and 104. (Reg. 37, Art. 80.) Extension of time for filing return. — Regulation. If it is impossible for the executor to file a com- plete return within a year from the date of death, he may make ap- plication to the collector for an extension of time for filing the return, stating in detail in his application the circumstances which prevent the filing of the return by the due date and setting forth briefly but fully a statement of what the gross estate consists, together with a statement of the amount of deductions claimed, provided that in the first instance the application be made at least 30 days prior to the due date of the return. If the collector is satisfied that a complete return can not be made he may grant extensions of time not to exceed 180 days from the due date, no single extension exceeding 60 days. At the expiration of the last extension period granted a return must be filed. If at that time it is still impossible to file a complete and accurate return, on account of the unsettled condition of the affairs of the estate, the return filed by the executor must be as complete as possible, and must set forth all the facts in his possession as to the gross and net estate. Such a return will be accepted by the collector; but the executor must file an amended return as soon as the condi- tion of the estate permits. The granting of an extension of time for filing a return does not operate to extend the time for the pay- ment of the tax, which is due one year after decedent's death unless the time for payment thereof be extended by the Commissioner, as provided in Article 93. Where application has been made for an extension of time to file a return, but no extension of time for the payment of the tax has been granted, the executor will be required to pay on the due date a sum of money sufiicient, in the opinion of the collector, to discharge the tax, even though an extension of time to file the return has been or may be granted. The statements accompanying the application will be sub- ject to investigation and verification in acting upon the application for extension and in fixing the amount which the executor will be required to pay on the due date of the tax as sufficient in the opinion of the collector to discharge the tax. (Reg. 37, Art. 81.) Form of return. — Regulations. The return must be made on Form 706, copies of which will be supplied by the collector. It must contain an itemized FEDERAL ESTATE TAX 1 501 inventory, by schedule, of the property constituting the gross estate, together with a full statement of deductions claimed, as therein pro- vided. The instructions printed on the form should be carefully followed. All documents and vouchers used in preparing the return should be retained by the executor, so as to be available for in- spection whenever required. Certified copies of the will, if any, must be submitted with the return, together with duplicate copies of the other documents required by the instructions printed on the form, or any documents which the executor may desire to submit with the return in explanation thereof. (Reg. 37, Art. 82.) The statute provides that the executor, in addition to filing notice and return, shall furnish such supplemental data as may be necessary to establish the correct tax. It is therefore the duty of the executor to furnish upon request copies of any documents in his possession relating to the estate, or on file in any court having jurisdiction over the estate, appraisal lists of any items included in the gross estate, copies of balance sheets or other financial statements relating to the value of stock, and any other information obtainable by him that may be found necessary in the determination of the tax. Failure to comply with such a request will render the executor liable to a fine not to exceed $500, and proceedings may be instituted in the proper United States court to secure compliance with the requirement. (Reg. Z7, Art. 83.) Form of return — non-resident estates. — Regulations. Pursuant to this provision the executor of a nonresident decedent is required to file with the return: (i) Certified copy of will, or, if the decedent left several wills, to govern in different jurisdictions, certified copy of each will. (2) Certified copy of inventory of foreign property filed under a foreign estate, succession or death-duty act; or, if no such inventory was filed, copy of inventory filed with the foreign court of probate jurisdiction. (3) Certified copy of schedule of claims filed under a foreign taxing act in cases where such claims are presented for deduction. If any item of deduction is not included in the schedule, the affidavit of the foreign executor or administrator with reference thereto should be submitted. The specified information is required, whether or not the executor wishes to claim deduction, and is subject to the provision of the statute (see Sec. 403) requiring him to include in his return the value of the gross estate situated in the United States. (Reg. ^y. Art. 84.) A return on Form 706 must be filed in duplicate with the Com- missioner of Internal Revenue, Washington, D. C, or with such collector of internal revenue as the Commissioner may designate, I502 MISCELLANEOUS TAXES within a year from the date of death of every nonresident decedent, if any part of the gross estate of such decedent was situated in the United States at the time of his death. It is the duty of any executor or administrator appointed in the United States to file a return for the whole of that part of the gross estate situated in the United States, whatever its value. If there is no such executor or administrator, every person in possession of any part of the gross estate in the United States may be required to file a return for such part. Except as otherwise specifically provided by these Regulations, notice will be given to such persons, however, where a return is required; and they are relieved of the duty of filing returns by the appointment of an executor or administrator in the United States, but not, however, by the appointment of a foreign executor or administrator. If, how- ever, a complete return is actually filed by the foreign executor of property in the United States, the person in possession need not file a return, except as otherwise specifically required by these Regulations. (Reg. 37, Art. 88.) Returns are privileged communications. — Regulations. All estate tax returns and notices are treated as privileged communications and may not be exhibited to any person other than the executor or his duly authorized attorney, except as stated in Article 86. This requirement of secrecy will be rigidly enforced, a'nd extends to information of a private nature submitted or obtained in connection with a return or notice. The requirement does not operate to prevent internal revenue officers from disclosing the returned value of any item or the amount of any specific deduc- tion where such disclosure is necessary in order to arrive at a cor- rect determination of the tax. This right of disclosure, however, does not extend to such information as the amount of the estate, ^he amount of tax, or other general data. Nor are the records in possession of the Bureau, whether on file with the Commissioner or the collector, open to inspection, except as provided herein. (Reg. Z7, Art. 85.) Where any person other than the executor has a material interest in ascertaining any fact disclosed by the return, or in obtaining in- formation as to the payment of the tax, he shall make a written ap- plication to the Commissioner of Internal Revenue for such informa- tion, setting forth the nature of his interest and the purpose of the application. The Commissioner will review the application, and, if it is approved, give written instruction to the collector to exhibit the return to the applicant, or give him such information as is spec- ified. LTnder no circumstances shall the collector give information to persons other than the executor except upon the written order of FEDERAL ESTATE TAX 1503 the Commissioner, and to the extent authorized by such order. (Reg. Z7, Art. 86.) In all cases where information is sought regarding an estate, or an interview asked, by an attorney whose name does not appear on form 706 as the attorney for the estate, the information or in- terview will be denied unless the attorney presents a signed state- ment from the executor, authorizing him to appear in his behalf. The limitation does not apply where an attorney asks a general ruling on a question relating to a specific estate, or where he asks information of the procedure to be followed in regard to filing notice or making payment. Where an attorney asks information, or an interview, and his name appears on the return as attorney for the estate, the information or interview will be granted if his identity is established. (Reg. 37, Art. 87.) Return by collector. — Law. Section 405. That if no administration is granted upon the estate of a decedent, or if no return is filed as provided in section 404, or if a return contains a false or incorrect statement of a material fact, the collector or deputy collector shall make a return and the Commissioner shall assess the tax thereon. Law. Section 131 1. [Rev. Stat., Section 3176.] If any per- son, corporation, company, or association fails to make and file a return or list at the time prescribed by law or by regulation made under authority of law, or makes, willfully or otherwise, a false or fraudulent return or list, the collector or deputy collector shall make the return or list from his own knowledge and from such in- formation as he can obtain through testimony or otherwise. In any such case the Commissioner may, from his own knowledge and from such information as he can obtain through testimony or other- wise, make a return or amend any return made by a collector or deputy collector. Any return or list so made and subscribed by the Commissioner, or by a collector or deputy collector, and approved by the Commissioner, shall be prima facie good and sufficient for all legal purposes. Regulation. Where the executor fails to file a return, or files an inaccurate one, the collector or deputy collector is required to make a return from such information as he possesses or is able to obtain. In such cases the Commissioner assesses the tax in the same manner as though the return had been filed by the estate. (Reg. 37, Art. 89.) 1504 MISCELLANEOUS TAXES Payment of Tax When tax due and payable. — In contradistinction to pay- ments required in the case of income and excess profits taxes, the amount of an estate tax is not payable in instahnents but in full one year after the date of the decedent's death. In view of the fact that the payment is made directly out of the corpus of the decedent's estate, there would be little reason for the spreading of such payment over any particular period. Should it happen that the selling of property or securities, in order to liquidate the liability at one certain time, would ob- viously be detrimental to the estate, but an extension of time might mean an alleviation of this hardship, the law empowers the Commissioner to grant such an extension up to a period of three years. Whether extension be granted or not, any tax due and not paid within one year and six months after date of decedent's death will be subject to interest at the rate of 6 per cent per annum from the date when the whole tax was originally due and payable. Law. Section 406. That the tax shall be due and payable one year after the decedent's death; but in any case where the Commis- sioner finds that payment of the tax within such period would im- pose undue hardship upon the estate, he may grant an extension or extensions of time for payment not to exceed three years from the due date. The executor shall pay the tax to the collector or deputy collector, and to such portion of the tax, not paid within one year and six months after the decedent's death, interest at the rate of 6 per centum per annum from the expiration of one year after such death shall be added as part of the tax irrespective of any extension or extensions of time that may have been granted for the payment of the tax, or any portion thereof. Regulation. The tax is due and payable one year from the date of death. No discount will be allowed for -payment in advance of the due date. The collector will grant to the person paying the tax duplicate receipts, eitlier of which will be sufficient evidence of such payment, and entitle the executor to be credited with the amount by any court having jurisdiction to audit or settle his accounts. Payment will not be accepted before a return in proper form has been filed, except in cases where an extension of time to file a return has been granted but no extension of time has been granted FEDERAL ESTATE TAX 1 505 within which to pay the tax, and the executor desires to make pay- ment under section 407 of the act of an amount sufficient in the opinion of the collector to discharge the tax. Payment of the amount of tax shown to ])e due by a return accepted by the col- lector, executed in good faith and accurate so far as the executor could ascertain from his own knowledge and in the exercise of dil- igence, will be considered payment of the tax in full under section 407 of the act, subject to adjustment resulting from investigation, except as to any item which should have been but was not embodied in the return. If at the time payment is made the exact amount of the tax can not be determined, the payment of a sum of money sufficient, in the opinion of the collector, to discharge the tax will be considered payment in full, except as the tax is adjusted after investigation. (See Arts. 78, 95.) If the return filed contains a gross or fraudulent misstatement of fact, the payment of the amount of tax shown to be due thereby will not be deemed to be payment in full of the tax, since the collector's decision is based upon the assumption that the return is made in good faith. (Reg. 37, Art. 90.) Payment of tax in Liberty bonds. — In accordance with .section 14 of the Second Liljerty Bond Act, as amended by the Third Liberty Bond Act, Lilierty bonds bearing interest at a rate higher than 4 per cent may be used in payment of estate tax to the amount of par and interest accrued at the time of payment, provided such bonds have been owned continuously l)y the decedent for at least six months prior to his death. Regulation. Payment of the estate tax may be made by the delivery of Liberty Bonds or other bonds of the United States bear- ing interest at a higher rate than 4 per cent per annum, provided they were owned by the decedent for at least six months prior to the date of his death. Such bonds are received in payment to the amount of par and interest accrued at the time of the payment. .... (Reg. 37, Art. 91.) The issues of Liberty bonds available for this purpose are : First 4%'s issued May 9, 1918 First. Second 4J4's " Oct. 24, 1918 Second 4J4's " May 9, 1918 Third 4^'s " May 9, 1918 Fourth 4J4's " Oct. 24, 1918 Victory 4-}4's " May 20, 1919" °' Victory 4^ notes are acceplaljle under the Victory Liberty Loan Act of March 3, 1919. l^o6 MISCELLANEOUS TAXES The use of Liberty bonds for payments of the estate tax will prove advantageous where such bonds are selling below par. In any case in which it is proposed to pay the tax in Liberty bonds, reference should be made to Department Cir- cular 225, dated January 31, 1921, containing detailed instruc- tions which are too lengthy to reproduce here. The computa- tion of accrued interest is to be made in accordance with the tables issued with the circular referred to. Payment of tax by uncertified check. — Uncertified checks, if collectible at par, may be accepted in payment of the estate tax. The regulation is permissive, not mandatory. Regulation Collectors may accept uncertified checks in payment of the estate tax provided such checks are collectible at par — that is, for their full amount, without any deduction for exchange or other charges. If the bank on which any such check is drawn should refuse to pay it at par, the check should be returned through the depositary bank, and be treated in the same manner as a bad check. All expenses incident to the attempt to collect such a check and the return of it through the depositary bank must be paid by the drawer of the check to the bank on which it is drawn, since no deduction can be made from amounts received in payment of taxes. (See Revised Statutes, Sec. 3210.) (Reg. 37, Art. 91.) Right to reimbursement not enforcible by Treasury. — Regulation. Two rights are here given. Persons in possession of property, and paying the tax, are entitled to reimbursement, either out of the undistributed estate or by contribution from other ben- eficiaries, of any excess of the amount paid over the amount of the tax upon the particular property in their possession. The executor is also entitled to require beneficiaries under insurance policies to bear their proportion of the tax. These provisions, however, are not designed to curtail the right of the Bureau to collect the tax from any person, or out of any property, liable therefor. The Bureau may not be required to apportion the tax among the persons liable. For example, where a transfer has been made in contemplation of death, the Bureau may hold both the executor and the transferee liable with respect to the tax upon the property transferred. In such case, if the tax is paid by the executor, he may not look to the Bureau for relief by refund of part of the tax. (Reg. 37, Art. 98.) FEDERAL ESTATE TAX 1507 Liability of transferee and insurance beneficiary. — Though property may have passed into the possession of a bene- ficiary through the medium of a trust made in contempla- tion of death or to take effect at or after death of decedent, and even in the case of insurance passing under contract to a specific beneficiary,^" the property or proceeds are subject to a lien to secure payment of taxes due, to the extent of the decedent's interest therein at the time of transfer. Law. Section 409. .... If (a) the decedent makes a transfer of, or creates a trust with respect to, any property in contemplation of or intended to take effect in possession or enjoyment at or after his death (except in the case of a bona fide sale for a fair considera- tion in money or money's worth) or (b) if insurance passes under a contract executed by the decedent in favor of a specific beneficiary, and if in either case the tax in respect thereto is not paid when due, then the transferee, trustee, or beneficiary shall be personally liable for such tax, and such property, to the extent of the decedent's interest therein at the time of such transfer, or to the extent of such beneficiarjr's interest under such contract of insurance, shall be subject to a like lien equal to the amount of such tax. Any part of such property sold by such transferee or trustee to a bona fide purchaser for a fair con- sideration in money or money's worth shall be divested of the lien and a like lien shall then attach to all the property of such transferee or trustee, except any part sold to a bona fide purchaser for a fair consideration in money or money's worth. Regulation. The amounts of the lien and of the personal lia- bility of the transferee, trustee, or insurance beneficiary are limited to the amount of the tax upon the transfer of the particular property in the possession of the person liable. Where the transferee or trustee sells the property to a bona fide purchaser for a fair con- sideration in money or money's worth, the lien upon such property is divested ; but there is substituted a lien upon all of the property of the transferee or trustee, except such part as may be sold to a bona fide purchaser for a valuable consideration. (Reg. 37, Art. loi.) The question of the taxability of insurance in favor of a third party has already been discussed in this chapter.*'" The right of recovery against the beneficiary, allowed the executor under section 408, in the case of the tax on such portion of the benefits received by him in excess of $40,000, inflicts a See page 1465. See page 1466. 1508 MISCELLANEOUS TAXES direct tax on the Ijenefieiar}- which is not in keeping with the general character of the tax imposed by the law. If an indi- vidual were bequeathed $50,000. he would receive the $50,000. provided there was sufficient residual property out of v^hich the estate tax could be paid. In the case of an insurance policy in favor of a beneficiary for a like sum, the executor is given the power to collect the portion of tax applicable thereto from such beneficiary, irrespective of whether or not there is a suffi- cient residual estate to meet the demands of the tax. The rate at which a beneficiary, under these circumstances, would be taxed at the will of the executor, must necessarily be an arbi- trary one dependent entirely upon the bracket which the final amount of the decedent's net estate reaches. An individual is interested to the extent of $3,000 insurance benefit in total benefits of this nature aggregating $100,000; the net estate amounts to $3,000,000. He is taxed 15.38 per cent on $2,000. i.e., 40/60 of his benefit. The amount of his legacy would be impaired to the extent of $307.60. or more than 10 per cent. Apart from any question of the legality of taxing proceeds from third party insurance, this provision not only works a hardship and imposes a direct tax on the beneficiary, but also has a further fault; the amount by which the beneficiary's legacy is reduced depends entirely on the total net estate of the decedent. This is an obviously unfair way of basing a tax on a beneficiary who has no other interest in the size of the estate. Unpaid tax a lien on estate. — Law. Section 409. That unless the tax is sooner paid in full, it shall be a lien for ten years upon the gross estate of the decedent, except that such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration, al- lowed by any court having jurisdiction thereof, shall be divested of such lien. If the Commissioner is satisfied that the tax liability of an estate has been fully discharged or provided for, he may, under regulations prescribed by him with the approval of the Secretary, issue his certificate releasing any or all property of such estate from the lien herein imposed. FEDERAL ESTATE TAX 1 509 Regulation. This lien attaches to every part of the gross estate, whether or not the property comes into the custody or control of the executor. The only property divested of the lien is such part as is used to pay charges against the estate and ad- ministration expenses allowed by the court which administers the estate. With this exception, the lien can only be divested by pay- ment. It attaches to the extent both of the original tax shown to be due by the return and of any additional tax found to be due upon investigation. Payment of the entire tax is necessary in order to destroy the lien. (Reg. 37, Art. 99.) Release of lien. — Regulation. The statute provides that, if the Commissioner is satisfied that the tax liability of an estate has been fully discharged or provided for, he may issue his certificate releasing any or all prop- erty of the estate from the lien. The issuance of certificates is a matter resting within the discretion of the Commissioner, and cer- tificates will be issued only in case there is actual need therefor. In most cases the receipts issued by the collector constitute sufficient acquittance. The tax will be considered fully discharged for the purpose of the issuance of a certificate only when investigation has been com- pleted, and payment of the excess tax determined to be due, if any, has been made. A certificate of release of lien may be issued by the Commissioner under these circumstances upon any or all prop- erty of the estate, upon the filing by the executor of an application in duplicate on Form 791. The form must contain all the informa- tion called for. Where the tax liability has not been fully discharged, as pro- vided above, no general certificate of release will be granted, but re- leases of lien upon particular items of property will be issued upon the filing with the Commissioner of such security, if any, as he may require. Where security is required, a corporate indemnity bond must be furnished, or Liberty Bonds, or other bonds of the United States, must be deposited with the collector. In lieu of such security, the Commissioner may in any case issue the release upon payment of the estimated tax upon the transfer of the property released, com- puted at the highest rate applicable to the estate. If, upon consider- ation of the application, the Commissioner finds the issuance of the certificate to be warranted, the collector will notify the executor of the amount of the bond, as fixed by the Commissioner. (Reg. 37, Art. 100.) Penalties There is only one penalty section under this title, making- s])ccific allusion to the sections dealing- with the estate tax. I^io MISCELLANEOUS TAXES The general provision of the Revised Statutes regarding penal- ties, claims for abatement or refund, and other administrative questions are the same as appi}- to the other titles of the 192 1 law. These are dealt with in detail in the respective chapters of this book. Law. Section 410. That whoever knowingly makes any false statement in any notice or return required to be filed under this title shall be liable to a penalty of not exceeding $5,000, or imprison- ment not exceeding one year, or both. Whoever fails to comply with any duty imposed upon him by< section 404, or, having in his possession or control any record, file, or paper, containing or supposed to contain any information concern- ing the estate of the decedent, or, having in his possession or control any property comprised in the gross estate of the decedent, fails to exhibit the same upon request to the Commissioner or any col- lector or law officer of the United States, or his duly authorized deputy or agent, who desires to examine the same in the performance of his duties under this title, shall be liable to a penalty of not ex- ceeding $500, to be recovered, with costs of suit, in a civil action in the name of the United States. Classification of penalties. — Regulation. Two kinds of penalties are provided for delinquency with respect to the duties imposed by the estate tax law : (i) A specific penalty, to be recovered by suit, unless adjusted by an offer in compromise ; and (2) A penalty of a certain percentage of the tax, to be added to the tax and collected in the same manner as the tax. In any case of delinquency for which more than one penalty is provided the Government may impose either or both penalties. (Reg. 37, Art. 102.) False and fraudulent notice or return. — Regulation. Where statements in the 60-day notice or in the return are knowingly and willfully false, the person making them is subject to a penalty of $5,000, or imprisonment for one year, or both ; and, for the false return, 50 per cent may be added to the amount of the tax. (Reg. 37, Art. 103.) Failure to file notice or return. — Regulation. For failure to file the 60-day notice or the return within the time prescribed, the person in default is subject to a penalty not to exceed $500; and, for the failure to file the return, 25 per cent may be added to the amount of the tax. Where it appears, FEDERAL ESTATE TAX 151 1 however, that the failure to file the return was due to a reasonable cause and not to willful neglect, no addition is made to the tax. (Reg. 37, Art. 104.) Failure to exhibit records or property. — Regulation. Where a person in possession or control of any record, file, or paper, supposed to contain information relating to the estate, fails to exhibit the same, upon the request of the Commissioner or any collector, he is liable to a penalty not to exceed $500, to be recovered by civil action. He must comply with such a request whether or not he believes that the documents contain information relating to the estate. A person in possession of property forming part of the gross estate, and refusing to exhibit the same upon the request of the Commissioner or a collector, is subject to a similar penalty. (Reg. 37, Art. 105.) Claims for Abatement and Refund Regulation. Under these provisions of law two forms of relief are afforded the executor in cases where he believes that an excessive amount of tax has been assessed against or paid by him, either upon the basis of the return or of the investigation conducted by the Bureau. The two forms of relief are : (i) Claim for abatement on Form 47 where the tax has been assessed but not paid. (2) Claim for refund on Form 46 where the tax has been paid. (Reg. 37, Art. 106.) Form 843 will not be used instead of 46 or 47. Claim for abatement. — Regulation. Claims for the abatement of taxes or penalties il- legally assessed must be made upon Form 47, and must be sustained by the affidavits of the parties against whom the taxes were assessed or of other parties cognizant of the facts. When a tax has been assessed, the presumption is that the assessment is correct; and the burden of showing that it was improperly or illegally assessed rests upon the applicant for abatement. The affidavit must therefore contain a full and explicit statement of all the material facts re- lating to the claim in support of which they are offered and which are essential to proper consideration. Nothing should be left to inference, but all the facts relied upon should appear upon the papers themselves. The filing of a claim for the abatement of a tax al- leged to have been erroneously assessed does not necessarily operate as a suspension of the collection of the tax. The collector may col- lect the tax if he thinks it necessary, and leave the taxpayer to his remedy of a claim for refund. (Reg. 37, Art. T07.) I5I2 MISCELLANEOUS TAXES Accrual of interest as affected by abatement CLAIM. Regulation. Where a claim for abatement is rejected, the making of the apphcation does not affect the running of interest. The allowance of the claim, however, in whole or part, discharges all interest obligations upon the portion of the claim allowed. The same rules apply where, upon the request of the executor, a rein- vestigation is made of the amount of an additional tax. (Reg. 37, Art. 108.) Limitation of time to file claim for abatement of EXCESS tax. — Regulation. If it is desired to file claim for abatement of the excess amount of tax disclosed upon investigation, such claim should be filed with the collector within 30 days of receipt of the Com- missioner's letter of notification. After that period the claim will not be considered, but the tax must be paid, and adjustment made by claim for refund. (Reg. 37, Art. 109.) Power to compromise or remit penalties. — Regulation. The Commissioner, with the advice and consent of the Secretary of the Treasury, may compromise any civil or criminal case arising under the internal-revenue laws instead of com- mencing suit thereon, and with the advice and consent of the Secre- tary, and upon the recommendation of the Attorney General, may compromise any such case after suit thereon has been commenced by the United States. Accordingly, the power to compromise extends to (a) both civil and criminal cases; (b) cases whether before or after suit; and (c) both taxes and penalties. Refunds can not be made of accepted ofTers in compromise in cases where it is subse- quently ascertained that no violation of law was involved. Xo power exists, however, to compromise a tax where its existence and amount are not disputed in good faith, and the taxpayer is solvent. Where a fine, penalty, or forfeiture, not exceeding $1,000 is incurred without willful negligence or fraud, it may be remitted by the Secretary of the Treasury ; and he may remit other fines, penalties, forfeitures, and disabilities where the court has inquired into the matter and made findings. (Reg. 37, Art. 112.) Claim for refund. — Regulation. Claims for refund of assessed taxes and penalties nuist be made on Form 46. Tn this case, as in the case of claims for abatement, the burden of proof rests ui)on the claimant. All the facts FEDERAL ESTATE TAX 1513 relied upon in support of the claim should be clearly set forth under oath. With the claim should be presented, in addition to the evi- dence : (i) Collector's receipt evidencing payment of tax. (2) W^here the claim is made by the executor or administrator, a certified copy of the letters testamentary or of administration, and a certificate that the appointment remains in full force and effect. (3) Where the executor or administrator has been discharged, a certified copy of the decree discharging him, and evidence as to the persons entitled to receive the refund, setting forth their names. Where the claim' is made on behalf of a number of persons, there should be furnished a power of attorney duly executed by all the beneficiaries showing the claimant's authority to act in their behalf. (Reg. 37, Art. no.) Payment of claims. — Regulation. Warrants in payment of claims allowed will be drawn in the names of the parties entitled to the money, and will, unless otherwise directed, be sent by the Treasurer of the United States directly to the proper parties, or their duly authorized at- torneys or agents; but if the claimants are indebted to the United States for taxes such taxes must be paid before the warrants are delivered. (Reg. 37, Art. in.) Refund of tax arising from change in law. — Due to the changes in the deductibility of certain items made by sec- tion 403 (a-2-3) and (b-2-3), a refund of tax is possible in certain cases. Law. Section 403. (b) (3) .... In the case of any estate in respect to which the tax has been paid, if necessary to allow the benefit of the deduction under paragraphs (2) and (3) of subdivision (a) or (b) the tax shall be redetermined and any excess of tax paid shall be refunded to the executor. The paragraphs referred to in the foregoing have reference to the deductibility from the value of the gross estate in the case of (i) residents and non-residents, of (2) the value of property forming part of the gross estate of any person who died within five years of decedent, and (3) the amount of bequests, legacies, etc. The deductions may be made in the case of the estate of any decedents who have died since Deceml)er 31, 191 7. Janu- I5I4 MISCELLANEOUS TAXES ary i, 1918, is the effective date of the law of 19 18, which first provides for the deduction of property coming under the specific headings enumerated in section 403 of the 1921 law. Personal liability of executor. — Law. Revised Statutes, Sec. 3467 (Comp. Sts., 1916, Sec. 6373.) Every executor, administrator, or assignee, or other person, who pays any debts due by the person or estate for whom or for which he acts, before he satisfies and pays the debts due to the United States from such person or estate, shall become answerable in his own person and estate for the debts so due to the United States, or for so much thereof as may remain due and unpaid. But see section 407 of the present law, discussed on page 1522. Miscellaneous Provisions Examination of records and taking of testimony. — Regulations. In order to ascertain the correctness of a return, or to make a return where none has been made, the Commissioner has power to require the attendance, and to take the testimony, of the person rendering the return, or any officer or employee of such person, or any other person having knowledge in the premises. Such person may be required to produce any relevant book, paper or other record. This power may be exercised by any revenue agent or in- spector designated for the purpose. (Reg. 37, Art. 114.) Where any person is summoned to appear and testify, or to produce books, papers, or other data, the District Court of the United States for the district in which such person resides has power to compel the giving of the testimony, or the production of the books, papers, or data, and to issue any appropriate process, writ, or order. (Reg. 37, Art. 115.) Executor's duty to keep records. — Regulation. It is the duty of the executor to keep such records as the Commissioner may require. Executors are required to keep complete and detailed records of the affairs of the estate, sufficient to enable the Bureau to determine accurately the amount of the tax Hability. (Reg. 37, Art. 117.) Executor's duty to render statements. — Regulation. It is also the duty of the executor not only to make the formal return, but also to render any other sworn statement FEDERAL ESTATE TAX 1515 which the Commissioner may require for the purpose of determining whether a tax liabiHty exists. (Reg. zy, Art. 118.) Scope of repeal. — Law. Section 1400. (a) That the following parts of the Revenue Act of 1918 are repealed .... to take effect .... Title IV (called "Estate Tax") ; on the passage of this act (b) The parts of the Revenue Act of 1918 w^hich are repealed by this Act shall (unless otherwise specifically provided in this Act) re- main in force for the assessment and collection of all taxes which have accrued under the Revenue Act of 1918 at the time such parts cease to be in effect, and for the imposition and collection of all penalties or forfeitures which have accrued or may accrue in relation to any such taxes. In the case of any tax imposed by any part of the Rev- enue Act of 1918 repealed by this Act, if there is a tax imposed by this Act in lieu thereof, the provision imposing such tax shall remain in force until the corresponding tax under this Act takes effect under the provisions of this Act. The unexpended balance of any appro- priation heretofore made and now available for the administration of any such part of the Revenue Act of 1918 shall be available for the administration of this Act or the corresponding provision thereof. Regulation. The Revenue Act of 1918 retains in force all taxes or penalties which had accrued prior to February 25, 1919. The procedure, however, with reference to the assessment and collection of all taxes, whenever they accrued, is governed by the statute from the time when it went into effect on February 25, 1919. (Reg. 37, Art. 119.) Interest under Revenue Act of 1916. — Regulation. The Revenue Act of 1916 provides that, where the tax is not paid within one year and 90 days from the date of the decedent's death, interest shall be added at the rate of ten per centum per annum from the date of death. Where the specified period had elapsed prior to February 25, 1919, this penalty has been incurred, and is not affected by the passage of the Revenue Act of 1918. Where, however, the period of one year and 90 days had not elapsed prior to February 25, 1919, the Revenue Act of 1918 extends the time of payment to one year and 180 days from the date of death. These rules operate as follows : Example : The year and 90 days, in a given case, expired on Feb- ruary 15, 1919, or ten days before the effective date of the Revenue Act of 1918. In this case interest at the rate of ten per centum per annum should be computed for the period of one year and 100 days from the date of death, or until the Revenue Act of 1918 took effect. 1516 MISCELLANEOUS TAXES If the tax is thereafter paid within the time prescribed by the new act (which allows an additional 80 days), no further interest ac- crues. If it is not paid within that period, additional interest accrues at the rate of six per cent from February 25, 1919, when the Revenue Act of 1918 took effect. Example: On February 25, 1919, in a given case, only one year and 80 days from the date of the decedent's death had elapsed. No penalty having been incurred, the estate has 100 additional days in which to make payment, viz.. the year and 180 days prescribed by the Revenue Act of 1918. If, however, the tax is not paid within this period, interest accrues at the rate, of six per cent from the expiration of one year from the decedent's death, as provided by the Revenue Act of 1918 (see Art. 94). While no interest may be added to the tax unless payment thereof has not been made within one year and 180 days after decedent's death, the tax itself is due and must be paid within one year after the decedent's death unless an extension of time for the payment thereof has been granted by the Commissioner. (Reg. 37, Art. 120.) Repeal of previous regulations. — Regulation. The foregoing regulations are prescribed in pur- suance of the authority conferred by the statute, and all rulings inconsistent with them are hereby revoked. (Reg. 37, Art. 121.) Proceedings in United States Court for China. — Law. Section 411. (a) That the term "resident" as used in this title includes a citizen of the United States with respect to whose property any probate or administration proceedings are had in the United States Court for China. Where no part of the gross estate of such decedent is situated in the United States at the time of his death, the total amount of tax due under this title shall be paid to or collected by the clerk of such court, but where any part of the gross estate of such decedent is situated in the United States at the time of his death, the tax due under this title shall be paid to or collected by the collector of the district in which is situated the part of the gross estate in the United States, or, if such part is situated in more than one district, then the collector of such district as may be designated by the Commissioner. (b) For the purpose of this section the clerk of the United States Court for China shall be a collector for the territorial jurisdiction of such court, and taxes shall be collected by and paid to him in the same manner and subject to the same provisions of law, including pen- alties, as the taxes collected by and paid to a collector in the United States. (c) The proviso in the Act entitled, "An Act making appropriation I FEDERAL ESTATE TAX 1517 for the Diplomatic and Consular Service for the fiscal year ending June 30, 1921," approved June 4, 1920, which reads as follows: Pro- vided. That in probate and administration proceedings there shall be collected by said clerk, before entering the order of final distribution, to be paid into the Treasury of the United States, the same inheritance taxes from time to time collected under the laws enacted by the Con- gress of the United States from the estates of decedents residing within the territorial jurisdiction of the United States," is hereby repealed. Apart from the particular application of the term ''resi- dent" indicated by the above section, there is the ordinary meaning of the term as generally used in the law. The ques- tion of citizenship does not enter into the matter at all; the two types of taxpayers involved being resident and non-resi- dent. The interpretation of what constitutes a resident is given in the following : Regulation. The following rules of evidence shall govern in determining whether or not an alien within the United States has acquired residence therein within the meaning of the Revenue Act. An alien, by reason of his alienage, is presumed to be a nonresident alien. ''I Such presumption may be overthrown (i) in the case of an alien who presents himself for determination of tax liability prior to departure for his native country, by (a) proof that the alien, at least six months prior to the date he so presents himself, has filed a declara- tion of his intention to become a citizen of the United States under the naturalization laws, (b) proof that the alien, at least six months prior to the date he so presents himself, has filed Form 1078 or its equivalent, or (c) proof of acts and statements of the alien showing a definite intention to acquire residence in the United States or show- ing that his stay in the United States had been of such an extended nature as to constitute him a resident; (2) in other cases by (a) proof that the alien has filed a declaration of his intention to become a citizen of the United States under the naturalization laws, (b) proof that the alien has filed Form 1078 or its equivalent, or (c) proof of acts and statements of an alien showing a definite intention to ac- quire residence in the United States or showing that his stay in the United States has been of such an extended nature as to constitute him a resident.'^- .... (Art. 312.) The definition contained in the regulations covering this title is not as fully explanatory as is that offered in the fore- going. The latter are not in conflict therewith, but form a '" This presumption rever.ses that of Reg. 45, Art. 312. ""'These factors were previously to be found in Reg. 45, Art. 313. i5i8 MISCELLANEOUS TAXES detailed interpretation of what should actually constitute a resi- dent under this title. The particular definition included in section 411 having regard to citizens of the United States coming under the juris- diction of the extra-territorial court in China, is necessitated in order to carry out the provision of the act alluded to in (c) of that section. Who shall pay the tax. — The tax is paid by the executor. The mode of payment has already been fully discussed in this chapter, but a new provision in the 192 1 law whereby the executor can be freed from his responsibility under certain circumstances *'* calls for further comment. This relief pro- vision is more apparent than real. Under the rule laid down in the statute he cannot get the promised relief until the Com- missioner has notified him of the amount of the tax, and such tax has been paid. Further, the Commissioner is permitted to take one year in which to furnish this information. In other words, the executor has to await the examination of his original return, the reassessment, if any, arising out of such examination, and the payment of the amount of any additional tax, before he can obtain his release, all of which proceedings may occupy a year to carry out. By the time he is relieved of his liability his executive duties, in the majority of instances, would have terminated and the liability for any further tax thereafter found to be due would be held against the bene- ficiaries, to the extent of their interests in the original estate. Regulation. The statute provides that the executor shall pay the tax.*^^ This duty applies to the tax upon the transfer of the entire estate, including property which will not come into the possession of the executor or administrator. As to the personal liability of the executor, see Article 113. (Reg. ^,7, Art. 92.) Extension of time for payment. — Regulation. In any case where the Commissioner finds that payment of the tax within one year after the decedent's death would "' Law, section 407, see page 1521. ^^ Law, section 407. FEDERAL ESTATE TAX 1519 impose undue hardship upon the estate, extensions of time will be granted for the payment of the tax for a period not to exceed in all three years from the due date. Extensions of time for tax pay- ment will be granted only in exceptional cases, where it is evident that the payment of the tax within the statutory period would cause the estate serious financial loss. No extension shall be for more than one year, and a substantial payment shall be made before each extension. Application for extension of time for payment should be filed with the collector, and should contain a full statement of the facts upon which the application is based. The collector will refer the application to the Commissioner, with suitable recommendations. The extension of time for the payment of the tax should not be confused with extension of time for filing the return. An extension of time to pay the tax does not relieve from the duty of filing the return within one year from the date of death. An extension of time for tax payment will not operate to prevent the accrual of interest upon the tax. (Reg. 37, Art. 93.) The provision in article 93 regarding extension of time for payment has been uniformly interpreted to require the pay- ment of at least 25 per cent of the tax on the due date. The tax is due and payable one year after decedent's death (section 406). Under the foregoing section, proceedings for the collection of the amount due may be instituted directly thereafter. The same section in the 1918 law allowed a period of grace for payment to the extent of 180 days after the due date. In one case it was desired to take advantage of this sec- tion and the collector, ignoring section 408 of the 19 18 law and justifying his action under Revised Statutes, section 3157, per- mitting distraint for recovery of taxes ten days after notice and demand, threatened immediately to distrain unless tax was paid in full. The 180-day period did not elapse for a further four months. The collector's right to collect under distraint was denied him."^ Out of this case has probably arisen the change in the law omitting any reference to 180 days and making the tax due and payable date one year after de- cedent's death. '"'■PoIk ct al. V. Pane U. S. Dist. Court, Rhode Tslaiid, Advance Cpin- ion.s, 276 Fed. 128, November 17, 1921. I520 MISCELLANEOUS TAXES Adjustment of tax after investigation. — Regulation. An investigation of every return for estate tax will be made by an internal-revenue officer, and the tax liability of the estate w^ill be finally determined by the Commissioner upon the basis of such investigation. If at the time the Commissioner's de- termination is made the tax has been paid upon the basis of the return, an adjustment will be made of the amount of tax. If the amount of tax already paid exceeds the amount of tax as finally determined, the Commissioner will refund such excess payment to the executor. If the amount of tax as finally determined exceeds the amount of tax already paid, the collector will notify the executor of the amount of the unpaid balance of the tax and will demand pay- ment thereof. Payment should be made by the executor immediately upon the receipt of such notification. Where the investigation of the return shows that no further tax is due, the executor will be noti- fied to this effect. Until the receipt of such notification, he should re- serve a sufficient portion of the estate to satisfy any excess tax. (Reg. 37, Art. 95.) While the foregoing regulation demands immediate pay- ment on notification of the unpaid balance, the law imposes interest on such balance only after a lapse of thirty days sub- sequent to notification. A month's credit is implied thereby. Interest ox additional tax. — Regulation. If an unpaid balance of tax is found to be due by the Commissioner after investigation, the statute provides that in- terest shall be added to the amount of such excess part of the tax at the rate of ten per centum from the expiration of 30 days after notification to the executor, provided the tax is not paid within such 30-day period. This interest will not begin to accrue, however, until the expiration of one year and 180 days after the decedent's death. (See Art. 94.) If a return is filed containing a gross or fraudulent misstatement of fact, and payment made of the tax shown to be due thereby, such payment will not be considered payment in full within the meaning of the statute. (See Art. 90.) Consequently, in such a case, interest upon the unpaid balance of tax, determined after investigation, will be added at the rate of six per centum per annum from the expiration of one year after the decedent's death. (Reg. 37^ ^^^- 9^-) Interest on unpaid tax. — Regulation. The statute provides that, if the tax is not paid within one vear and 180 davs after the decedent's death, interest at I FEDERAL ESTATE TAX 1521 six per centum per annum from the expiration of one year after the decedent's death shall be added as part of the tax. This provision applies to the original amount of tax shown to be due by the return accepted by the collector. It applies in all cases in which penalties have not accrued under the Revenue Act of 1916. (See Art. 120.) (Reg. 37, Art. 94.) Interest on additional assessment. — Law. Section 407. That where the amount of tax shown upon a return made in good faith has been fully paid, or time for payment has been extended, as provided in section 406, beyond one year and six months after the decedent's death, and an additional amount of tax is, after the expiration of such period of one year and six months, found to be due, then such additional amount shall be paid upon notice and demand by the collector, and if it remains unpaid for one month after such notice and demand there shall be added as part of the tax interest on such additional amount at the rate of 10 per centum per annum from the expiration of such period until paid, and such addi- tional tax and interest shall, until paid, be and remain a lien upon the entire gross estate Collector must issue duplicate receipts. — Law. Section 407 The collector shall grant to the person paying the tax duplicate receipts, either of which shall be sufficient evidence of such payment, and shall entitle the executor to be credited and allowed the amount thereof by any court having jurisdiction to audit or settle his accounts Commissioner to determine tax within one year. — Law. Section 407. .... If the executor files a complete re- turn and makes written application to the Commissioner for determin- ation of the amount of the tax and discharge from personal liability therefor, the Commissioner, as soon as possible and in any event within one year after receipt of such application, shall notify the executor of the amount of the tax, and upon payment thereof the ex- ecutor shall be discharged from personal liability for any additional tax thereafter found to be due, and shall be entitled to receive a re- ceipt or writing showing such discharge: rmvldcd. nowcver, That such discharge shall not operate to release the gross estate from the lien of any additional tax that may thereafter be found to be due while the title to such gross estate remains in the heirs, devisees, or distrib- utees thereof; but no part of such gross estate shall be subject to such lien or to any claim or demand for any such tax if the title thereto has passed to a bona fide purchaser for value. 1522 MISCELLANEOUS TAXES The paragraph in section 407 which permits an executor, by fihng written apphcation, to obtain his discharge from per- sonal HabiHty " for any subsequent assessment is a new pro- vision. Under the 19 18 law, executors have been held respon- sible for estate taxes imposed long after the estates themselves have been closed. Collection of tax. — Law. Section 408. That if the tax herein imposed is not paid on or before the due date thereof the collector shall, upon instruction from the Commissioner proceed to collect the tax under the provisions of general law, or commence appropriate proceedings in any court of the United States, in the name of the United States, to subject the property of the decedent to be sold under the judgment or decree of the court. From the proceeds of such sale the amount of the tax, together with the costs and expenses of every description to be al- lowed by the court, shall be first paid, and the balance shall be deposited according to the order of the court, to be paid under its direction to the person entitled thereto The foregoing section omits a provision which appeared in the 19 18 Act restraining the collector from enforcing pay- ment should there be reasonable cause for further delay. Since the procedure is now dictated by instructions from the Com- missioner, appeal to him is required if delay is necessary (section 406). Regulations. The remedy by action, here provided for, is not exclusive. For other available remedies for the collection of the tax, see Article 116. (Reg. 37, Art. 97.) The provision of the statute quoted above applies to the estate tax law ; and three remedies are thus provided for the collection of the tax : (i) The collector may issue warrant of distraint authorizing the seizure and sale of any or all of the assets of the estate. (See R. S. Sees. 3187 et seq.; Comp. Sts., 1916, Sec. 5909 et seq.) (2) The collector may commence in any court of the United States appropriate proceedings, in the name of the United States to subject the property of the decedent to sale under the judgment or decree of the court. (See Sec. 408 ; Art. 97.) (3) The personal liability of the executor, of the transferee or Rev. Stat., .section 3467. FEDERAL ESTATE TAX 1523 trustee of property transferred in contemplation of death, and of the beneficiary of taxable life insurance (See Art. loi) may be en- forced by any appropriate action. (Reg-. 37, Art. 116.) Reimbursement. — Law. Section 408 If the tax or any part thereof is paid by, or collected out of that part of the estate passing to or in the possession of, any person other than the executor in his capacity as such, such person shall be entitled to reimbursement out of any part of the estate still undistributed or by a just and equitable contribution by the persons whose interest in the estate of the decedent would have been reduced if the tax had been paid before the distribution of the estate or whose interest is subject to equal or prior liability for the pay- ment of taxes, debts, or other charges against the estate, it being the purpose and intent of this title that so far as is practicable and unless otherwise directed by the will of the decedent the tax shall be paid out of the estate before its distribution. If any part of the gross estate consists of proceeds of policies of insurance upon the life of the decedent receivable by a beneficiary other than the executor, the ex- ecutor shall be entitled to recover from such beneficiary such portion of the total tax paid as the proceeds, in excess of $40,000, of such policies bear to the net estate. If there is more than one such bene- ficiary the executor shall be entitled to recover from such beneficiaries in the same ratio. » CHAPTER XLI FEDERAL CAPITAL STOCK (EXCISE) TAX As a means of raising additional revenue, Congress in 1916 imposed an excise tax, effective January i, 1917,^ on corpora- tions for the privilege of doing business. Since that date many imsuccessful attempts have been made to repeal or change the law.^ The net result of the changes from 1916 to January I, 1922, is an increase in the rate and a reduction in the exemp- tion. The 1 92 1 law (which, as to the capital stock section^ does not become effective until July i, 1922) re-enacted the tax in substantially the same form as it appeared in the 1918 law, the principal change being that insurance companies sub- ject to tax imposed by section 243 or section 246 of the 192 1 law are exempt from the capital stock tax.^ The rate now in force for domestic corporations is $1° for each full $1,000 of the average fair value of the capital stock for the year preceding the taxable year in excess of the ex- emption of $5,000." The rate is comparatively low and the exemption such that the total tax is not excessive. In his report for 1919 the Commissioner states: "The early regulations touching valuations have been radically elab- orated and modified until under present approved methods it 'Title 1\" of the Revenue Act of September 8, 1916 (Public No. 271, 64th Congress). ' In considering the Revenue Act of 1921 the Senate Finance Committee omitted the tax. " Section 1000. * [Former Procedure] Section 1000 (c) of 1918 law read "The taxes imposed by this section shall apply to mutual insurance companies." Stock companies were taxable as ordinary corporations (Reg. 50, Art. 22). Or- ganizations doing business on reciprocal or inter-indemnity plan were sub- ject to tax. (C. B. 4. page 272; L. O. 1003.) ^ The rate under the 1916 law was 50 cents for each $1,000, and the exemption was $99,000. The rate was increased to $1 and the exemption reduced to $5,000 by the 1918 law. The provisions of the 1918 law (passed February 24, 1919) were made retroactive to July i, 1918. ' Foreign corporations, however, are not permitted anv deduction. 1524 FEDERAL CAPITAL STOCK (EXCISE) TAX 1525 has become necessary to individualize each case, considering- all elements and factors which throw light on values and harmonizing them so far as possible in the ultimate values found." This is an admission that the earlier regulations were wrong. The early administration of the law did not reflect credit on the Treasury. Originally an attempt was made to divide corporations into a few classes and value the capital stock of all companies in each on practically the same basis. During recent years, however, there has been a continuous improvement in administration. Theoretically, the tax is on the privilege of doing business in a corporate capacity, but it is difficult to assess a tax on the ''fair" value of capital stock without considering past earn- ings, so that in this respect the tax amounts to a duplication of the income tax.'^ When the law was enacted all the arguments as to the difficulty of administering a property tax were ignored. The injustice of placing a burden upon an unprofitable business was brushed aside. The tax does not apply to individuals and partnerships. It is somewhat similar to various state laws imposing what are known as taxes on "corporate excess." Tax commissions have frequently commented on this system of taxation as having caused much difficulty, and litigation has been frequent. Apparent market value is never to be taken as conclusive, because the courts will permit a taxpayer to point out any unfairness in an assessment based thereon. Earning l^ower is never to be taken as the sole factor of valuation be- cause earnings fluctuate too greatly. All the corporations (educational, fraternal, etc.) exempt under the income tax law are also exempt from this tax. In addition, many corporations organized for profit but not ' This condition is to some extent overcome by reason of the fact that the capital stock tax is an allowable deduction from gross income in deter- mining the net income subject to the income and excess profits taxes. With the repeal of the high excess profits ta.x rates the relative burden of the capital stock tax increases. 1526 MISCELLANEOUS TAXES "doing business," as interpreted by the Supreme Court of the United States, are also exempt. This apphes to lessor, inactive and similar corporations. The tax is due in advance and the next return will be due in July, 1922. The law [section 1000 (a-i)] provides that the computation of the tax of a domestic corporation shall be based on "the fair average value of its capital stock for the preceding year." Therefore, the return due in July, 1922, will be based on the average value, etc., during the year July I, 1921. to June 30, 1922 — the government's fiscal year.* The Treasury has issued regulations^ which are reproduced .in the following pages, governing the preparation of returns, etc. The law is wisely silent as to many details which usually encumber tax bills. In his report for 1920 the Commissioner states that — Owing to the retroactive feature of the Revenue Act of 19 18, which was passed February 24, 19 19, changing the rate and lowering the exemption, the work of the division was greatly increased; but * The following provision is made on form 707 for a corporation's fiscal year which ends at some date other than June 30: "In item 7 on page I hereof the taxpayer will show the closing date of its fiscal year ended between July I, 1921, and June 30. 1922, if other than June 30, and the information furnished under exhibits A, B and C will be as of the year or years ended on such date, which should be used annually." ' [Former Procedure] Regulations 38 were issued October 19, 1916. Regulations 38 (revised) were issued August 9. 1918. Regulations 50 were issued April 29, 1919. Regulations 50 (revised) were issued June 21, 1920, and are still in effect. In the opinion of the author the require- ments of the 1916 regulations were reasonable but T. D. 2503 (June 25. 1917) imposed new methods of ascertaining the "fair value" of the cor- porate stock which were fallacious, not in accord with the law and unen- forceable. As the valuation of capital stock is the basis for the assessment of the tax, the importance of a correct formula for calculating "fair value" should not be underestimated. Detailed criticism of the regula- tions will be found in Income Tax Procedure, 1918, pages 628 to 677. Regulations 38 (revised, 1918) and Regulations 50 (April, 1919) did not continue the former objectionable instructions. Therefore, it is con- sidered unnecessary to repeat in this book most of the comments on the original regulations. But taxpayers whose returns for the fiscal year ended June 30, 1918, and earlier periods have not been examined or finally settled should refer to the 1918 edition of this manual. From information which has come to the author it seems that very many close corporations were over-assessed, but that practically no corporation whose stock was listed on an exchange was so treated. The corporations which were over-assessed should apply for a refund. FEDERAL CAPITAL STOCK (EXCISE) TAX 1527 the audit of returns for the taxable period ended June 30, 1919, was practically completed by January i, 1920, except in the case of cor- porations delinquent in filing returns, or cases reopened by reason of additional information contained in subsequent returns or obtained by field investigation. The audit of the returns for the taxable period ended June 30, 1920, was begun immediately, and it will be completed by the time the returns filed for the coming year are arranged for audit. Difficulty has been encountered in procuring and retaining capable examiners, owing to the qualifications required. This division has evolved into a staff of valuation experts on questions of estimating the worth of collateral securities and all forms of property. It requires men of sound judgment, a general knowledge of business conditions, and some knowledge of law, accounting practice, and financing procedure. During the year the number of employees was reduced from 148 to an average working force of 115, and at the same time the work has been kept on a current basis. A revision of capital stock tax regulations has been accomplished with a view to putting into taxpayers' hands complete information for the preparation of returns. The modifications in the regulations are not extensive, but changes of importance have been made in the provisions relative to tentative returns ; to cases where a change in number of shares has occurred in the outstanding stock of a cor- poration during the year immediately preceding the taxable period; to questions of parent and subsidiary corporations or affiliated cor- porations; and to questions of classifying corporations exempt on account of personal service. Returns are checked with those of previous years to detect in- consistencies. Periodical conferences are held between group heads and administrative officers of the division, in order that the examining force may receive the benefit of conclusions reached and the inter- pretations placed upon the law and regulations, from the considera- tion of intricate cases actually before the division for determination. And in his report for 1921 the Commissioner states : "Dur- ing the year this division has evolved a staff of valuation ex- perts on questions pertinent to an equitable administration 01 the capital-stock tax." For convenience the text of the 192 1 law and such part of Regulations 50 (revised June, 1920) applicaljle thereto will be reproduced herein. Regulations 50 (revised June, 1920) interpret the 19 18 law. Regulations under the 192 1 law have not yet been issued. The capital stock tax section of the 192 1 law becomes effec- 1528 MISCELLANEOUS TAXES tive Inly i, 192-'. The 1918 law continues in effect nntil the 1 92 1 law becomes effective/" Domestic; Corporations Effective date. — Regulation Special taxes of which this is one, become due on the first day of July'^ in each year, or on commencing any trade or business on which such tax is imposed. In the former case the tax is for one year, and in the latter case it is for the period from the first day of the month in which the liability to the special tax is incurred to the first day of July following Xo portion of the tax is refundable where a corporation ceases to do business during the year. (Reg. 50, revised. Art. i.) The foregoing" regulation is based on section 3237, Revised Statutes,^" which applies to the assessment of special taxes. As to corporations organized and l)eginning corporate activities after July i in any year, however, section 3237 is superseded by the act imposing the federal capital stock tax. Section 1 000 (b) of the law, quoted on page 1535, specifically pro- vides that the tax "shall not apply in any year to any corpora- tion which was not engaged in business .... during the preceding year ending June 30." This limitation is recognized in article 26 of Regulations 50, which will be foimd on page 1536. Scope of tax. — Law. Section 1000. (a) .... (i) Every domestic corpora- tion .... '" Section 1400 of 1921 law. " Corporations whose fiscal years end at dates other than June 30 may submit figures based on their own fiscal years. (Instructions 2, form 707). '"Law. "All special taxes shall become due on the ist day of July, 1891, and on the ist day of July in each year thereafter, or on commencing any trade or business on which such tax is imposed. In the former case the tax shall be reckoned for one year, and in the latter case it shall be reckoned proportionately from the ist day of the month in which the liability to a special tax commenced to the ist day of July following." [Section 3237, Revised Statutes, as amended by Section 53 of the act of October i, 1890 (26 Stats., 567)-] FEDERAL CAPITAL STOCK (EXCISE) TAX 1529 Definition of domestic corporations. — Regulations. A domestic corporation is a corporation created or organized in the United States, which includes the States, Terri- tories of Alaska and Hawaii, and the District of Columbia. (Reg. 50, revised, Art. 8.) The term "corporation" includes associations, joint-stock com- panies, whether created by statute or by contract, and insurance com- panies, but not partnerships, properly so called, and whether or not organized for profit or having a capital stock represented by shares. (Reg. 50, revised. Art. 2.) Personal service corporations.^' — Section 1000 of the 19 18 law imposes a capital stock tax upon all domestic corporations except those enumerated in section 231 of that act. Among the corporations thus exempted [subdivision (14)] are per- sonal service corporations. Section 1000 of the 192 1 law pro- vides that on and after July i, 1922, "in lieu of the tax im- posed by Section 1000 of the Revenue Act of 1918," every domestic corporation, except those enumerated in section 231 of that law, shall pay a capital stock tax. Section 231, sub- division (14), exempts personal service corporations with this limitation : "This subdivision shall not be in effect after December 31, 1921." Both laws specifically provide that the taxes imposed shall not apply to any corporation which was ''[Former Procedure] Under the 1918 law [section 231 (14)] per- sonal service corporations were exempt because they were taxed as part- nerships. Insurance companies were subject to tax under the 1918 law (including tax for the year beginning July i, 1021) but not under the 1921 law. The capital stock tax section of the 1921 law is not effective, how- ever, until July i. 1922. To be exempt from the capital stock tax under the 1918 law, personal service corporations were required to be granted full classification as such by the Income Tax Unit for the purpose of the income and profits taxes. Art. 28, Reg. 50 (revised), required that returns be filed and fair value of capital stock shown. Tax was not to I)e computed, however, and in lieu thereof the words "exemption claimed" inserted. A full statement of the reasons for claiming exemption was required to be attached to the return. Regulation. " .... To be exempt from capital stock tax, corpora- tions must have previously been granted full classification as personal ser- vice corpcjrations for llie purpose of Federal income and profits taxes under K'e.i^nlations 45, revised." (Keg. 50, revised, Art. 27.) I530 MISCELLANEOUS TAXES not engaged in business during the preceding year ending June 30. It will be noted that the capital stock tax imposed by the Act of 192 1 takes effect "on and after July i, 1922,'' and is "in lieu of the tax imposed by Section 1000 of the Rev- enue Act of 19 18." It would seem that by virtue of section 1400 (b) of the 1 92 1 law the capital stock provisions of the 1918 law remain in effect until July i, 1922, except that after December 31, 1921, personal service corporations are no longer exempt from the tax imposed thereby. It may readily be, therefore, that Congress intended that a tax should be imposed, under the 19 18 law, upon personal service corpora- tions from and after December 31, 192 1. The statute, however, affords no justification for the impo- sition thereof. Presumably, as the tax imposed by both the 19 18 and 1 92 1 laws is an excise tax, it was for the privilege of doing business for the whole year or such part thereof as any corporation might see fit to remain in business. The 192 1 law sets up no standard by which it is possible to determine what proportion of the tax shall be imposed for the privilege of doing business from December 31, 1921, until July i, 1922. There is nothing in the law to show that Congress intended to make the tax retroactive so as to cover the period from July I, 192 1, to December 31, 1921. Indeed, by failing to subject personal service corporations to the tax in question as soon as the law should take effect, demonstrates a contrary intent. Without express authority from Congress, it would certainly be improper to impose a tax equal to that which is exacted from corporations for the privilege of doing business for a whole year. On the other hand, to attempt to apportion the tax would be illegal because there is no statutory authority for doing so. Taxes .cannot be imposed or exacted except by express legisla- tive authority. There thus appears to be a lapse in the law (a situation of frequent occurrence), and bv reason thereof no tax can be imposed under the 1918 law on personal service corporations, nor under the 192 1 law until July i, 1922. Sec- tion 3237 of the Revised Statutes is not applicalile because FEDERAL CAPITAL STOCK (EXCISE) TAX 1531 the provisions thereof which proxidc lor tlie reckoning of taxes proportionately apply only to a trade or business which was commenced after the first of Jul}' in any given year. Associations and limited partnerships which are included. Regulations. Associations and joint-stock companies include organizations, by whatever name known, '^ which act or do business in an organized capacity, whether created under and pursuant to State laws, agreements, declarations of trust, or otherwise, the net income of which, if any, is distributable among the members or share- holders on the basis of the capital stock held by each, or, where there is no capital stock, on the basis of the proportionate share of capital which each has or has invested in the business or property of the organization An organization, the membership interests in which are transferable without the consent of all of the members, however the transfer may be otherwise restricted, and the business of which is conducted by trustees or directors and officers without the active participation of all the members as such, is an association. (Reg. 50, revised, Art. 3.) The test of liability in all cases involving trusts of the Massa- chusetts type is whether the cestuis que trustent have by the terms of the trust agreement a voice in the management or control of the trust. Where the trustees are in complete control of the business, the beneficiaries having no control except the right of filling vacan- cies among the trustees or of consenting to a modification of the terms of the trust or of dissolving the trust, no association exists. If, however, the cestuis que trustent have a voice in the control or management of the business of the trust, whether through the right to elect trustees periodically or to remove the trustees or to restrict the trustees as to the management of the trust or otherwise, the trust is an association within the meaning of the statute. Where the trustees hold in their own right a sufficient number of the cer- tificates of beneficial interest to constitute control as between the beneficiaries, the trust will be held to be an association regardless of the powers conferred upon the trustee by the instrument creating the trust. (Reg. 50, revised. Art. 7.) A partnership bank, conducted like a corporation and so organ- '* "Massachusetts trusts" were held (o be exempt from the excise tax in Eliot v. Freeman, el al. [220 U. S. 178, 55 L. Ed. 424, 31 Sup. Ct. 360, (T. D. 1686)], ami corporations in hands of a receiver are exempt. (T. D. 2424.) In Crocker v. Malley (249 U. S. 223, 63 L. Ed. 573. 39 Sup. Ct. 270, 2 A. L. R. looi) certain types of Massachusetts trusts were held not to be "associations" of the corporate type. 1532 MISCELLANEOUS TAXES ♦ ized that the interests of its members may be transferred without the consent of the other members, is a joint-stock company or asso- ciation within the meaning of the statute. A partnership bank, the interests of whose members can not be so transferred, is a partner- ship. (Reg. 50, revised, Art. 6.) Partnerships with limited liabiHty or partnership associations au- thorized by the statutes of Pennsylvania and a few other States are only nominally partnerships. Such so-called limited partnerships, offering opportunity for limiting the liability of all the members, providing for the transferability of partnership shares, and capable of holding real estate and bringing suit in the common name, are more truly corporations than partnerships, and are taxable as cor- porations. In all doubtful cases limited partnerships will be treated as corporations unless they submit satisfactory proof that they are not in effect so organized. Michigan partnership associations are corporations. The liability of Virginia limited partnerships is deter- mined in each case from a consideration of the certificate of part- nership and all pertinent facts relative thereto. (Reg. 50, revised, Art. 4.) Since the tax is imposed upon the privilege of doing busi- ness as a corporation, the foregoing article appears to be too sweeping in its terms. The courts may be expected to interpret the law so as to exclude rather than include doubtful cases. ^^ Article 1506 of Regulations 45, issued in regard to income and profits taxes, originally provided that ''Michigan and \^ir- ginia partnership associations are corporations" ; but this arti- cle was amended by T. D. 2943 (November 6, 19 19) to ex- cltide Virginia partnership associations. See further articles 1505 and 1506 of Regulations 62. Limited partnerships which are not included. — Regulation. So-called limited partnerships of the type author- ized by the statutes of New York and most of the States are partner- ships and not corporations within the meaning of the statute. Such limited partnerships which can not limit the liability of the general partners, although the special partners enjoy limited liability so long as they observe the statutory conditions, which are dissolved by the death or transfer of the interest of a general partner, and which can not hold real estate or sue in the partnership name, are so '° Crocker v. Mallry. 24Q U. S. 222. 63 L. Kd. S73' 39 Sup. C"t. 270. 2 A. L. R. looi. FEDERAL CAPITAL STOCK (EXCISE) TAX 1533 like common law partnerships Ihat they can not be differentiated there- from for tax purposes. Miclugan and Illinois limited partnerships are partnerships. California special partnerships are partnerships. (Reg. 50, revised, Art. 5.) Corporation Must be "Doing Business'* to be Taxed Law. Section 1000. (a) .... (i) ... . shall pay annually a special excise tax with respect to carrying on or doing busi- ness, .... Regulation. The basis of the tax in the case of a domestic cor- poration is "carrying on or doing business" in the capacity of a cor- poration, association, or insurance'*' company. The words "carrying on or doing business" must be given their ordinary and natural sig- nification. "Business" is a very comprehensive term and embraces whatever occupies the time, attention or labor of men for the purpose of livelihood or profit. In other words, business necessarily involves the idea of gain. The true basis of distinction is, in the first instance, between — (a) A corporation organized for the purpose of doing business as above defined, and (b) A corporation organized for the sole purpose of owning and holding property and distributing its avails; and, in the second instance, between — (c) A corporation of class (a) which is continuing the body and substance of the business for which it was organized or is still active and maintaining its organization for the purpose of continued efforts in the pursuit of profit or gain, and (d) A corporation which, although included in clas3 (a), has substantially retired from the business for which it was organized and has reduced its activities to the mere owner- ship and holding of property, distributing its avails, and doing only the acts necessary to the maintenance of its corporate existence and the private management of its purely internal affairs. The distinction in each case must depend upon the peculiar facts in the case. Corporations of class (a) will be presumed to be sub- ject to the tax unless they submit proof, satisfactory to the Com- missioner, that they are not actually carrying on or doing business. If a corporation claim exemption on the ground that it belongs to '"Insurance companies subject to the income lax imposed by section 243 or 246 of the 1921 law are now exempt from capital stock tax. They were taxable under the igi8 law. Certain other insurance companies, de- scribed in section 231 (10), are also exempt. 1534 MISCELLANEOUS TAXES class (b), it will be required to file an excerpt from its charter set- ting forth its corporate powers together with a full and comprehensive statement showing the nature of the activities in which it is and has been actually engaged. If it claim exemption on the ground that it belongs to class (d), it will be required to furnish a copy of any amendment of its charter, resolution of its board of directors, or other evidence, satisfactory to the Commissioner, showing that it has reduced its activities to the mere ownership of property, receipt of its avails, and the doing of only what is necessary to the maintenance of its corporate existence. ^^ (Keg. 50, revised, Art. 10.) "Doing business" illustrated. '^ — Regulation. Corporations organized for the purpose of and actu- ally engaged in such activities as buying, selling, or dealing in mineral or timber land, or other real estate; leasing property, collecting rents, managing office buildings, making investments of profits ; leasing lands and collecting royalties, managing wharves, dividing profits; and in some cases investing the surplus, are engaged in "carrying on or doing business" within the meaning of the statute. A corporation organized for the purpose of, and actually engaged in, buying mineral or timber land or other real estate and holding it with a view to future sale at an advance is carrying on or doing business. A corporation organized for the purpose of owning and leasing real estate which has leased all of the property under its control is still engaged in doing business unless, under the terms of its lease, its activities have been reduced to the mere receipt and distribution of the avails of the leases at the actual cost of so doing. If it is still maintaining its organization for the purpose of continued effort in the pursuit of profit and gain it is doing business. A corporation ow-ning or managing real estate which leases all of its property but under the terms of the lease is required to maintain or keep the property in repair is doing business. A corporation engaged in mining or in developing and speculat- ing in mineral lands is doing business. A corporation engaged in buying and selling securities or other property is doing business even though for a period it makes no purchases or sales because of unfavorable market conditions. A corporation formed to take over miscellaneous stocks, bonds or other property (as of an estate), to negotiate sales of various items from time to time as opportunity and judgment dictate, and to dis- " This regulation elaborates the foriiuT regulation but makes no im portant change in substance. "For court decisions bearing on liability and non-liability to tax, see Income Tax Procedure. 1918, pages 654-659. FEDERAL CAPITAL STOCK (EXCISE) TAX 1535 tribute the profits from time to time as liquidation is effected, is, while so engaged, carrying on or doing business. A parent corporation which finances or manages the operations of its subsidiaries is doing business. A so-called holding company which, under its charter, is author- ized to and does, in addition to receiving and distributing the avails of the property or securities, held by it, finance the operations of its subsidiaries, is engaged in doing business. A corporation organized for the purpose of taking over and hold-' ing securities, timber lands, coal lands, or other real estate, is held to be doing business, if it makes investments or reinvestments of its surplus income or funds in excess of an amount necessary to main- tain its original investments.'-' (Reg. 50, revised, Art. ll.) Not "doing business" illustrated. — Regulation. Holding companies as distinguished from parent corporations, and corporations all of whose property and business is operated by, or is in the hands of, a receiver or the Alien Property Custodian, are not doing business. A holding company is defined as one whose corporate powers are limited to the mere owning and holding of property and distribution of its avails, or one which, although incorporated for the purpose of doing business as defined in article 10, has substantially retired from the business for which it was organized and has reduced its activities to the mere ownership and holding of property, distributing its avails, and doing only such acts as are necessary to the main- tenance of its corporate existence and the private management of its purely internal affairs. A holding" company, as above defined, will not be considered to be doing business by reason of the reinvestment of its surplus income or funds to the extent only of maintaining its original in- vestments.-" (Reg. 50, revised. Art. 12.) Corporations Which Are Not Subject to the Tax Law. Section 1000. .... (b) The taxes imposed by this section shall not apply in any year to any corporation which was not "This is only clalxiration of a former regulation. "" [Former Procedure] T. D. 2429, dated January 4, 1917, held that a holding company (having several subsidiaries), the only busi- ness of which was "to receive dividends and interest from the oper- ating companies, pay interest on its own indebtedness and distribute its surplus income as dividends among its own stockholders," is en- gaged in business within the meaning of the act of September 8, 1916, and is subject to the capital stock tax. It will be noted that this decision has been reversed and corporations with activities limited to those described are not liable to the tax. 1536 MISCELLANEOUS TAXES engaged in business (or, in the case of a foreign corporation, not en- gaged in business in the United States) during the preceding year end- ing June 30, nor to any corporation enumerated in section 231, nor to any insurance company subject to the tax imposed by section 243 or 246. If, on June 30, 1922, or prior, a corporation formally de- cides to liquidate, no return need be made thereafter. Period of doing business determines tax liability.-^ — Regulation. The tax being payable in advance does not apply to any corporation which was not engaged in business during any part of the fiscal year preceding the year for which the tax is due, but if it was in business even one day of the preceding year and one day of the taxable year it is subject to the tax. There is no relation between the amount of the tax payable and the length of time the corporation was in business. A corporation engaged in business during a part of the preceding year, but not engaged in business at the beginning of the taxable year, is not required to make any return if it is dissolved or in process of dissolution, but if it is only temporarily inactive and subsequently during the year reengages in business it should file a return in the month in which it recommences business and pay the tax due from the first of such month to the end of the taxable year. A corporation organized and beginning corporate activities on or after July i is not subject to tax for the remainder of the taxable period in which the com- pany was organized, unless as of July i, it takes over the business of an organization which was subject to capital stock tax, in which event the new corporation is required to file a return and pay the tax. In the case of foreign corporations '"engaged in business," means the transaction of any business within the United States. (Reg. 50, revised. Art. 26.) Exempt corporations. — In addition to corporations not "doing business" the thirteen classes of corporations enumer- ated in section 231 of the income tax law, and insurance com- " [Former Procedure] "Doing business" by railroad corporation under federal control. — Regulation. "A corporation owning a railroad controlled and operated by the Government is exempt from liability for a given tax year only in case it does no business during such year. The liability of a corporation which actually does business is not affected by the control over its rail- road exercised by the Government " (Reg. 50, Art. 20.) For detailed procedure regarding railroads, see Reg. 50, Arts. 20 and 21; T. D. 2800 (March 12, 1919) ; and T. D. 3156 (April 11, 1921). FEDERAL CAPITAL STOCK (EXCISE) TAX 1537 panics (taxed under sections 243 or 246), are exempt. For details, see Chapter II. Return by corporation claiming exemption. — Regulation. Where the officers of a corporation are of the opinion that it is exempt from the tax under section 231 of the Revenue Act of 1918, or on account of not being engaged in business, Form 707 (Revised) [Appendix B] should be filled out and filed with the collector, together with a comprehensive statement of the reasons for claiming exemption. In such case the fair value should be reported on page i of the form, but the tax not computed, notation "Exemption claimed" being made instead. If exemption has been allowed for the preceding taxable year and there has been no change in the status or conditions of the company then the first 14 lines of Form 707 (Revised) should be completed and a statement attached to the effect that exemption is claimed for the same reasons as for the previous year and that the same status and conditions of the company exist for the taxable period in question. In this way the records of the collectors' offices will be complete and corpora- tions will avoid requests for the filing of returns and unnecessary correspondence. The determination of liability rests in the first in- stance with the Commissioner of Internal Revenue and without com- plete information it is impossible to make a decision. (Reg. 50, revised, Art. 28.) Rate and Computation of Tax for Domestic Corporations Law. Section 1000. (a) . . . . (i) Every domestic corporation shall pay annually a special excise tax equivalent to $1 for each $1,000 of so much of the fair average value of its capital stock for the preceding year ending June 30 as is in excess of $5,000. In estimat- ing the value of capital stock the surplus and undivided profits shall be included; . . . .-- J" [Former Procedure] Both the 1916 and 1918 laws imposed this tax on insurance companies. 1918 Law. Section 1000. " . . . . (b) In computing the tax in the case of insurance companies such deposits and reserve funds as they are re- quired by law or contract to maintain or hold for the protection of or pay- ment to or apportionment among policyholders shall not be included. "(c) .... and in the case of every such domestic [mutual insur- ance] company the tax shall be equivalent to $1 for each $1,000 of the excess over $S,ooo of the sum of its surplus or contingent reserves main- tained for the general use of the business and any reserves the net addi- tions to which are included in net income under the provisions of Title II, as of the close of' the preceding accounting period used by such company for purposes of making its income tax returns." 1538 MISCELLANEOUS TAXES Regulation. The tax is at the rate of $i for each full $i,ooo of the fair average value of the capital stock of the corporation in excess of the prescribed deduction of $5,000. The tax is com- puted not upon the par value of the stock, but upon the fair average value for the preceding year, or for the period during which it has been issued, if less than a year, of the capital stock outstanding at the date of the incidence of the tax. In the case of a domestic cor- poration it is on an entirely different basis from the excess profits tax, which is concerned with invested capital and not with the fair average value of the capital stock. Stock in the treasury of a cor- poration is not regarded as outstanding unless pledged as security for a debt. No deduction is allowed corporations organized in the United States for capital invested outside of the United States. If the corporation is doing business it is taxed on its entire capital stock even though most of it may not be employed in the business. (Reg. 50, revised, Art. 13.) The foregoing regulation states (negatively) that pledged treasury stock must be regarded as outstanding. The author is unable to follow this reasoning. The net effect, apparently, is to increase the value of gross assets, but the net worth of a corporation does not increase proportionately to an increase in gross assets. Treasury stock is of value as collateral to the pledgee only for purposes of con- trol or similar reason. Its value as collateral is nil if the cor- poration's indebtedness to a creditor is acknowledged. Methods of ascertaining fair value. — Regulations. Every domestic corporation shall make return on Form 707 (Revised) regardless of the par value of its capital stock. Also see articles 28 and 33. The fair average^" value of the capital stock of a corporation and the tax payable thereon shall be deter- mined in accordance with the instructions in the form, which pro- °'Form 707 (revised 1919) calls for the total stock outstanding on the last day of the corporation's fiscal year. The law [section 1000 (a-i)], however, provides that the amount of the tax shall be computed on the basis of the "fair average value of its capital stock for the preceding year." Regulation. "If a corporation has increased or decreased its capital stock during the fiscal year, a statement should be attached to the back of the return setting forth the number of shares of stock outstanding each month, with the average fair value of the stock for that month, com- puted under one of the three cases." (T. D. 2503, June 25, 1917.) FEDERAL CAPITAL STOCK (EXCISE) TAX 1539 vides in Exhibit A for tlie book or fair value of the assets, in Exhibit B for the market value of the shares, and in Exhibit C for the value of the capital stock based on the capitalized earnings. All the in- formation called for must be given in every case where it is pro- curable. (Reg. 50, revised. Art. 31.) The fair average value of the capital stock for the purpose of determining the amount of the capital stock tax must not be confused with the market value of the shares of stock where it may be neces- sary to determine such value under other provisions of the revenue laws. The fair average value of the capital stock, the statutory basis of the tax, is not necessarily the book value or the value based on prices realized in current sales of shares of stock or even the value, determined by capitalization of earnings, although it may be more directly dependent upon the last. It should usually be capable of appraisal by officers of the corporation having a special knowledge of the affairs of the corporation and general knowledge of the line of business in which it is engaged. Provision is accordingly made in Exhibit C of Form 707 (Revised) for the tentative determination of the fair value of the capital stock by capitalizing the net earnings of the corporation on a percentage basis fixed by its officers as fairly representing the conditions obtaining in the trade and in the locality. But such fair value .... must not be set at a sum less than the re- constructed book value shown by Exhibit A, unless the corporation is materially affected by extraordinary conditions which support a lower valuation. In any such case a full explanation must accompany the return. The Commissioner will estimate the fair value of the capital stock in cases regarded as involving any understatement or under- valuation (Reg. 50, revised, Art. 14.) The capital stock tax on domestic companies is measured by the fair value of the total capital stock, including the sur- plus and undivided profits, for the year preceding the taxable year, whether the conduct of the business is profitable or other- wise.^* Regulation. The surplus and undivided profits of a corporation must be included in estimating the fair average value of its capital stock. If the fair average value be determined from the book value, the surplus and undivided profits are included in the assets, if from sales, they are necessarily a factor in determining the market price, and if from net income, they are reflected to a greater or less extent in the earnings. (Reg. 50, revised. Art. 15.) For the purpose of this tax the fair value of the entire Form 707, page 4, instructions (see Appendix). I540 MISCELLANEOUS TAXES capital stock of a going concern, regardless of stock ownership or the ability of individual stockholders to liquidate their hold- ings, is required. The sales prices for any number of shares of stock less than a majority interest are not necessarily indica- tive of the fair value of the entire capital stock. The capital invested, the nature of the business, the kind of assets (slow or quick turning), goodwill, franchises, earning capacity, etc., are important factors that affect the worth of enterprises and must be given due consideration in arriving at the fair value at any given date."' The three exhibits, A, B and C, are provided to indicate the information desired and the manner in which it should be furnished. So far as adaptable these forms should be com- pleted by taxpayers, but if the}- find it more convenient they may attach to this return their own statements, provided sub- stantially the same information is furnished. In any event, taxpayers should attach any additional statements that will aid in a comprehensive understanding of the taxpayer's return, so that the Commissioner of Internal Revenue may more equitably determine the correctness of the fair value reported in item 15 on page i hereof.'" Exhibit A provides for adjusting any overstated or under- stated values contained in the taxpayer's books of account, and exhibit C provides for showing an adjusted income, which should be the actual operating income to be used for capitaliz- ing on a percentage basis fixed b)'- its officers as fairly repre- senting conditions obtaining in the trade and in the locality. If the reconstructed book value shown by exhibit A or the market value shown by exhibit B is greater than the valua- tion returned by the taxpayer, a comprehensive statement showing any extraordinary conditions which are relied on in support of the valuation claimed must be submitted. In any case in which the fair value is understated the amount will be redetermined by the Commissioner."' "^Form 707, page 4, instruction i. ^ Form 707, page 4, instruction 3. "Form 707, page 4, instruction i. FEDERAL CAPITAL STOCK (EXCISE) TAX 1541 It will be noted that the balance sheet to be furnished under exhibit A is as of the close of the year preceding the taxable year. Since such a balance sheet will not reflect the "average" book value for the year, especially when material changes have been made in either the assets or liabilities, additional statements which will reflect the desired value should be fur- nished. The foregoing is a clear statement of corporations' rights under the law. Briefly stated, a corporation should follow this procedure : Fill in the answers called for by exhibits A, B or C — any or all. If the result does not produce a fair value, additional statements supporting the value claimed to be fair should be prepared and attached to the form.-® It is wholly unnecessary for a corporation to accede to an assessment which overesti- mates the "fair average value of its capital stock." The exhibits called for in form 707 are described in the official instructions (page 4, .form 707) as follows: Exhibit A: Condensed balance sheet. — Furnish under exhibit A a condensed balance sheet as of the closing date of the fiscal year given in item 7 on page i hereof. "Books of account." — These columns must show the amounts as carried in the taxpayer's books of account. "Fair value." — Refer to article i above, defining the value re- quired, and in the event the columns "books of account" contain any overstated or understated values show herein the actual values. "Difference." — These columns will show the difference between the columns "books of account" and "fair value." Any material dif- ferences must be explained in such manner as to enable the Commis- sioner of Internal Revenue to determine if they are proper and acceptable. For this purpose the differences shown herein need not be covered by corresponding adjustments in the taxpayers' books of account. "Treasury stock"-'^ and "treasury bonds." — Tn the event the tax- "*For comments on methods of arriving at fair value, see Income Tax Procedure, 1918, pages 628-654. "° In arriving at the fair value of a corporation's own stock, treasury stock should always be first deducted from the nominal amount outstand- ing. This greatly simplifies the calculation and prevents complications which develop when stock is worth either more or less than par. 1542 MISCELLANEOUS TAXES payer holds in its treasury any of its own stock or bonds, advice must be furnished as to whether such stock and bonds are pledged or unpledged. ''Other assets" and "other liabilities." — If material amounts are shown, a comprehensive analysis of them must be attached. "Profit and loss." — If the "profit and loss" balance is a debit the amount should be shown in red. Exhibit A of form 707 calls for the deduction of treasury stock from the gross amount of capital stock so that the net outstanding stock is shown. This is the correct basis for valu- ation of the stock. Stock in the treasury has in effect been paid off so far as the former holders thereof are concerned. Therefore, only the stock still outstanding in the hands of stockholders represents capital actually employed in the busi- ness. Why "advice must be furnished as to whether such (treas- ury) stock and bonds are pledged or unpledged" is not clear, since it can neither increase nor decrease the net outstanding- stock, the fair value of which is the basis of the tax.^° It must be borne in mind that the tax is to be computed on the basis of "the fair average value of the capital stock for the preceding year." [Law, section 1000 (a-i).] If the book value of the shares is used as a proper measure for taxation, and if a net profit has been earned during the preceding year, the average value of each share will be less than the value at the end of the year. A statement of net worth, prepared by adjusting book values to actual values, is of great service in ascertaining the fair value of corporate stock, but book value is only one factor. It is, how^ever, not always practicable to place a "fair value" on fixed assets ; in fact it is usually impossible to assign any value to such assets other than the book value. Also, the value of manufactured or partly manufactured goods on hand is extremely difificult of determination, especially in the case of an unprofitable concern. The fair value of such goods at a "" See page 1538. I FEDERAL CAPITAL STOCK (EXCISE) TAX 1543 given date is certainly influenced by the profitableness or other- wise of the manufacturing operations. Capital stock is not worth book value even when book values are adjusted, unless recent earnings produce an ade- quate return. In a vast majority of cases when earnings of one or more years are poor, there is a reflection of this unsat- isfactory condition in the fair value of the capital stock. In such cases or when the earnings have fluctuated greatly or when the average annual earnings, capitalized at a proper rate, do not fully support the book value or the adjusted book value, it is quite evident that the real "fair value" is an amount less than the book value and possibly more than the capitalized income value, depending upon the character of the assets, i.e., quick or slow turning, liquid or otherwise, etc. Buyers simply will not pay book value for the shares of a corporation unless a fair average annual return is being real- ized on such book value. If a corporation reports that the fair average value of its capital stock is equal to the aggregate of capital stock and sur- plus when its average net earnings thereon for several preced- ing years have been less than 20 per cent, it is in effect placing a higher value on its fixed assets than has usually been found to be justified. Exhibit B : Quotations or outside sales prices. — Furnish under exhibit B the prices quoted on a recognized stock exchange or on the New York curb, or the prices at which outside sales were made if the stock is not listed, for the period of 12 months ending with the close of the taxpayer's fiscal year as given in item 7 on page i hereof. If the stock is listed the name of the exchange from which re- ported quotations are taken must be shown in the space provided therefor, and the prices reported will be the mean of the highest and of the lowest bid^^ price during each month, from which the average for the year will be obtained. If the taxpayer prefers, a schedule may be attached to this return showing the highest and "This is a correct basis. Reg. 38, 1916, Art. 6 (a), called for averaging highest bid prices. 1544 MISCELLANEOUS TAXES lowest bid price at which stock was quoted for each day of the year and the average obtained therefrom. If the stock is not listed and outside sales have been made at prices known or determinable by the officers making this report, such prices will be reported herein. A statement of the number of shares involved and the conditions under which sales were made at other than exchange quotations must accompany this return. Sales to employees or directors for qualifying purposes, or sales which are restricted as to resale, or sales at prices otherwise specially influ- enced, will not be considered representative of the fair value of the entire capital stock and should not be included. In the column "No. shares outstanding" should be shown the total number of shares outstanding at the close of each month. The average value per share will be determined as follows: First. If no change occurred in the number of shares outstand- ing during the year, total the quotations or sales prices for the months reported and divide by the number of months in which quotations or sales prices are shown. Second. If any change occurred in the number of shares out- standing during the year, total the quotations or sales prices for the months reported during which the number of shares outstanding at date of incidence of the tax has been outstanding and divide by the number of months used in the computation. "Date of incidence of the tax" is July i of the taxable year.^^ Exhibit C : Annual income. — Furnish under exhibit C the annual income and other data for the five fiscal years ended with the close of the taxpayer's fiscal year as given in item 7 on page i hereof, or for the period during which the corporation has been engaged in business if for a shorter period. "Net income." — In this column will be shown the income re- turned for the purpose of the income tax and excess profits tax. "Deductions" and "additions." — Refer to article i of these special instructions, and show in these columns such amounts as should be deducted from or added to "net income" to arrive at the adjusted income which may be capitalized to determine the fair value of the ^- [Former Procedure] Form 707 for tax year July i, 1919, to June 30, 1920, provided : "If any change occuTed in the number of shares outstanding during the year, calculate the total value of the outstanding shares each month upon the reported prices and divide the total of such monthly valuations by the sum of the number of shares outstanding each month." The former regulation is sound hut it is doubtful if the present regu- lation is equitable. FEDERAL CAPITAL STOCK (EXCISE) TAX 1545 capital stock. A comprehensive analysis of any amounts reported therein should be attached to this return. Some of the principal items frequently requiring adjustment follow: Deductions : Income and profits taxes not deductible in computing income subject to tax. Depreciation and depletion. Interest charges not deductible in computing income subject to tax. Losses not fully deductible in computing income subject to tax. Additions : Dividends from other corporations not included in computing income subject to tax. Income from securities of a state, municipality, or of the United States, not included in the income tax return. Expenditures made for additions and betterments, or reserves for such purposes, made against income whether direct or through expenses. "Adjusted income." — This column will reflect the amounts result- ing from adjustment of amounts shown in three preceding columns. "Number shares/' — Herein should be given total number of shares of all classes of stock outstanding at close of each fiscal year. "Dividends declared." — Herein should be reported the percentage of dividends declared on the par value of each class of stock out- standing each year. The amount represented by the percentages shown in this column must not be deducted from the columns "net income" or "adjusted income." "Depreciation." — Hereunder will be reported the amount actually charged against income each year in the taxpayer's books of account for depreciation. "Depletion." — In the case of mines, oil and gas wells, other natu- ral deposits, and timber, valuations reported as the basis of depletion in computing Federal income and profits taxes should be shown in the "Fair value" column [of Exhibit A]. Capitalising net income. — The officers making the return will capitalize the average annual income on a percentage basis that fairly represents the conditions obtaining in the trade in the locality that representative enterprises must earn in order to maintain their stock at par. In other words, if enterprises engaged in a similar business must on the average earn 12 per cent on their issued capital stock to keep the value of their stock at par, the net income should be capitalized by dividing it by .12. Some of the best stocks in this country, which are valued for the purpose of this tax at their average quotations on the 1546 MISCELLANEOUS TAXES New York Stock Exchange (a fair basis in many cases, as the sales are numerous and actual transactions between willing buyer and willing seller are after all the best indication of value) have during recent years shown 30, 40 or even 50 per cent per annum earned on their par value, though their selling prices in the open market have often not been above par. An industrial stock to be valued at par should have net tangible assets equal to par, unless the average earnings exceed 20 per cent per annum on the capital stock. If the earnings are considerably above 20 per cent per annum, fair value may be more than par, but the physical assets must always be considered. If earnings are on a down- ward trend, the average may be disregarded. Only in ex- ceptional cases should the item of goodwill be a factor in valuations under this act. If the goodwill actually has a pres- ent value, it will be reflected in the earnings shown in exhibit C. An excise tax imposed on the privilege of doing business as a corporation should be construed in favor of the taxpayer, and speculative values and other items which sometimes in- fluence high prices for shares should be ignored. In considering earnings as a basis for valuation, it should be remembered that if the earnings include unusual profits, which it is not expected will recur periodically, a prospective purchaser of the stock would not pay a price based on cap- italizing such extraordinary profits. Unless exhibit A sup- ports the capitalized value of profits of an unusual nature, it would be fallacious to capitalize them for valuation purposes. Income and excess profits taxes should be deducted before earnings are capitalized for the purposes of the excise tax. When net profits of past years are used in calculating aver- age earnings, net losses must also be used in the computation. Issuance of new stock does not affect average in- come CAPITALIZED. Ruling. Should adjustment be made in determining average in- come under Exhibit C, when capital increased from ten thousand to fifty thousand in nineteen nineteen? FEDERAL CAPITAL STOCK (EXCISE) TAX 1547 (Answer.) Your wire twenty-sixth. Disregard number shares outstanding when capitalizing net income, Exhibit C of Form 707. (Telegram of inquiry from Morris F. Frey, the Guaranty Trust Company, New York, N. Y., and the reply thereto signed by Deputy Commissioner James Hagerman, Jr., and dated July 27, 1920.) Preferred and common stock. — Since many corporations have more than one class of stock, provision must be made for a calculation which gives due weight to the fair value of the en- tire outstanding capitalization. It is believed that a short and simple rule will settle any apparent difficulties in determining a proper valuation. As TO PREFERRED STOCK. — If preferred stock has a market value, the actual number of shares of preferred stock outstand- ing multiplied by the average market value of each share will produce the desired result. If preferred stock has no market value, but if its book value is in excess of par, and if some value is ascribed to the common stock, the preferred stock should be listed at par. There are, however, many classes of preferred stocks. When there is no cumulative provision as to dividends ; no. or only partial, preference as to assets; a low rate of dividend, or other factors which, as compared with similar preferred stocks having a market value, would tend to lower the fair value of the preferred stock, full weight must be given to all factors and that value must be placed upon each share of preferred stock which can be supported as being a fair value. As TO COMMON STOCK. — If it be borne in mind that the one base of the tax is the net worth of the corporation, it will simplify the calculations whenever more than one class of stock is concerned. In all cases (exclusive, of course, of corpora- tions the market value of whose shares can be ascertained) the fair value of a corporation's entire capitalization will have to be determined. This should be done regardless of the dif- ferent classes of shares, if any. After a trustworthy estimate has been made, the aggregate valuation placed upon the one 1548 MISCELLANEOUS TAXES or more classes of preferred stock should be deducted; the balance represents the proper valuation for the common stock. Deductions and Credits Law. Section 1000. (a) (i) .... a .... tax ... . equivalent to .... so much of the fair average of its capital stock .... as is in excess of $5,000 Corporation must file return even though the fair average value of its stock does not exceed $5,000. — Regulation. From the total fair average value of the capital stock the sum of $5,000'" is to be deducted, and the tax is upon each full $1,000 of any balance. Accordingly, corporations the fair aver- age value of whose capital stock is not more than $5,000 are not subject to tax, but for the purpose of avoiding error every corpora- tion is required to file a return as directed in article 31. (Reg. 50, revised. Art. 16.) Returns Time of making returns. — Regulation. It shall be the duty of every corporation liable to the tax on or before the 31st day of July in each year to make a return, verified by oath, to the collector of the district in which its principal place of business is located. If any corporation fails to make and file a return within the time prescribed by law or by regulation made under authority of law, or makes, willfully or other- wise, a false or fraudulent return, the collector or deputy collector shall make the return from his own knowledge and from such infor- mation as he can obtain through testimony or otherwise. In any such case the Commissioner may, from his own knowledge and from such information as he can obtain through testimony, or otherwise, make a return or amend any return made by a collector or deputy collector. Any return so made and subscribed by the Commissioner, or by a collector or deputy collector and approved by the Commis- sioner, shall be prima facie good and sufficient for all legal purposes. If on account of sickness or absence of the officer of the corporation charged with making the return, it is impossible to prepare and file a return on or before the 31st day of July (the due date), the collector, upon application in writing, may allow an extension of time not exceeding 30 days from July 31, in which to file the return. If extension is granted, the letter of the collector should be attached Prior to July i, 1918, the exemption was $99,000. FEDERAL CAPITAL STOCK (EXCISE) TAX 1549 to the return. On no account is the Commissioner of Internal Revenue or the collector authorized to grant an extension of time in which to file capital stock returns in excess of 30 days from July 31, the due date. If for reasons, other than absence or sickness, beyond the control of the officers making the return, it becomes impossible to file a completed return within the time prescribed by law, a tenta- tive return may be filed, thus avoiding penalty for failure to file within the prescribed time. See following article. (Reg. 50, revised, Art. 33.) Tentative return. — Regulation. The filing of a tentative return will avoid the penalty for delinquent filing, but does not authorize the withholding of the tax. The regulations do not permit the filing of a tentative return to stay indefinitely the filing of a completed return and the collection of the tax due; therefore, a tentative return clearly marked "Tentative return" should be prepared in as complete a manner as possible, including, among other information, a basis for the com- putation of the tax — that is, an estimate by the officers of the cor- poration of the approximate fair value of the capital stock in order that an initial assessment may be made. When the completed return is filed, it should be clearly marked "Completed return," showing that a tentative return was filed. Such action will prevent duplicate assessments and ordinary penalties. In every case a statement should be attached to the tentative return, indicating the approximate date the completed return may be expected. Upon receipt of the com- pleted return any adjustment necessary in the assessment of the cor- rect tax due will be made. (Reg. 50, revised. Art. 34.) When return must be filed before information is available.— Ruling. Answering your letter of July 3, 1919, in which you make inquiry as follows : "What is the best procedure for reporting net income under exhibit C of capital stock tax returns, form 707, in the case of corporations whose fiscal year ends June 30, and who have not filed return for Federal income tax purposes before the time for filing capital stock tax returns has expired?" you are advised paragraph 3, special instructions i, page 4, form 707, states : " . . . . and the taxpayer will complete each exhibit or state why the required data are not available." The law provides that capital stock tax returns shall be filed dur- ing the month of July for the taxable period beginning July i and that the collector is empowered to grant an extension of thirty days I5SO MISCELLANEOUS TAXES beyond the due date of filing only in case of sickness or absence of the officer charged with the preparation of the return. You will therefore note there is no authority under the law for granting an extension for any reason beyond thirty days from July 31, 1919. Capital stock tax returns should therefore be completed so far as practicable and filed with the collectors within the prescribed time with the statement that unavailable data will be furnished in a sup- plemental report at the earliest possible date. In the case of any failure to make and file a return within the prescribed time a penalty of 25 per centum of the amount of the tax attaches, except that when the failure to file was due to a rea- sonable cause and not to willful neglect no such addition shall be made to the tax. The above procedure will avoid any assertion of the penalty or question as to what constitutes a reasonable cause. (Letter to The Corporation Trust Company, signed by Deputy Commissioner J. Hagerman. and dated July 11, 1919) The law should be amended to provide ample time within which to file accurate returns. Affiliated corporations, returns of. — Regulation. Although section 240 of the Revenue Act of 1918 requires a consolidated return for affiliated corporations for the pur- pose of income tax^* for the purpose of capital stock tax each cor- poration must render a separate return in complete form. So-called subsidiary corporations, all or a part of the stock of which is owned by another corporation, must render separate returns, the same as every other corporation. No deductions from the assets are per- mitted on account of inter-company balances, and the shareholdings must be reported in the "Fair value" column at their actual worth at the time of making the return. No deduction is allowed in the return of one corporation for the tax paid by another. If the fair value is determined by any method other than herein provided, the following requirements must be complied with: (a) The parent company must submit with its return a list of all subsidiaries and the districts in which the returns were filed; (b) the return of the sub- sidiary company must show the name of the parent company and the district in which the return was filed; (c) the method of determining the fair value, if other than by Exhibits A, B, and C, must be fully explained; (d) a copy of any agreement existing between parent company and subsidiary must be furnished, or a statement made that none exists; and (e) a combined balance sheet and a combined net ** The 1921 law provides for filing either consolidated or separate in- come tax returns for tax years beginning on or after January i, 1922. Th:» change will have no effect on the capital stock tax returns. FEDERAL CAPITAL STOCK (EXCISE) TAX 1551 income statement must be submitted for consideration in connection with any estimate of fair value made on behalf of the reporting corporation. (Reg. 50, revised, Art. 35.) Rulings. In reply to your letter of May 17, 1919, requesting an interpretation of article 106 of Regulations 50,^^ regarding capital stock tax returns required of affiliated corporations, you are advised that the sentence, "If the fair value of its capital stock is based upon a consolidated report, a copy of such report should be attached to the capital stock tax return of each affiliated corporation," refers to each corporation of an affiliated group, that is, the parent company as well as each subsidiary. Article loi, Regulations 50,^*^ requires every domestic corporation to file a return regardless Of the par value of its capital stock unless specifically exempt under section 23 1.^' An exemption of $5,000 is allowed. In many cases, as for instance, in the case of selling agencies separate corporations are formed in order properly to handle certain business under various state laws and in reality are branches or de- partments of the parent corporation. The business is controlled by the parent corporation and the result of operations is a matter of bookkeeping. The capital stock tax being imposed upon the fair value of the capital stock of corporations it makes little difference by what method such fair value is determined. Therefore, if affiliated corporations are best able to determine the fair value of the respective companies through a consolidated report such privilege is permitted by the De- partment, but it seems preferable to leave this to the corporations interested subject to approval by the Commissioner of Internal Rev- enue rather than attempt to outline a specific method that would apply to all. (Letter to The Corporation Trust Company, signed by Deputy Commissioner J. Hagerman, and dated June 2, 1919.) Referring to office letter of June 2, 1919, it has come to the attention of this office that a number of taxpayers are construing this letter as granting special privileges not intended and not per- mitted under the law and regulations. This letter properly inter- preted reflects the views of this office and is applicable to such cases. The taxpayers, however, may have been misled by the wording of the heading, which reads : "Consolidated Returns of Affiliated Corporations" and it is suggested with a view to avoiding further misunderstand- ing that the heading be revised, as follows : "Art. 35 of Reg. 50, revised, is substantially the same. "Art. 33 of Reg. 50, revised. "The 1921 law also exempts from this tax insurance companies tax- able under section 24.3 or 246. 1552 MISCELLANEOUS TAXES "Returns of Affiliated Corporations based upon a Consolidated Report." The difficulty of outlining a general ruling that covers all ques- tions relating to affiliated corporations should be appreciated and the taxpayer must realize that the tax is imposed upon the fair value of the capital stock of each individual corporation as disclosed by the facts in a given case, regardless of corporate affiliations. Only under certain conditions are corporations permitted to arrive at the fair value of the capital stock of the respective companies through a con- solidated report, that is, where the fair value cannot be determined independently. In interpreting the letter above mentioned, distinction must be drawn between the word "return'" and the word "report." Under all circumstances individual returns are required of every corpora- tion regardless of the basis used in arriving at the fair value. (Let- ter to The Corporation Trust Company, signed by Deputy Commis- sioner J. Hagerman, and dated November ii, 1919.)'^ ^' [Former Procedure] Additional returns for taxable year ended June 30, 1919, when required on accoimt of retroactive features of law. — Regulation. "Under the Revenue Act of 1916 the time for filing capital stock tax returns for the fiscal year ending June 30, 1919, was extended to September 30, 1918, and in the case of Hawaii to October 31, 1918. Any corporation which failed to file a return for such fiscal year for the former tax, whether or not it was liable thereto, must file a return for such fiscal j'ear under the present statute before June i, 1919 Where returns were filed for the fiscal year ending June 30, 1919, such returns will be used so far as practicable in making the additional or orig- inal assessments for such taxable period. In the case of domestic and foreign mutual insurance companies, the new basis for the tax will neces- sitate supplemental statements, which should be furnished upon request. For the taxable period July i, 1918, to June 30, 1919, letters will be for- warded to taxpayers showing how the original or additional assessment has been determined, in order that the collector's bill when presented may be understood and payment promptly made " (Reg. 50, Art. 105.) As previousl}^ stated, the provisions of the 1918 law were made retro- active to July I, 1918. Formerly some corporations were not required to file returns, but due to the small exemption provided by the 1918 law the Treasury decided to require returns from all corporations beginning with returns for the taxable year July i, 1918, to June 30, 1919. Returns made necessary by the new regulations of the Treasury were due before June I, 1919. So far as practicable the tax at the increased rate, after giving effect to the reduced exemption for the year ended June 30, 1919, was computed by the Treasury from information contained in the returns pre- viously filed. FEDERAL CAPITAL STOCK (EXCISE) TAX 1553 Payments^'' Time of payment of tax. — The tax is assessed annually in advance.*" Decision. The capital stock tax imposed by the Act of Septem- ber 8, 1916, is not illegal because assessed and collected in advance under regulations of the Treasury Department, the act, by sections 407 and 409, contemplating that a corporation must pay a tax on its capital stock for the preceding year in order to do business for the coming year. Regulation. All assessments shall be made by the Commissioner. The collector shall within 10 days after receiving any list of taxes from the Commissioner give notice to each corporation liable to pay any tax stated therein, to be left at its place of business or to be sent by mail, stating the amount of such tax and demanding payment thereof. If such corporation does not pay the tax within 10 days after the service or the sending by mail of such notice, it shall be the duty of the collector to collect the tax with a penalty of 5 per cent additional upon the amount of the tax and interest at the rate of I per cent a month. A collector has no authority to extend the time for payment of the tax, and any extension granted by him will be at his own risk. All taxes are payable direct to the collector of internal revenue of the district in which return is filed. The col- lector may accept payment of the tax when the return is filed as an "advance collection," subject to any adjustment later found neces- sary, but no corporation is required to pay the tax until after notice and demand. Tax due from a corporation is legally collectible from the stockholders or others who have received its assets upon liquida- tion. (Reg. 50, revised, Art. 36.) °' [Former Procedure] Tax paid under former law, credit for. — RiT.ULATioN. "Where a corporation has paid the tax for tlie fiscal year July i, 1918, to June 30, 1919, under the Revenue Act of 1916, the amount so paid may be credited against the tax imposed by the present statute for such period and only the excess of the tax over such amount will be collected. For the rates of the former tax and its other provisions see Reg. 38 (revised). Because of the reduction of the exemption from $99,000 to $5,000 in the case of domestic corporations and of the abolition of any exemption in the case of foreign corporations, many corporations must now pay the tax which were formerly exempt " (Reg. 50, Art. 81.) *" Washington Water Power Co. 7". U. S. (not yet rc])ortcd), U. S. Court of Claims, February 14. 1921. (T. D. 3160). 1^54 MISCELLANEOUS TAXES Penalties Failure to pay. — Regulation, (a) Any corporation which fails to pay the tax when due and payable is liable to a penalty of $i,ooo. If it willfully refuses to pay or willfully attempts to evade the tax, it is liable also to a fine of $10,000.00 and costs and to a 100 per cent penalty to be added to the tax. See also article 41. (b) Any officer or employee of a corporation who in the course of his duty fails to pay the tax when due and payable is liable to a penalty of $1,000. If he willfully refuses to pay or willfully attempts to evade the tax, he is liable also to a fine of $10,000 and costs and to imprisonment for a year, and to a penalty of the amount of the tax unpaid or evaded. (Reg. 50, revised. Art. 42.) It is to be noted that the specific penalties of $1,000 and $10,000 are additional to the 5 per cent penalty and i per cent per month interest penalty referred to in article 36. (See page 1553 ) Failure to make return and penalty for false return. — Regulation, (a) Any corporation which fails to make a return within the required time is liable to a penalty of $1,000. If it will- fully refuses to make a return it is liable also to a fine of $10,000 and ousts, (b) Any officer or employee of a corporation who in the course of his duty fails to make a return within the required time is liable to a penalty of $1,000. If he willfully refuses to make a return he is liable also to a fine of $10,000 and costs and to imprison- ment for a year, (c) Section 3176 of the Revised Statutes,*^ as amended by section 1317 of the Revenue Act of 1918, also provides: In case of any failure to make and file a return or list within the time prescribed by law, or prescribed by the Commissioner of Internal Revenue or the collector in pursuance of law, the Commis- sioner of Internal Revenue shall add to the tax 25 percentum of its amount, except that when a return is filed after such time and it is shown that the failure to file it was due to a reasonable cause and not to willful neglect, no such addition shall be made to the tax. In case a false or fraudulent return or list is willfully made, the Com- missioner of Internal Revenue shall add to the tax 50 percentum of its amount. The amount so added to any tax shall be collected at the same "Section 1311 of the 1921 law re-enacts section 3176, Rev. Stat., as amended by the 1918 law. F£:deral capital stock (excise) tax 1555 time and in the same manner and as part of the tax unless the tax has been paid before the discovery of the neglect, falsity or fraud, in which case the amount so added shall be collected in the same manner as the tax. (Reg. 50, revised, Art. 43.) Doing business without payment of tax. — Regulation. Every corporation which does business without having paid the tax is liable to a penalty of $1,000. A corporation paying the capital stock tax is not on that account exempt from any occupational tax. For other penalties see articles 42 and 43. (Reg. 50, revised, Art. 41.) Foreign Corporations Law. Section 1000. (a) . . . . (2) Every foreign corporation shall pay annually a special excise tax with respect to carrying on or doing business in the United States, equivalent to $1 for each $1,000 of the average amount of capital employed in the transaction of its business in the United States during the preceding year ending June thirtieth Definition of foreign corporation. — Regulation. A foreign corporation is a corporation created or organized outside the United States as defined in Article 8.*' (Reg. 50, revised. Art. 9.) Scope of tax. — Regulation. The basis of the tax in the case of a foreign cor- poration is "carrying on or doing business in the United States." A foreign corporation is carrying on or doing business in the United States if it maintains an agent or an office or warehouse in the United States, or, in the case of an insurance company, if it writes insurance policies here, or in any other way enters the United States for the purposes of its business. The purchase of supplies in the United States in the furtherance of continued efforts in the pursuit of profit or gain is carrying on or doing business in the United States. (Reg. 50, revised. Art. 17.) It may be assumed that the term "doing business" as ap- pHed to the activities of a foreign corporation in the United States, will be interpreted in the same manner as when applied to a domestic corporation doing business in another state. " See page 1529. 1556 MISCELLANEOUS TAXES If so, the mere purchase of suppHes does not constitute "doing business."" Rate of tax. — Regulation. The tax is at the rate of $1 for each full $1,000 of the capital of a foreign ^corporation actually employed^* in the transaction of its business in the United States, and is in all cases to be computed on the basis of the average amount of capital so employed during the preceding year ending June 30. The measure of the tax is accordingly different from that in the case of domestic corporations which pay a tax measured by the fair average value of their capital stock. No deduction from the total fair average amount of capital so employed is allowed in computing the tax. (Reg. 50, revised, Art. 20.) Capital "employed" in the United States. — Regulation. The "'capital employed in the transaction of its business in the United States" means the portion of the total capital, surplus, and undivided profits, of the foreign corporation, utilized for the purpose of doing business in the United States. A foreign corporation may have income from sources within the United States for the purpose of the income tax, and yet not have capital em- ployed in the transaction of business here for the purpose of the capital stock tax. Compare articles 91-93 and 550 of Regulations 45. A foreign corporation not actually doing business in the United States is not subject to tax, and accordingly the investment of a part of its funds in United States stocks and securities will not con- stitute capital employed in its business in the United States. For the definition of "doing business" see article lo."^^ If a corporation does business here, then, although the mere investment of funds in United States securities is not such a taxable employment of capital, such investment will constitute capital employed in the transaction of business in the United States, if made in a subsidiary corporation which the foreign corporation uses as an instrumentality for the suc- cessful conduct of its own business in the United States. Thus the investment of the funds of a foreign corporation in the purchase of facilities, although apparently independent, for the purpose of its business here, or the purchase of stock and securities of a subsidiary corporation for the same purpose, will constitute the employment of capital in the transaction of business in the United States. A foreign corporation may not escape taxation by organizing, or purchasing See page 1533- ^The word "invested" was used in the 1916 law. 'See page i533- FEDERAL CAPITAL STOCK (EXCISE) TAX 1557 the stock of another corporation to own the facihties which the for- eign corporation needs in its business. See article 352, Regulations 45. (Reg. 50, revised. Art. 18.) If the foreign corporation does no business whatever in the United States, a separate domestic corporation being util- ized for the carrying on of business in this country, it is obvi- ous that the law imposes the capital stock tax only on the sub- sidiary. The mere ownership of the stock of an American corporation by a foreign corporation does not of itself con- stitute doing business by the latter in the United States. "Capital 'employed' in the United States" illustrated. — Regulation. A foreign corporation may employ capital in the transaction of its business in the United States in various ways. For example, the investment of funds in property in the United States used in its business, in stocks and securities of subsidiary corpora- tions as explained in article 18, in bills and accounts receivable repre- senting business done in the United States, in merchandise kept here for sale, in materials manufactured here, and in deposits in United States banks maintained for use in business here. Generally speaking, approximately such proportion of the entire capital of a foreign corporation will presumably be emploj^ed in the transaction of its business in the United States as the gross amount of its busi- ness in the United States bears to its total gross business, but this will not always be true, since a corporation may conceivably transact a greater or less volume of business in one* country than in another on the same amount of capital. (Reg. 50, revised, Art. 19.) Basis of tax, foreign corporation, — Regulation. The measure of the tax is the average amount of capital employed in the transaction of business in the United States during the preceding fiscal year. It will usually be sufficient to determine the amount of capital so employed at the beginning of each year and the amount so employed at the end of such year, and to divide the sum of such amounts by two. Where, however, there have been material changes in the amount of capital, the average amount should be determined with due regard to the times at which such changes occurred. A foreign corporation may, if it so desire, compute the average amount of capital employed on a monthly basis. (Reg. 50, revised. Art, 21,) 1558 MISCELLANEOUS TAXES Capital "employed" includes borrowed capital. — Ruling. Following question submitted on behalf our client the Company, a foreign corporation. Referring Article 33 [Art. 18], Reg. 50, is capital stock tax to be computed on entire amount of capital employed in this country irrespective of whether that capital consists in part of company's own capital and in part of borrowed capital? Kindly wire reply collect. (Answer'.) Your wire 25th. Capital stock tax is imposed upon capital employed irrespective of its nature whether borrowed, paid in or earned. (Telegram of inquiry from E. G. Shorrock & Co., Seattle, Washington, and the reply thereto, signed by Deputy Com- missioner J. Hagerman, and dated October 30, 1919.) Form 708, which provides for determining the capital em- ployed in the United States by a foreign corporation, calls for a statement of the total capital, surplus and undivided profits (whether employed within or without the United States) and a statement of the assets employed in the trans- action of business in the United States. The latter statement makes no provision for deducting liabilities incident to the transaction of business in the United States. In the case of a foreign corporation all of whose capital was employed in the United States, this would lead to the absurd result of show- ing a larger amount of capital employed in the United States than its actual total capital. Of course, if the corporation had absolutely no liabilities the result would be the same in both statements; but as practically all corporations have liabiHties, proper deduction should be made from the United States assets for the liabilities incident to the business in this country. Return by foreign corporations. — Regulation. Every foreign corporation carrying on or doing business in the United States shall make return on Form 708 (Re- vised) irrespective of the amount of capital employed in this coun- try in the transaction of its business. The capital actually employed in the transaction of the business of a foreign corporation in the United States and the tax payable thereon shall be calculated in accordance with the instructions on the form.**' See also articles 17, 18, 19, 20 and 21. (Reg. 50, revised. Art. 32.) '" See Appendix B. FEDERAL CAPITAL STOCK (EXCISE) TAX 1559 Inspection of Returns Regi^lation. The returns upon which the tax has been deter- mined by the Commissioner, although public records, are in general open to inspection only to the extent authorized by the President. All bona fide stockholders of record owning i per cent or more of the outstanding stock of any corporation shall, upon making request of the Commissioner, be allowed to examine the annual income re- turns of such corporations and of its subsidiaries, but such privilege of examination is personal and can not by power of attorney be dele- gated by the stockholder to another. Only such officers of any State as are charged with the enforcement of a State income-tax law shall have access to the returns of any corporation, or to an abstract thereof showing the name and income of the corporation, at such times and in such manner as the Secretary may prescribe, and then only in case the information is to be used by them in connection with such enforcement. Any stockholder who is allowed to examine the return of any corporation, and who makes known in any manner whatever not provided by law the amount or source of income, profits, losses, expenditures, or any particular thereof, set forth or disclosed in any such return shall be guilty of a misdemeanor and be punished by a fine not exceeding $1,000, or by imprisonment not exceeding i year, or both. (Reg. 50, revised. Art. 30.) Section 257 of the lav^, which referred specifically to in- come tax returns and on which the foregoing regulation is based, was by section 1000 (c) also made applicable to capital stock tax returns. Abatement and Refund of Taxes Regulation. Section 3220. of the Revised Statutes, as amended by section 1316 of the Revenue Act of 1918 [re-enacted without change as section 1315 after 1921 law] provides: Section 3220. The Commissioner of Internal Revenue, subject to regulations prescribed by the Secretary of the Treasury, is authorized to remit, refund, and pay back all taxes erroneously or illegally as- sessed or collected, all penalties collected without authority, and all taxes that appear to be unjustly assessed or excessive in amount, or in any manner wrongfully collected; also to repay to any collector or deputy collector the full amount of such sums of money as may be recovered against him in any court, for any internal-revenue taxes collected by him, with the cost and expenses of suit; also all damages and costs recovered against any assessor, assistant assessor, collector, deputy collector, agent, or inspector, in any suit brought against him 1560 MISCELLANEOUS TAXES by reason of anything done in the due performance of his official duty, and shall make report to Congress at the beginning, of each regular session of Congress of all transactions under this section. Section 3225 of the Revised Statutes, as amended by section 1316 of the Revenue Act of 1918 [re-enacted without change as section 1323 of the 1921 law], however, provides: Section 3225. When a second assessment is made in case of any list, statement, or return, which in the opinion of the collector or deputy collector was false or fraudulent, or contained any understatement or undervaluation, such assessment shall not be remitted, nor shall taxes collected under such assessment be refunded or paid back or recovered by any suit, unless it is proved that such list, statement, or return was not willfully false or fraudulent and did not contain any willful under- statement or undervaluation. For the procedure regarding claims for abatement or refund, see Regulations 14 (Revised). (Reg. 50, revised, Art. ^y.) Medium of Payment of Tax Regulation. Collectors may accept uncertified checks in payment of taxes, provided such checks are collectible at par — that is, for their full amount, without any deduction for exchange or other charges. The collector will stamp on the face of each check before deposit the words, "This check is in payment of an obligation to the United States and must be paid at par. No protest," with his name and title. The day on which the collector receives the check will be considered the date of payment so far as the taxpayer is concerned, unless the check is returned dishonored. If one check is remitted to cover the taxes of two or more corporations, the remittance must be accompanied by a letter of transmittal stating (a) the name of the drawer of the check; (b) the amount of the check; (c) the amount of any cash, money order, or other instrument included in the same remittance; (d) the name of each corporation whose tax is paid by the remittance; (e) the amount of the payment on account of each corporation; and (f) the kind of tax paid. (Reg. 50, revised. Art 39.) Dishonored checks, procedure. — Regulation. If the bank on which any such check is drawn shall refuse to pay it at par, the check shall be returned through the de- positary bank and be treated in the same manner as a bad check. All expenses incident to the attempt to collect such a check and the return of it through the depositary bank must be paid by the drawer of the check to the bank on which it is drawn, since no deduction can be made from amounts received in payment of taxes. See section 3210 FEDERAL CAPITAL STOCK (EXCISE) TAX 1561 of the Revised Statutes. If any taxpayer whose check has been re- turned uncollected by the depositary bank shall fail at once to make the check good, the collector shall proceed to collect the tax as though no check had been given. A taxpayer who tenders a certified check in payment for taxes is not released from his obligation until the check has been paid. See chapter 191 of the act of March 2, 191 1. (Reg. 50, revised, Art. 40.) Credit of Munition Manvifacturer's Tax Regulation. From the tax payable as above determined the amount, if any, of the munition manufacturer's tax imposed by Title III of the Act of September 8, 1916 (no longer in effect since Janu- ary I, 1918), actually paid by the corporation since making its last previous return hereunder is deductible. If a munition manufacturer's tax is due and payable but has not been paid at the time the capital stock tax becomes due and payable no credit of the munition manu- facturer's tax is permissible, until after the munition manufacturer's tax has been paid. After it has been paid the credit may be availed of by a claim for the refund of so much of the capital stock tax actually paid as is not in excess of the munition manufacturer's tax which became due and payable within the same calendar year. (T. D. 3009, signed by Commissioner Wm. M. Williams, and dated April 22, 1920.) (Reg. 50, revised. Art. 10.) Election to be taxed as corporation. — The 192 1 law^' pro- vides that in the case of the organization as a corporation, within four months of the passage of the act, of any trade or business in which capital is a material income-producing factor and which was previously owned by a partnership or individual, the net income of such trade or business from January i, 192 1 (if it was not less than 20 per cent of its invested capital), may at the option of the individual or partnership be taxed as the net income of a corporation is taxed under the income and excess profits taxes.*^ The invested capital and net income *' Section 229. " [Former Procedure] Election to be taxed as corporation. — Regulation. A business enterprise (a) which was organized as a corporation before July i, 1919, (b) in which capital is and has been a material income-producing factor, and (c) which was previously owned by a partnership or individual, may elect to be taxed as a corporation on its net income from January i, 1918, to the date of organization of the corporation. In such event the corporation shall be treated as if in existence 1562 MISCELLANEOUS TAXES shall be computed in the same manner as they would be de- termined if the corporation had been in existence on January I, 1 92 1. All other provisions of law with respect to tax on corporations are made efifective as of January i, 192 1. It is specifically provided that any taxpayer who takes advantage of this provision shall pay the capital stock tax imposed by the 191 8 law, commencing with January i, 1921. Under the 191 8 law, a corporation commencing business January i, 1921, would pay capital stock tax from July i, 1921. The intention is fairly clear that the capital stock tax is to be paid for the first six months of 192 1, but the language is not. In this respect the law differs from the provisions concerning personal service corporations as to which no intention to tax from January i, 1922, can be found. Final determination and assessment. — Section 13 12 of the 1 92 1 lav/ permits of an agreement in writing between the tax- payer and the Commissioner with respect to the amount of tax liability. It is provided that when such agreement is entered into, the case shall not be reopened by either the government or the taxpayer and no suit to overthrow it shall be enter- tained by any court, except upon a showing of fraud or mal- feasance or misrepresentation of fact materially affecting the determination of the tax liability.^" This is a reasonable and wise provision of law. It will, however, undoubtedly be more beneficial with respect to taxes since January i. 1918, for the purposes of the income tax, the war profits and excess profits tax, and the capital stock tax. The adoption of any other date than January- i, igi8, for such purpose is not permissible. But this option is not extended to a business enterprise with a net income for the taxable year 1918 less than 20 per cent of its invested capital. The clauses of section 407, Revenue Act of 1916, as amended, and section 1000, Revenue Act of 1918, which require that a corporation must have been engaged in business some part of a year preceding the taxable period in order to be liable for the tax, are not applicable to corporations filing returns under section 330 of the Revenue Act of 1918; that is to say, organizations electing to report as corporations under the provisions of this section, are required to file capital stock tax returns for the six months' period from January i to June 30, 1918, and for all subsequent taxable periods. (Reg. 50, revised. Art. 29.) " See page 210. FEDERAL CAPITAL STOCK (EXCISE) TAX 1563 other than the capital stock tax. The section of the Bureau handling this tax is on a fairly current basis and, so far as the author knows, cases in the capital stock tax section are not reopened as frequently as in some other sections of the Bureau. Treasury decisions not necessarily retroactive. — Section 1 3 14 of the 1 92 1 law provides that Treasury decisions or rul- ings of the Commissioner or the Secretary which are not im- mediately occasioned or required by a decision of a court of competent jurisdiction, are not necessarily retroactive in effect. The question of retroactive appliance of such rulings is left to the discretion of the Commissioner with the approval of the Secretary. Limitations upon additional assessments and refunds. — Section 1322 provides that, notwithstanding the provisions of section 3182 of the Revised Statutes, assessments of addi- tional taxes must be made within four years after such taxes become due. This provision applies only in the absence of fraud or an attempt to evade tax. In the latter case, assess- ment may be made at any time. This section became effective upon the passage of the 1921 law, November 23, 192 1, and, as it modifies the limitation in section 3182, Revised Statutes, additional assessments of capi- tal stock tax for the tax period beginning July i, 1918, may be made at any time before July 31, 1922. Section 1316 of the 1921 law amends section 322tS. Revised Statutes," and provides for the filing of claims for refund of taxes erroneously or illegally assessed or collected at any time within four years next after payment of such tax. Limitation upon suits. — Section 1320 of the 192 1 law provides that no suit or proceeding for the collection of any internal revenue tax shall be begun after the expiration of five See Chapter IX. 1564 MISCELLANEOUS TAXES years from the time such tax was due, except in the case of fraud. ^^ Suits begun prior to the passage of the 192 1 law are not affected by this Hmitation. Limitation of criminal prosecution. — Section 1321 of the 192 1 law amends the Act of July 5, 1884, and provides that no person shall be prosecuted, tried, or punished for any of the various offenses arising under the internal revenue laws unless the indictment is found or the information is instituted within three years of the commission of the oft'ense. This pro- vision became eff'ective with the passage of the 192 1 law on November 23, 1921. Interest on refunds and judgments. — Section 1324 pro- vides, with certain limitations, for the payment of interest by the government on refunds and judgments.^' Unnecessary examinations. — Section 1309^^ of the 1921 law provides that taxpayers shall not be subject to unnecessary examinations or investigations. Only one inspection of the taxpayer's books of account shall be made for each taxable year, unless the taxpayer requests otherwise, or unless the Commissioner, after investigation, notifies the taxpayer in writing that an additional investigation is necessary. '' See Chapter VIIL '^ See Chapter IX. ^^ See page 115. [Former Procedure] Credit for munition manufacturers' tax. — Section 407 of the 1916 law provided for a credit of the munition manufacturers' tax actually paid against the capital stock tax under certain conditions. The Treasury at first construed tliis section literally and disallowed claims for refund where the capital stock tax became due and payable before the munitions tax in the same calendar year. T. D. 3009, dated April 20, 1920, reversed this procedure and permitted claims for refund to be filed. This Treasury de- cision was intended to validate crior claims, but section 3228, Revised Statutes, as it then read, limited the period of claim to two years. Had taxpayers followed the law and not the regulations, the claims would have been in order. Section 3228, Revised Statutes, has been revised by the 1921 law (sec- tion 1326) and extends the limitation period to four years, applying the change to claims submitted under the 1916, 1917, 1918 and 1921 laws. Un- less the right to claim accrued before November 23, 1917, they are barred and the revision of section 3228, Revised Statutes, is of no benefit. APPENDIX A SUPPLEMENT TO EXCESS PROFITS TAX PROCEDURE 1921 The material contained in this appendix is pro- vided for the purpose of bringing up to date Excess Profits Tax Procedure, 1921. The appendix is divided into chapters corresponding to those of the 1921 book, and all comments and rulings are pre- ceded by a page reference. It is thought that by this means, the reader v^ill be enabled to bring up to date his copy of Excess Profits Tax Procedure, 1921. CHAPTER I INTRODUCTION (and FAREWELL) The excess profits tax law became effective January i, 1917; it became inoperative December 31, 1921. It was con- ceived in the necessities of the war. It has been called illegiti- mate (certainly no one claims the distinction of being its father) but the United States Supreme Court has thrown the protection of the Constitution around it. It had no friends; but it raised more money than any other tax measure in the history of the world. Why not let it die in peace? If we do not, the agricultural bloc will revive it to raise the money for the soldiers' bonus. CHAPTER II ADMINISTRATION AND APPLICATION OF THE LAW Page 12 Administration. — The excess profits tax section of the law is administered by the Commissioner in the same manner as is the income tax law. Changes in administrative procedure during 1921 are fully discussed in Chapter VII of this book. Page 14 Types of corporations subject to the tax. — Aside from adding a few corporations to the exempt list/ the new law does not change the applicability of the excess profits tax law. A change has been made in case of the income of foreign cor- 1 Section 231, see page 34 et seq. 1567 1568 EXCESS PROFITS TAX PROCEDURE— 1921 porations engaged in shipping- and in case of domestic cor- porations which derive the major part of their income from the possessions of the United States.^ CHAPTER III EXEMPTIONS The 1 92 1 law makes the following changes in the pro- visions which govern exemption from the excess profits tax. Pages 18 and 23 Income from gold mining.— Under section 304 (c) of the 1 9 18 law, that proportion of the net income of a corporation which is derived from the mining of gold is exempt from the excess profits tax. There w'as no similar exemption under the 1 91 7 law. The 1921 law makes the income from gold mining exempt from the excess profits tax as imposed by the 191 7, 1918, or 192 1 laws. Law. Section 304 (c) In the case of any corporation engaged in the mining of gold, the portion of the net income derived from the mining of gold shall be exempt from the tax imposed by this title or any tax imposed by Title II of the Revenue Act of 1917, and the tax on the remaining portion of the net income shall be the same proportion of a tax computed without the benefit of this subdivision which such remaining portion of the net income bears to the entire net income. The Senate amendment to this section applied only to ex- cess profits taxes assessed under the 19 17 law and which remained mipaid. This discrimination between taxpayers who had paid their taxes for 191 7 and those who for some reason had been able to suspend the date of payment until after the eft'ective date of the 1921 law, was removed in conference, so that all taxpayers engaged in the mining of gold will either Sections 217 and 233. Sections 262, see page 1324. EXCESS PROFITS TAX PROCEDURE— 1921 1569 have the 1917 tax refunded if already paid or will not be assessed if the tax has not yet been paid. The method of computing the tax shown on page 24 of Excess Profits Tax Procedure, 1921, can be applied in prin- ciple to 19 1 7 taxes. Page 19 The rate of 10 per cent, being the rate of income tax un- der the 1 9 18 law, must be amended to read 12^ per cent, effec- tive January i, 1922. Exempt corporations. — Certain changes have been made in section 231 of the law, which defines the corporations that are exempt from tax. These changes are fully dealt with in Chapter II. , Page 21 Personal service corporations. — The status of personal ser- vice corporations for 1921 is unchanged. From January i, 1922, this class of corporations will be taxed as ordinary cor- porations. The constitutionality of the method of taxing personal service corporations under the 19 18 law is still in doubt. That the doubt is a strong one is evidenced by the extraordinary provision of section 1332 of the 192 1 law, which provides for the taxation of personal service corporations as ordinary cor- porations — retroactive to January i, 1918 — if the method of taxation provided under the 1918 law is finally adjudged invalid. Full consideration is given to this question in Chapter XXIV. Page 27 [Former Procedure] Income from isolated transactions. — An officer of a cor- poration secured an option on its control several years prior to 191 7, exercised the option in 191 7, and earned a commis- sion on the transaction. The Treasury held that the income 1570 EXCESS PROFITS TAX PROCEDURE— 1921 "was made possible through his business connections" and assessed the excess profits tax imposed by section 209 of the 1917 law.^ The foregoing ruHng is hardly consistent with a recent de- cision of the United States District Court for the Eastern District of Pennsylvania.^ The court held that the commis- sions received by a lawyer as executor of the estate of a friend need not be included in income subject to the excess profits tax imposed by section 209. The court said : Decision. With respect to the theory on which the case was tried, it seems to us that it is very fairly and clearly stated in article 8 of the regulations. A contrast is there drawn, or at least distinction made, between what a person makes it his trade, profession, business, or emphatically vocation to do, what he holds himself out as prepared to do, and some particular thing of the same kind, which he does, but which is an incidental, accidental, isolated, particu- lar thing, which he happened to do. We confess, however, our inability to grasp the thought of a distinction between such isolated things, growing out of the importance of the thing done or the demands which it makes upon the time of the person doing it. It seems to us that this works confusion in the thought of the real distinction as expressed in the regulations. The whole thought is conveyed in an expression which is not uncommon when a person is asked to do something which, as another expression goes, is "out of his line." The expression first referred to is, "I don't make a business of doing this, but I will do it for you." The doing of it may result in such person devoting practically his whole time to it, without involving the thought of making it his business. There is much the same distinction made between amateurs and professionals in athletics, although the test usually applied there is the commercial test. Nevertheless the distinction referred to exists. The amateur does not make, as the professional ex vi termini does, the sport his trade, occupation, business, or profession, even although he, as he not infrequently does, devotes more time in de- veloping and perfecting skill in it than the avowed professional does. The difference is suggestive of a dift"erence in motive, but there is the other thought also. This case, however, has taken a turn which compels us to take an ^ C.B. 4, page 350, A.R.R. 350. ' Cadzivlader v. Lederer, 273 Fed. 879; affirmed, August 18, 1921, 274 Fed. 753. EXCESS PROFITS TAX PROCEDURE— 1921 1571 altogether practical view of the disposition to be made of it. The burden was, of course, upon the plantiff to make out his case. This he did, if the theory, upon which the case was submitted, was the true theory, by his testimony that his profession was that of a lawyer, and that he did not make a business of acting as executor, although he had so acted in one isolated case, wholly disassociated from his professional work. It would seem that the commissions of a lawyer who acted as executor were "made possible by his business connections" ; but the court found in efifect that section 209 applies only to one's regular business, but not to isolated transactions which grow out of it. CHAPTER IV RETURNS The 1 92 1 law provides in general (section 336) that every corporation not specifically exempt^ must make a re- turn for purposes of the excess profits tax for the year 1921. After 1 92 1, excess profits tax returns are no longer required. Special provisions are made, however, which provide that the returns of corporations which report on a fiscal year basis shall show the tax properly attributable to the respective 'calendar years.^ A new class of corporations is referred to in section 262 (corporations in which the major part of the income is from a possession of the United States). These are to be treated as foreign corporations, and for purpose of the excess profits tax they are assessed under sections 327 and 328.^ In- asmuch as foreign corporations are not assessed on the basis of invested capital, in making returns of income on form 1120 no computation of invested capital need be made.* 1 See Chapter II. 2 Section 335. ^ The relief sections — see page 1637. *Reg. 62, Art. 870, Reg. 45, Art. 871. 1572 EXCESS PROFITS TAX PROCEDURE— 1921 Corporations whose entire income is derived from gold mining need not compute invested capital, because the exemp- tion of such income from the excess profits tax provided for in the 1918 law is extended to 192 1 by the new law,° Returns of "government contract" corporations. — The 1 92 1 law re-enacts those provisions of the 19 18 law which impose a tax at the high 19 18 rates on net income in excess of $10,000 derived from "government contracts" realized in 1921. Law. Section 301 (b) For the calendar year 1921 there shall be levied, collected, and paid upon the net income of every corporation which derives in such year a net income of more than $10,000 from any Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive, a tax equal to the sum of the following: (i) Such a portion of a tax computed at the rates specified in subdivision (a) of section 301 of the Revenue Act of 1918, as the part of the net income attributable to such Government contract or contracts bears to the entire net income. In computing such tax the excess-profits credit and the war-profits credit which would be applicable to such calendar year under the Revenue Act of 1918 if it had been continued in force, shall be used; (2) Such a portion of a tax computed at the rates specified in subdivision (a) of this section as the part of the net income not attri- butable to such Government contract or contracts bears to the entire net income. For the purpose of determining the part of the net income attri- butable to such Government contract or contracts, the proper appor- tionment and allocation of the deductions with respect to gross income derived from such Government contract or contracts and from other sources, respectively, shall be determined under rules and regulations prescribed by the Commissioner with the approval of the Secretary. For the purpose of computing the higher tax applicable and the proper apportionment thereof, form 1120S must be filed. It should be noted particularly that while the higher 19 18 rates are applied to "government contract" income, the excess profits credit and the war profits credit for the year 1921 are ° [Former Procedure] The 1921 law (section 304-6) specifically extends to 1917 the exemption from excess profits tax of income from gold mining. See page 1568. EXCESS PROFITS TAX PROCEDURE— 1921 1573 the same as would have been obtained if the 1918 law had been continued. Returns for fiscal year 1920-1921. — Although the tax rates on corporations for the calender years 1920 and 1921 are the same, net income is determined differently under the 19 18 law, which was in effect in 1920, than under the 1921 law, which governs 1921 returns. Law. Section 335 (a) That if a corporation (other than a personal service corporation) makes a return for a fiscal year begin- ning in 1920 and ending in 1921, the war-profits and excess-profits tax for the taxable year 1921 shall be the sum of: (i) the same proportion of a tax for the entire period computed under the Revenue Act of 1918, which the portion of such period falling within the calendar year 1920 is of the entire period, and (2) the same proportion of a tax for the entire period computed under this title, which the portion of such period falling within the calendar year 1921 is of the entire period. Any amount heretofore or hereafter paid on account of the tax imposed for such taxable year by the Revenue Act of 1918 shall be credited towards the payment of the tax as above computed, and if the amount so paid exceeds the amount of such tax, the excess shall be credited or refunded to the corporation in accordance with the provisions of section 252 of this Act. It will, therefore, be necessary to make, in effect, two re- turns; one in which the net income and the tax are computed under the provisions of the 1918 law, and the other in which the net income and the tax are computed under the provisions of the 1 92 1 law. Returns for fiscal year 1921-1922. — Since the excess profits tax provisions are not in effect after December 31, 1921,*^ it is necessary, in making return for a fiscal year beginning in 1921 and ending in 1922, to allocate to 192 1 the proper proportion of the excess profits tax attributable to the period prior to January i, 1922. Law. Section 335 (b) If a corporation (other than a personal service corporation) makes a return for a fiscal year begin- Section 301 (a). 1574 KXCESS PROFITS TAX PROCEDURE— 1921 ning in 1921 and ending in 1922, the war-profits and excess-profits tax for the portion of the year falling within the calendar year 192 1 shall be an amount equivalent to the same proportion of a tax for the entire period computed under this title, which the portion of such period falling within the calendar year 1921 is of the entire period. There is, of course, the increased income tax at the 1922 rate which must be shown to be allocated to 1922 income in the return. Consolidated returns. — Affiliated corporations are given the option of filing either consolidated returns or separate returns for any taxable year beginning on or after January i, 1922.^ The excess profits tax provisions of the 19 18 law, however, are in effect until December 31, 1921, so that returns for 192 1 or for fiscal years beginning in 1921 must be on a consolidated basis if the corporations are affiliated. Law. Section 240 (e) Corporations which are affiliated within the meaning of this section shall make consolidated returns for any taxable year beginning prior to January i, 1922, in the same manner and subject to the same conditions as provided by the Revenue Act of 1918. The question of what constitutes affiliation and the relevant provisions of the 19 18 law governing procedure for 1921 are discussed in detail in Chapter XIV of Excess Profits Tax Procedure, 192 1. Reference should also be made to the cor- responding chapter of this appendix for rulings issued in 192 1. The Treasury required consolidated returns for excess profits tax for the taxable year 19 17, although the 191 7 law did not specifically so provide. The 1921 law (Section 1331)* in effect validates the Treasury regulations under the 191 7 law requiring consolidated returns, and extends affiliation to partnerships for 191 7. In specific cases, the Treasury had re- fused to accept returns of partnerships affiliated with cor- porations. " Law, section 240 (a). See Chapter XIV of this appendix. ^ See page 1627. EXCESS PROFITS TAX PROCEDURE— 1921 1575 Foreign corporations. — Foreign corporations are still ex- cluded from the benefits (if any) of consolidated returns. A domestic corporation which owns a majority of the voting stock of a foreign corporation, although still allowed a credit for foreign taxes paid on account of such shares against the taxes assessed in the United States, has had such credit ma- terially restricted by sections 238 (e) of the 1921 law which has been substituted for section 240 (c) of the 1918 act.^ CHAPTER V COMPUTATION AND RATES OF THE TAX , The rates of the 19 18 law applicable to 1919 and subse- quent years, apply to 192 1 for purposes of the excess profits tax. Special provision, however, is made in the case of fiscal year corporations. In the case of fiscal years beginning in 1920 and ending in 1921,^ separate computations have to be made under each act (with different methods of determining net income), and the sum of the proper proportion of each resulting tax is taken. For a fiscal year ending in 1922, the computation is made for a full year and then prorated.^ Net income from government contracts received in 192 1 (if in ex- cess of $10,000) is subjected to the higher rates at which this type of income was taxed under the 1918 law, viz., 30 and 65 per cent excess profits tax, and 80 per cent war profits tax.^ The limitation of tax (section 302) providing for lower rates of tax on corporations with small net incomes, has been re-enacted in the new law. The profits taxes are imposed upon the net income for the taxable year as determined for federal income tax purposes.* In case of corporations which have a fiscal year, part of which " For a full discussion of the limitation on credit for foreign taxes to domestic parent corporation having a foreign subsidiary, see page 948. ^ Section 335 (a). 2 Section 335 (b). •' Section 301 (b). •* Section 320. 1576 EXCESS PROFITS TAX PROCEDURE— 1921 falls in 1920, the net income as determined under the 19 18 law must also be ascertained, and the computation of the tax must be made under that act in order to obtain the proper proportionate tax applicable to the 1920 income.^ Page 54 Income from government contracts. — It is important to note that while the higher rates (war profits tax) apply to net income exceeding $10,000 which was realized in 192 1 from government contracts, the excess profits credits and war profits credits applicable to the year 1921, computed under the 19 18 law, are to be used. The limitation of tax under section 302^ is also specifically made applicable to the taxes computed at the 1918 rates. In some cases in which it was not feasible to allocate costs and expenses on the basis of gross income, the ratio of govern- ment and non-government sales to total sales has been used as an equitable method of arriving at the income to be taxed at the rates applicable.^ Page 62 Lower rates applicable in certain cases — no prorating of limitation under section 302. — The new law re-enacts the limi- tation provisions in order to give relief to corporations which have small net incomes. The provision also applies to "gov- ernment contract" income which is subjected to the higher 19 1 8 rates. The Secretary of the Treasury had previously recom- mended that the old law be amended in order to provide for the reduction of the limitations of $3,000 and $20,000 in case of corporations which report for less than a full year. The Treasury had required such reduction, as set forth in Regula- tions 45, articles 732-733. However, Congress did not act on the recommendation, and the 1921 law contains no such re- quirement. The Treasury has now amended articles 732 5 Section 335. ^ See Appendix C. ^ See also C.B. i, page 269; A.R.M, i. EXCESS PROFITS TAX PROCEDURE— 1921 1577 and 733 in order to allow the limitations to be applied with- out any proportionate reduction, as follows : Regulations. Limitation zvhen return for fractional part of year. — When a return is rendered for a fractional part of a year, the limitation shall be computed in the same manner as if the period covered by the return were a full taxable year. Illustration of computation of limitation of tax.—li in the il- lustration used in Article 720 the invested capital had been $100,000 and the net income $80,000, the tax computed under section 301 (a) of the statute would be $56,200. Section 302 provides, however, that tax under section 301 (a) shall not be more than 30 per cent of the net income in excess of $3,000 and not in excess of $20,000 plus 80 per cent of the net income in excess of $20,000. The tax at the 30 per cent rate will be $5,100 (art. 731) and the balance of the tax will be 80 per cent of $60,000 (the net income in excess of $20,000), or $48,000. The total tax will therefore be $5,100 plus $48,000, or $53,100. The tax under section 301 (a), amounting to $56,200, will accordingly be reduced to $53,100. (T. D. 3245, amending Arts. 732 and 733. Reg. 45, dated November 14, 1921.) Articles 732 and 733 of Regulations 62 incorporate the above changes, the example, liowever, using 1921 rates in- stead of those for 1918. In the official illustration given in article 733, before amendment,^ in which the limitations were prorated : The excess profits tax amounted to $55,825 In the amended article, the tax is (for details see illustration on page 1579) 53,100 Excessive tax imposed $2,725 The excessive tax may be accounted for as follows : Part of year not prorated (3 months) 3/12 3/12 of $17,000 ($20,000 — $3,000) = $4,250 at ^0% = $1,275 3/12 of $20,000 (limitation not re- duced) = $5,000 at 80% = 4,000 Net reduction in tax due to not reducing limitations $2,725 The 19 18 rates are used in the official illustration. Of course, for 192 1, the excess profits tax rates are 20 and 40 per cent. In all instances in which taxpayers have paid an excessive tax due to the reduction of the limitations under section 302, a claim for refund, or a claim for credit should be filed. ^ See Excess Profits Tax Procedure, 1921, pages 70-71. 1578 EXCESS PROFITS TAX PROCEDURE— 1921 r :? m O o '-' ad o < O Ph p:; o u o o I— I H < in Q «-< CO u « h? W Z W M ;^ c/} w - u o w o ?°- O IN ^ O ^ S >* to w o u w 2D S " J 6" d CO m- m- \4 O -^ O O « O Q to CO -I M Oh Wr S^ u 0*0 ■5 c^ fooo 4/J^ ooU U o (J_ ^ O f^ ,S CO "^ 'cooo u ^;; a u= fL, O ^ o cq 1000" ^ U (1^ CO ^ o r^ H J2 Ah m in IN. "^l Ph ^^ 5;^ fe « H 10 EXCESS PROFITS TAX PROCEDURE— 1921 1579 But section 302 provides that the tax shall not exceed 30 per cent of the net income in excess of $3,000 and not in ex- cess of $20,000 plus 80 per cent of the net income in excess of $20,000. Article 732 of Regulations 45 (as amended by T. D. 3245) does not now require these amounts to be re- duced when computing- the limitation of the tax for less than twelve months : Net Income in excess of $3,000 but not in excess of $20,000=$! 7,000 at 30%= $ 5,100 80% of net income ($80,000) in excess of $20,000 48,000 Total $S3,ioo Therefore the Excess and War Profits Tax to be paid is $53,100 Page 93 Computation of tax for fiscal years ending in 1921 and 1922. — Two computations should be made, both for income and for excess profits tax purposes — one under the 19 18 law, with its definition of net income, the other under the 192 1 law, which differs in a number of particulars (deductibility of additions to reserves for bad debts, interest on loans to carry Liberty bonds, etc.). The sum of the pro rata parts of the total tax for each full year is the total tax for the fiscal period. If the income of a taxpayer for a fiscal year ending in 1 92 1 is the same whether computed under the 19 18 law or under the 192 1 law, the computation of the tax need only be made for one year, since the rates of the excess profits tax (except in the case of government contract income)^" and the income tax are the same for 1920 (under the 19 18 law) as for 192 1. Law. Section 335. (a) That if a corporation (other than a per- sonal service corporation) makes return for a fiscal year beginning in 1920 and ending in 1921, the war-profits and excess-profits tax for the taxable year 1921 shall be the sum of: (i) the same proportion of a tax for the entire period comp\ited under the Revenue Act of 1918, h 1" See page 1572. 1580 EXCESS PROFITS TAX PROCEDURE— 1921 which the portion of such period falling within the calendar year 1920 is of the entire period, and (2) the same proportion of a tax for the entire period computed under this title, which the portion of such period falling within the calendar year 1921 is of the entire period. Any amount heretofore or hereafter paid on account of the tax im- posed for such taxable year by the Revenue Act of 1918 shall be credited towards the payment of the tax as above computed, and if the amount so paid exceeds the amount of such tax, the excess shall be credited or refunded to the corporation in accordance with the provisions of section 252 of this Act. (b) If a corporation (other than a personal service corporation) makes a return for a fiscal year beginning in 1921 and ending in 1922, the war-profits and excess-profits tax for the portion of the year falling within the calendar year 1921 shall be an amount equivalent to the same proportion of a tax for the entire period computed under this title, which the portion of such period falling within the calendar year 1921 is of the entire period. For fiscal years which ended in 1921, two computations of the excess profits tax are made, each for a full year, one under the 1918 law, and one under the 1921 law, and these are then prorated. The sum of the proportional parts is the total excess profits tax payable. Since the computations are made under two separate laws in which some of the items which make up net income and in- vested capital are treated differently, care must be taken to see that these are handled in accordance with the law under which the computation is being made. It is probable that a special form of return wnll be provided by the Treasury for fiscal year corporations, which will show the items that require different treatment under the two laws. In the case of fiscal years which end in 1922, the excess profits tax is first computed for the entire period and then prorated. For example, assume the case of a corporation with a fiscal year ending May 31, 1922, and that the excess profits tax computed for a full twelve months' period was $36,000. The excess profits tax payable would be 7/12 thereof, or $21,000. For the method of computing the income tax in the case of fiscal years ending in 1922, see page 165. The computation of the tax in the case of personal ser- EXCESS PROFITS TAX PROCEDURE— 1921 1581 vice corporations which have tiscal years ending in 1921 and 1922, is dealt with in Chapter XXIV. [Former Procedure] The confusion that arises in the minds of taxpayers, par- ticularly in dealing with those provisions of the law which provide for computations, is illustrated in two recent decisions involving the interpretation of section 201 of the 191 7 law. In the first case^^ the court said, in part : Decision. According to section 201 of the Revenue Act of 1917, supra, a tax is imposed at the rate of 20 per cent upon "the amount of the net income in excess of the deduction .... and not in excess of fifteen per centum of the invested capital for the taxable year," etc. While the entire section is not free from ambiguity, the court is of. the opinion that, having in mind the necessity of adopting a con- struction in accordance with the intent of Congress when the act was adopted, that urged by the government must prevail. If it had been the purpose of Congress to have the tax computed as plaintiff contends, the first paragraph of section 201 would have provided for the levy of a tax "equal to the following percentages of the net income less the deduction determined as hereinafter provided," making no mention of any deduction in the following paragraph. If the section as it now reads is carefully analyzed, it is apparent that the amount of the net income which is to be taxed at the rate of 20 per cent is not more than 15 per cent of the invested capital for the taxable year. But not so much of the net income as is represented by such 15 per cent is to be so taxed because there must first be allowed the deduction. The court uses a method that will prove helpful in inter- preting any of the sections involving computations, viz., to restate the law so as to give effect to an alternative compu- tation. The same point, viz., that the exemption (in effect, excess profits credit) was not to be first deducted from the entire net income, but was to be applied to the net income in the first bracket, was also decided in another case. The effect of the " Greenport Basin & Construction Co. v. U. S., 269 Fed. 58 (U. S. District Court for the Eastern District of New York, November 18, 1920). 1582 EXCESS PROFITS TAX PROCEDURE— 1921 difference in the two methods is clearly stated by the court^* as follows : Decision. A comparison of the two methods shows that, by making the deduction from the first item of 15 per cent of invested capital, the amount taxed at the 20 per cent rate is diminished by the amount of the deduction, and the amount taxed at the 60 per cent rate is increased by the amount of the deduction A large part of the difficulty in construing the 20 per cent par- agraph arises from the fact that the amounts involved are expressed in descriptive terms and not in figures. If the act taxed the amount of the net income in excess of $50,000, and not in excess of $100,000 we would have no difficulty in understanding that the amount to be taxed was the difference between $100,000 and $50,000. The last sentence quoted above indicates admirably how, by substituting actual figures, a clearer conception of the mean- ing of the law may be obtained. CHAPTER VI CREDITS AND SPECIFIC EXEMPTIONS Page 109 Domestic corporations which derive more than 80 per cent of their gross income from sources within possessions of the United States, do not receive the $3,000 exemption.^ This is the only change made by the new law in the excess profits credit and the specific exemption of $3,000, except that it eliminates the provisions dealing with the war profits credit and specific exemption. This has resulted in a few changes in the numbering of paragraphs and subdivisions. For in- stance, section 301 (d) of the 19 18 law now becomes section 301 (c). ^^ Ehret Magnesia Mfg. Co. v. Lederer, 273 Fed. 689. (U. S. District Court for the Eastern District of Penna., No. 7044, May 23, 1921, issued as T.D. 3200, dated July 19, 1921. 1 Section 312. EXCESS PROFITS TAX PROCEDURE— 1921 1583 [Former Procedure] Page 120 Computation of average deduction. — The Treasury has ruled that in computing the "average deduction" under section 205 of the 19 1 7 law, the averaging is to be done after the limitations provided in section 203 have been applied.^ CHAPTER VII INVESTED CAPITAL— BORROWED MONEY Page 123 The excess profits tax is a tax on net income, but the tax is measured by a computation of invested capital. Congress adopted a formula for the computation which, considering war conditions, corporate records, and the utter impossibility of using an actual value basis, is as nearly equitable as could be devised. From the time of the passage of the 191 7 law it was certain that the constitutionality of the formula and of other sections of the law would be tested in the courts. For- tunately, the first case decided by the United States Supreme Court was one which squarely raised the most important con- troversial points which have been raised. Constitutionality of excess profits tax, — In handing down its decision in the case of La Belle Iron Works v. United States,'^ the Supreme Court dealt with the contention raised by the appellant, that the excess profits tax was unconstitu- tional. The digest of the decision, published as T. D. 3181,^ states succinctly the salient points of the decision, as it relates to constitionality, as follows : Decision. It was not unreasonable for Congress, in adjusting the excess profits tax, to accord preferential treatment to capital repre- 2 1-2-24; A. R. R. 716. ^41 Sup. Ct. 528. 2 C. B. 4, page 144- 1584 EXCESS PROFITS TAX PROCEDURE— 1921 senting actual investments, as compared with capital representing higher valuations based upon estimates, however reliable, of what probably could be realized were the property sold instead of re- tained Cases decided under the equal protection clause of the fourteenth amendment to the Constitution are not authority in determining whether a Revenue Act operates to produce baseless and arbitrary discriminations, to the extent of rendering the tax invalid under the due process clauses of the fifth amendment, as the fifth amendment has no equal protection clause, and the only rule of uniformity pre- scribed with respect to duties, imports, and excises laid by Congress is the territorial uniformity required by section 8 of article I ; nor are cases based upon the due process clause of the fourteenth amend- ment applicable The Act, in basing "invested capital" upon actual costs to the ex- clusion of higher estimated values, is not violative of the due process clause of the fifth amendment to the Constitution in that it is so wholly arbitrary as to amount to confiscation ; the Act treats all corporations and partnerships alike so far as they are similarly circumstanced, and if in its application the tax in particular instances may seem to bear upon one corporation more than upon another, this is due to differences in their circumstances, not to any uncertainty or want of generality in the tests applied. Page 127 Computation of invested capital — cash or accrual basis. — Ruling. A corporation which reports its income on a cash receipts and disbursements basis may not take accrued items into consideration in computing its invested capital. (B. 34-21-1787; O. D. 1007.) The effect of this ruling is, that corporations keeping their accounts by the single-entry system of bookkeeping are com- pelled to compute their invested capital on a cash basis, omitting both accounts payable and accounts receivable, even though in a statement made up in such a form the net worth does not truly represent the amount of capital invested in the business. Page 129 When demand notes payable to stockholders do not con- stitute liability. — Ruling. Recommended, that treasury demand notes drawn by order of the president of a corporation payable to its stockholders, EXCESS PROFITS TAX PROCEDURE— 1921 1585 but not in proportion to shareholdings, do not constitute a liability of the corporation even though such notes are charged against sur- plus on the books of the company. (C. B. 4, page 362; A. R. R. 473.) This case is somewhat unusual and does not enumerate a principle to be generally applied. In arriving at this decision, the Committee on Appeals and Reviews pointed out that a corporation cannot, without consideration, issue notes to its stockholders for the amount of its surplus, except by declaring a dividend pro rata according to stockholdings; and without such formal declaration the notes do not constitute a liability, no matter what entries have been made in the books of account. Furthermore, in the instant case, the notes were not delivered to the stockholders, but were held by the treasurer of the company. Hence, the amount of the notes payable should be included in invested capital. Page 133 Dividends left in business. — Ruling. A Massachusetts corporation formally declared a divi- dend duly recorded in the minutes book, the resolution stating that the date of payment would be determined at a later date. Later a second dividend by informal action was credited to the stockholders, although its declaration was not recorded in the minutes book. Both dividends were credited to the respective accounts of the stockholders with the understanding among them that they were not to be drawn against and were not to bear interest. They have been treated as liabilities of the corporation from 1916 and no interest has been paid or accrued thereon. Held, under Massachusetts court decisions, that the amount of surplus credited to the stockholders without formal action was equiva- lent to a dividend. Accordingly, the corporation's surplus must be reduced from the date the first dividend was formally declared and in the case of the second dividend, from the date the agreement was made informally to credit the stockholders' accounts. ('B. 34-21-1786; O. D. 1006.) This decision should be compared with A. R. M. 71 (C. B. 3, page 348). The controlling feature would seem to be the application of the Massachusetts corporation law. If the credit balances were treated as liabilities in statements for 1586 EXCESS PROFITS TAX PROCEDURE— 1921 credit purposes, such as those furnished to mercantile agencies, the ruHng is sound. Page 137 [Former Procedure] Amended returns for 1917 — community property of hus- band and wife. — Ruling. In filing amended returns under T. D. 3071 (C. B. 3, p. 221), husband and '^vife may file separate excess profits tax returns for 1917, in which the community income may be divided between them. The invested capital of either the husband or the wife should be computed by adding that portion of the invested capital which is his or her separate property to one-half of that portion of the in- vested capital which is community property. The full amount of the specific exemption authorized by the statute may be claimed by each. (C. B. 4, page 254; O. D. 881.) Page 140 Advances to partners to purchase stock. — Where stock in controlled companies was purchased by a partnership, the cost being prorated among the partners and charged to their per- sonal accounts, the stock being from time to time used as collateral for loans obtained by the partnership, it has been held that the amounts charged to the partner's personal ac- counts represent advances by the partnership to the partners, and do not reduce invested capital. Partners received interest on the credit balances in their capital accounts and were charged interest on the debit balances referred to above.* The distinction is made between specific advances to purchase stock and debit balances representing withdrawals of capital. Page 141 Invested capital of partnerships. — The Treasury has held that debit balances of partners representing moneys advanced by the partnership may be included in invested capital.' The ruling is somewhat inconsistent with former rulings. Em- phasis is placed upon the fact that interest was charged on *B. 39-21-1848; A. R. R. 619. 5B. 39-21-1848; A. R. R. 619. EXCESS PROFITS TAX PROCEDURE— 1921 1587 the balances and that the securities individually purchased and owned by the partners were available as collateral. There is not the slightest difference between large debit and credit balances and one account with a net balance. Thus a partner has a credit balance of $i,cx)0,ooo; he withdraws $500,000 and invests it in securities. According to the rulings the partnership would have $1,000,000 of invested capital if it kept two ledger accounts, and $500,000 if it kept one ac- count! The treatment of interest is similar; crediting interest on $1,000,000 and debiting interest on $500,000 is precisely the same as one calculation of interest on a net credit balance. The invested capital of partnerships in 191 7 depends on facts — not on bookkeeping methods. CHAPTER VIII INVESTED CAPITAL— ADJUSTMENT OF ASSET VALUES The decision of the Supreme Court in La Belle Iron Works V. United States-^ has clarified many matters relating to in- vested capital. It is held that unrealized appreciation has no place in invested capital," cost alone being admissible ; how- ever, the court clearly brought out the fact that the cost (less adjustments for depreciation, depletion, etc.) of all assets in existence on January i, 191 7, should be included in invested capital at that date. The application of this decision to specific phases of the subject is brought out in the following pages. Page 146 (footnote) Revaluation at January i, 1914. — In the La Belle Iron Works case,^ the court disallowed appreciation in value as an Mi Sup. Ct. 528; issued as T. D. 3181. ~ Except when January i, 1914, revaluations are provided for. ^41 Sup Ct. 528. 1588 EXCESS PROFITS TAX PROCEDURE— 1921 element in invested capital, but commented at some length upon the exception to the rule found in the 191 7 law. In view of previous attempts by the Treasury to restrict the scope of the section, it is of interest to note that the court's references in- dicate that, when called upon to interpret section 207 (a) of the 191 7 law, the intention of Congress to permit the inclusion of appreciation will be upheld. The cases in which advantage of the section can be taken are extremely few, but when a case arises it should receive the full benefit of the privilege. Appreciation in values must not be included. — The La Belle Iron Works, prior to 1904, acquired a tract of ore lands for $190,000. Through development and exploration large bodies of ore were discovered, and by 19 12 the ore body was valued at $10,105,400. In 19 12 the company revalued its property on its books and declared a stock dividend of $9,- 915,400. In making its tax return for 1917 the company in- cluded the 19 12 revaluation in its invested capital. The Treas- ury disallowed the appreciation; the company paid an addi- tional tax and then brought suit for refund. The lower court decided against the company, and the Supreme Court affirmed the decision of the lower court on May 16, 1921.* The decision is voluminous, but does not require extended comment. The court refers to the consideration which Con- gress gave to the "value" basis for invested capital and the difficulties and possible evasion which would follow if inter- ested parties were permitted to use their own estimates of values. The court comments upon the final adoption of the term "invested capital," and places peculiar emphasis upon the word "invested," which it holds to preclude appreciation or increment in value. The decision greatly strengthens claims for actual values paid in. This point is commented upon elsewhere.^ The author has consistently advised taxpayers that appre- *4i Sup. Ct. 528. ^ See page 1609. EXCESS PROFITS TAX PROCEDURE— 1921 1589 dated values cannot, under any circumstances, be included in invested capital until realized,*' nor can appraisals, however scientifically made, increase invested capital if the element of unrealized appreciation is in any way included. The difference between restoring capital items improperly or inadvertently charged off prior to 191 7, and including ap- preciated values, will always be a troublesome point. General rules are not applicable. Each case must be judged according to the facts which a careful analysis of the accounts reveal. Where, however, it can be shown with reasonable assurance that an appraisal value does not contain a material amount of appreciation, but that on the contrary it is on a basis sub- stantially of cost less depreciation actually accrued, the author sees no objection (nor is there any inhibition against it in the excess profits tax laws) to using such an appraisal as the basis for restoring in effect capital expenditures which were absorbed in operating expenses in earlier years. "Where appraisals were made prior to the war period, or can otherwise be shown to exclude any appreciation, it would appear that an appraisal may in some cases be even a better and more effective means of restoring to the accounts capital ex- penditures previously absorbed in operating expenses, than the identifying of specific expenditures and the setting up of theo- retical depreciation thereon. The appraisal has the advantage of making certain that the plant facilities or additions repre- sented by the capital expenditures previously written off are still in use; also the depreciation actually sustained or accrued is based on an actual survey of the property. The present attitude of the Treasury regarding appraisals is shown in the following: Ruling. The Committee has reconsidered its Recommendation 490 (not pubHshed) in the matter of the appeal of the M corporation from the action of the Income Tax Unit in assessing excess profits taxes for the year 1917 under the provisions of section 210 of the Revenue Act of 1917 and for subsequent years under the provisions of sections 327 and 328 of the Revenue Act of 1918. '^ Always excepting the January i, 1914, provision. 1590 EXCESS PROFITS TAX PROCEDURE— 1921 In a memorandum from the Unit transmitting this case to the Com- mittee the following statement is made : The corporation was organized in 1914 and took over the assets and assumed all the liabilities of two going concerns, the O corporation and the P partnership, the entire capital stock of the new corpraotion, 4x dollars, issued to the stockholders of the old corporation and the members of the partnership. The evidence submitted in the form of various appraisals shows that the assets acquired had a valuation far in excess of the capital stock. The corporation, however, could not submit any data show- ing the cost of the assets, as the records had been destroyed by water. In January, 1921, appraisals of the different classes of assets were made as of 1914 by different individuals assisted by others who were employed by the corporation in 1914. In the conference the manager of the corporation first stated the method used in determining whether the assets listed were acquired in the consolidation in 1914 was by taking an appraisal made in 1917 and eliminating therefrom all items shown by the books to have been purchased and charged to the asset accounts from 1914 to the date the appraisal was made. Later he stated that the appraisal was made by the former employees going through the department and listing the assets which from their own knowledge were acquired in the con- solidation and afterwards comparing these items with the appraisal made in 1917. In the consideration of this cast it is necessary to refer to the provisions of the Revenue Act of 1917 which deals with tangible property paid in for stock. The pertinent part of section 207 (a) reads as follows: .... (2) the actual cash value of tangible property paid in other than cash, for stock or shares in such corporation or partnership, at the time of such payment (but in case such tangible property was paid in prior to January i, 1914, the actual cash value of such property as of January I, 1914, but in no case to exceed the par value of the original stock or shares specifically issued therefor), and (3) paid in or earned surplus and undivided profits used or employed in the business, exclusive of undivided profits earned during the taxable year Article 63, Regulations 41, interprets the foregoing provisions of the statute and reads as follows : Where it can be shown by evidence satisfactory to the Commissioner of Internal Revenue that tangible property has been conveyed to a corpora- tion or partnership by gift or at a value, accurately ascertainable or definitely known as at the date of conveyance, clearly and substantially in excess of the cash or the par value of the stock or shares paid therefor, then the amount of the excess shall be deemed to be paid-in surplus. The adopted value shall not cover mmeral deposits or other properties dis- covered or developed after the date of conveyance, but shall be confined to the value accurately ascertainable or definitely known at that time. Evidence tending to support a claim for paid-in surplus under these circumstances must be as of the date of conveyance, and may consist, among other things, of (i) an appraisal of the property by disinterested author- ities, (2) the assessed value in the case of real estate, and (3) the market price in excess of the par value of the stock or shares. The pertinent part of the Revenue Act of 1918 reads as follows: .... (2) Actual cash value of tangible property, other than cash, bona fide paid in for stock or shares, at the time of such payment, but in EXCESS PROFITS TAX PROCEDURE— 1921 1591 no case to exceed the par value of the original stock or shares specifically issued therefor ; unless the actual cash value of such tangible property at the time paid in is shown to the satisfaction of the Commissioner to have been clearly and substantially in excess of such par value, in vi^hich case such excess shall be treated as paid-in surplus Article 836, Regulations 45, interprets the foregoing quoted pro- vision of the statute and reads in part as follows : Evidence ofifered to support a claim for a paid-in surplus must be as of the date of the payment, and may consist among other things of (a) an appraisal of the property by disinterested authorities made on or about the date of the transaction; (b) certification of the assessed value in the case of real estate; and (c) proof of a market price in excess of the par value of the stock or shares. The additional value allowed in any case is confined to the value definitely known or accurately ascertainable at the time of the payment The records in the case show that for several years prior to 1914 the P partnership had conducted a repair business. In 190- a corporation known as the O corporation was incorporated, its entire capital stock being owned by the P partnership. In 1914 this corpora- tion and the P partnership, consisting of A, B, and C, were con- solidated and incorporated under the name of the M corporation, with a capital stock issue of 4X dollars. This capitalization was nomi- nal and was not based on any valuation of either plant, as it was not deemed necessary to set an actual value on the asset because of the fact that all the corporate stock was held by the three members of the partnership. During the lifetime of A the partnership's account- ing system was very lax and, as shown by a number of affidavits filed in behalf of the M corporation, all the books, balance sheets, and other accounting records of the P partnership and the O corporation were rendered useless during a storm in 1918, so that at the present time no records exist from which might be obtained a complete state- ment as to the cost of the assets taken over by the M corporation in the consolidation of 1914. Under these circumstances the Unit holds that the statutory invested capital of the corporation can not be satis- factorily determined, and proposes to make assessment of excess profits tax under the provisions of section 210 of the Revenue Act of 1917 and section 328 of the Revenue Act of 1918. The corporation has had various appraisals and estimates made in an effort to show the value of the assets in order to establish a claim for paid-in sur- plus, which appraisals may be classed as follows : (i) Two appraisals were made by engineers versed in the par- ticular line of business in 1917. Each of the gentlemen who fixed upon the values shown above was undoubtedly well qualified to make appraisals covering the assets of the character owned by the M corporation, but it is to be noted that while there is a net difference of but 2x dollars between the totals of the two sets of figures no one unit was given the same value except 1592 EXCESS PROFITS TAX PROCEDURE— 1921 in the case of automobiles, etc., the difference in the values given the other items ranging from i/iox dollars in the case of office furniture to 2^2^ dollars in the case of other property, which in a measure in- dicates the difficulties experienced in fixing upon definite values. (2) Three affidavits as to the value of the property taken over by the M corporation were submitted by persons familiar with values of such property. Each of these gentlemen stated in his affidavit that of his own knowledge and belief the plant and equipment of the P partnership in 1914 was worth 6ox dollars, while the fair value in 1914 of the plant and equipment of the O corporation as estimated by one of them was 241^1; dollars and by the other two about 240.r dollars, al- though no value is placed upon any individual assets. (3) Three affidavits similar to the next above made give a value of 29i.r dollars. (4) A composite appraisal made in 1921 — assets being divided into classes and itemized and each class appraised by men particularly qualified for the work, showing a total value as of 1914 of 304.1- dol- lars. This last appraisal was taken subsequent to a conference held in 1920 between representatives of the taxpayer and members of the Income Tax Unit, during which the former were advised that in or- der to establish a claim for paid-in surplus evidence must be fur- nished showing the assets taken over upon consolidation, the cash value of the assets as of that date, the cost of subsequent additions by years, the proportion of such cost, if any, which had been included in the deductions claimed on taxpayer's returns, and the assessed value of the properties. To each individual appraisal which forms a part of this composite appraisal is attached an affidavit signed by the appraiser indicating the character of the work performed and the experience had by him in the past which would serve to qualify him to place fair and just values on the particular class of assets covered by his appraisal, but the appraisals contain little or no evidence of the facts upon which they are based and as to how they acquired their information or data to make up the appraisals, or as to how the appraisals were constructed. It was stated during a conference granted representatives of the taxpayer by this Committee that no assets were included in these appraisals except such as were positively known to have been in the possession of the P partnership and the O corporation and taken over by the M corporation at the time of con- solidation except an item of "Hand tools," etc., valued at 4X dollars, with reference, to which the representatives of the taxpayer volun- teered the information that such item was a mere estimate. No other proof is submitted to show how it was known that nothing was included except that which was in the possession of the company in 1914. EXCESS PROFITS TAX PROCEDURE— 1921 1593 Accompanying this appraisal are statements taken from the books showing the amounts expended in the purchase of additional assets during the years 1914-1919, the amount of depreciation charged off during each of those years, and a summary showing the adjusted values of all lands, buildings, machinery, and equipment for the years 1914-1919 based on the appraisal made as of January i, 1914. As shown above, the appraisals forming the first set were taken in 1917 and show values as of that year. The affidavits forming the second and third sets contain nothing except general statements to the effect that in the opinion of the affiants the assets taken over upon consolidation were worth certain amounts in 1914. Neither of these appraisals or estimates, therefore, can be said to be of such a satis- factory and convincing character as to justify the acceptance of the values therein stated for invested capital purposes in the computation of excess profits tax liability without further investigation by the Unit to ascertain whether such values were computed upon the basis outlined herein. The representatives of the taxpayer have stated to the Commit- tee that their whole objection to assessment under the provisions of sections 210 and 328 of the Revenue Acts of 1917 and 1918, respec- tively, is on the ground that such a method of assessment affords no stable basis from year to year for a determination of the corporation's tax liability, for which reason they desire that the corporation be classed as one having a determinable statutory invested capital rather than as one entitled to relief under the provisions of the said sections even though its tax liability be greater under the first method than under the latter. The values as stated in the four sets of appraisals mentioned above were apparently fixed by men who were well qualified for the work, but a different value is stated in each appraisal, which indicates the difficulties experienced in carrying out such a task and the practi- cal difficulty in establishing cost. The first appraisal being taken at 1917 values, and the affidavits comprising the second and third ap- praisals, so called, being nothing more than general statements, can not be accepted. The fourth appraisal, while stated in detail, shows in some cases approximations and not actual ascertainment of values. That part of this appraisal which covers fire protection system, plumbing and piping, indicates that the great majority of the items so covered was approximated, while that part which covers certain other property indicates that the quantity of material entering into the construction of such assets has been approximated. Errors in stated figures which affect the total value shown have also been made. While many of the assets covered by this appraisal are of such character and size, such as lands, large machines, etc., as to be easily identified as having been among the assets transferred, even after a lapse of years, by k 1594 EXCESS PROFITS TAX PROCEDURE— 1921 those who had worked with, around, and among them, and their value as of time of transfer more or less satisfactorily established, yet it is to be noted that this appraisal covers hundreds of very minor items which, because of their lack of size, importance, and cost, ranging in stated figures from a few cents to not more than $50, lack distinctive character, and the Committee finds it hard to believe that such assets would so firmly fix themselves in the remembrance of any man or men as to permit such persons to positively identify them in 192 1 as having been the identical articles which were in the hands of the P partnership and the O corporation and transferred to the M corporation in 1914, especially when it is known that many of such items were removed from a plant and reinstated and rearranged in new buildings in another community. It is also shown by an ap- praisal made in 19 17, by competent men, and before the loss of the book records, that the value of the assets at that time was a little less than 240.V dollars and there is nothing to show why the assets were worth approximately 6o.v dollars more in 1914 than in 1917. It was stated in conference that since the consolidation in 1914 accurate book records have been kept from which it is possible to accurately determine just what additions to the plant had been made in order that the appraisals as of 1914 might contain nothing ac- quired since consolidation, and yet, in a statement filed with the Unit, the cost of such additions made during the year 191 7 was stated as i%x dollars, while in a later statement such cost is stated as i i/6x dollars, which fact throws doubt upon the accuracy of such book records as have been kept. In the said appraisal the value of all flat lands, regardless of location or character, is stated at a certain amount per square foot, but no statements have been submitted showing the values placed thereon for local tax purposes. In the consideration of the case the Committee has pointed out certain discrepancies in the appraisals which it is sought to have the Income Tax Unit accept as a basis for the allowance of a paid-in surplus. These discrepancies raise a doubt as to the accuracy of the figures submitted in such appraisals and of the facts upon which such appraisals are based. The appraisals in question are apparently based upon the opinions of persons qualified to testify in a matter of this kind, but it does not appear that the inventory of the assets of this corporation, as enumerated in the appraisals, has been valued upon a cost basis. It is thought possible to so value the assets in this case when the appraisals have been modified in accordance with the method hereinafter outlined and to this end the Unit should make or have made an independent appraisal for the purpose of verifying or check- ing the amounts and values stated in the appraisals submitted by this company before accepting same as representing sound values of the assets at the time they were paid in to the corporation in 1914. In the past it has been the policy of the Bureau to construe EXCESS PROFITS TAX PROCEDURE— 1921 7595 strictly llic requireuieiits of article 63, Regulations 41, and article 836, Regulations 45 (1920 edition). As a result of such construction of these articles numerous retroactive or retrospective appraisals have been rejected as a basis for a claim for paid-in surplus. The Committee has made an exhaustive study of appraisals and their re- lation to invested capital of corporations. It has also considered ap- praisals in connection with establishing March i values for purposes of depreciation and depletion, and for purposes of establishing certain values in connection with amortization claims, and has reached the conclusion that the Unit has been too strict in interpreting the pro- visions of the statute and the articles of regulations interpreting same quoted above, and that retrospective appraisals, if made upon the basis hereinafter outlined and proof is furnished of the facts upon which they are based, may properly be accepted as a basis for the al- lowance of a paid-in surplus. The Unit, as well as the Committee, is continually fixing values for one purpose or another. This is par- ticularly true in fixing the March i values for the purpose of com- puting gain or loss upon the sale of an asset which has been held for some time and which is of a class not regularly dealt in by the public. In the instant case it is not only necessary to determine the actual cash value of the tangible assets at the time paid in in 1914 for the purpose of invested capital, but it is necessary to determine the fair market value of the depreciable property so paid in as at March i, 1913, for depreciation purposes and also for the purpose of ascertain- ing whether or not the stockholders in the O corporation and the partners in the P partnership derived any profit from the sale of these assets to the M corporation. It is understood that the stockholders and copartners did not include any profit in the computation of their net income for the year 1914. In making a retroactive or retrospective appraisal to show the actual cash value of tangible assets at the time paid in at some date in the past, care should be exercised in order to eliminate any apprecia- tion written upon the books of the corporation since the date of ac- quisition, and also to value the assets in question at cost. In the case of the La Belle Iron Works v. United States (C. B. 4, page 373), de- cided by the Supreme Court on May 16, 1921, it was held that any appreciation in value of property over its cost is not to be included in invested capital as paid-in surplus. Treasury Decision 3220 (Bul- letin 37-21-1822) was promulgated subsequent to this decision and requires the filing of amended returns in all cases where taxpayers have written appreciated or inflated values upon their books and have used same in determining the amount of their invested capital. It would, therefore, appear that no appreciation over cost can be recognized in the computation of invested capital and that appraisals made for the purpose of establishing invested capital and for the 1596 EXCESS PROFITS TAX PROCEDURE— 1921 purpose of allowance of a paid-in surplus should be based upon the actual cost of the tangible properties as they existed at the time they were paid in, giving particular attention and consideration to the origi- nal cost and depreciated reproduction cost as at the basic date and the remaining expectancy of life. In order to accomplish this result it will be necessary to inventory at cost as of the basic date (the date of acquisition) the property then on hand and in many cases to es- tablish by historical investigation the date of original acquisition, date of renewal, and the cost of additions made subsequent to the date the property was paid in. Adjustments should be made for property scrapped or discarded and for depreciation. The books of account, if available, should be considered the best evidence as to dates of acquisition and actual cost. The asset ac- count showing the tangible property may be incomplete for many reasons and may include property still on the books that has been dis- carded as well as property in existence that has never been capitalized or entered on the books and certain arbitrary amounts charged oft as depreciation which have no relation to the expired and remaining life of the propertj^ The tangible property actually in existence and in use should be considered as the basic evidence of the invested capital in existence and should be used as a basis for the proper correction of the ac- counts to correctly reflect the actual investment in the depreciable properties in existence during the taxable years. The burden of proof is upon the taxpayer when a claim for a paid-in surplus is made, and in so far as the records of the taxpayer may be incomplete or the regulations permit values of the property at the date paid in should be established by proof. The regulations quoted above do not prescribe any specific method for ascertaining the facts, but only indicate some of the means by which appropriate proof may be furnished which would be acceptable to the Bureau. A retrospective appraisal is in substance the opinion of experts based upon the facts presented to them and as such is admissible as evi- dence of a paid-in surplus, but its value as proof of a paid-in surplus must depend upon the truth of the facts upon which it is based. Necessarily, if any of the facts presented to the experts are not ac- curate, the experts' opinion is inaccurate to the extent that such facts are inaccurate. In order, therefore, for the Bureau to accept as con- clusive a retrospective appraisal, it must be satisfied under the regu- lations that the facts upon which the appraisal is based are true. In determining whether or not the facts are true the Bureau should ac- cept such proof of the facts as is ordinarily accepted in business transactions of like character. In all such inquiries the Bureau is dealing with facts which themselves come within the control of human will or human caprice, and the evidence for which depends on the trustworthiness of human informants. Such evidence may range EXCESS PROFITS TAX PROCEDURE--1921 1597. through every degree, from the barest likelihood to that undoubted moral certainty on which every man acts without hesitation in prac- tical affairs. The Bureau must receive and consider such appraisals, therefore, with a sound and intelligent discretion as it considers much other evidence, and be content to accept them, without being able to prove their accuracy as mathematicians judge accuracy, if they convince the mind of their correctness to that moral certainty upon which practical men of affairs act. In view of the foregoing, it is recpmmended that the action of the Income Tax Unit in holding that the invested capital can not be satisfactorily established and that assessment of excess profit taxes for the year 191 7 should be made under the provisions of section 210 of the Revenue Act of 1917 and for the subsequent years under the provisions of sections 327 and 328 of the Revenue Act of 1918 be reversed; that Committee on Appeals and Review Recommendation 490 sustaining the action of the Unit be revoked; that retrospective appraisals be accepted as evidence of paid-in surplus when made upon the basis herein outlined and the facts upon which the ap- praisals are based have been established by proof ; that the retrospec- tive appraisals and the facts upon which they are based in the instant case be verified to determine the method of their construction and the truth of the facts upon which they are based ; and that in this and in all similar cases where the law directs that the value of prop- erty at a given basic date be ascertained, the Unit be instructed to receive such proof of the facts as is ordinarily accepted in important business transactions of like character and that the practice which has obtained in the Unit in refusing to receive such proof on the ground that it consisted of so-called retroactive appraisals be dis- continued. (I-5-60; A. R. R. 747.) Page 152 Salaries waived by officers of corporation constitute paid-in surplus. — Ruling. The return of a corporation for the j^ear 1920 showed a deficit of 2jr dollars. One of the liabilities of the corporation was a valid obligation to pay its three officers salaries amounting to t,x dollars. The officers waived their right to these salaries and in January, 192 1, the corporation credited its surplus account in the amount of ^x dollars. Held, that the amount of the salaries, the right to which was waived, is paid-in surplus and not income of the corporation for the year 1920. (B. Digest 37-21-1821; O. D. 1034.) Cancellation by stockholders of claims owing to them. — Ruling. The original paid-in capital of a corporation is un- changed by an operating deficit, and the cancellation by stockholders 1598 EXCESS PROFITS TAX PROCEDURE— 1921 of claims owing to such stockholders resulted in effect in an additional contribution to the corporation's capital account which assumed for the purposes of invested capital the nature of paid-in surplus. This is true regardless of any transfers of stock as between the stockholders which may or may not have been a consideration moving to the cancel- lation of the claims. (B. 47-21-1936; A. R. R. 678.) Property acquired by merger must be valued at cost. — Ruling. The M Company was organized subsequent to 1919. Soon thereafter it acquired all the capital stock of the N Company by issuing to the stockholders of the N Company its own stock in an amount equal to the par value of their shares of stock. The M Company thereupon by merger absorbed the N Company and became the owner of all the property of the N Company, which consisted of real estate, buildings, machinery and equipment, stock on hand, and work in process. This property had been purchased by the N Com- pany in the same year at a bargain, as shown by an appraisal made of the property about the time it was taken over by the M Company. Held, that the company could not include in its invested capital as paid-in surplus the excess of the value of the property over the pur- chase price paid therefor. Any excess resulted from a successful bar- gain and is not paid-in surplus. Paid-in surplus as used in section 326 of the Revenue Act of 1918 does not mean the excess value of property purchased in a bona fide sale over the purchase price thereof. To constitute paid-in surplus of a corporation there must, in effect, be a gift to the corporation. (C. B. 4, page 384; O. D. 813.) The above ruling is sound unless the stockholders of M and N companies were to a substantial degree the same. In such case the element of gift would be present. Paid-in surplus. — The decision of the United States Su- preme Court in the La Belle Iron Works case' greatly strengthens the position of taxpayers who legitimately claim that at the date of acquisition assets were undervalued. The claim of the La Belle Iron Works Company was rejected be- cause it was conceded that the appreciation in value arose after the acquisition of the property. The company was allowed the full value of the capital which it "invested" ; subsequent increments in value were disallowed. When values existed at '41 Sup. Ct. 528. EXCESS PROFITS TAX PROCEDURE— 1921 1599 the time property was paid in, the Supreme Court held that Congress intended that full effect must be given to such values, even though, at the time, the values in excess of the par value of the stock were not set up on the books. In specific language the Supreme Court holds that the definition of invested capital in the laws contemplates the in- clusion of "what actually was embarked at the outset or added thereafter, disregarding any appreciation in values." The court, in defining the word "invested," discussed the two major elements which must be present and added, "in either case involving a conversion of wealth from one form into another suitable for employment in the making of the hoped-for gains." Pago 156 When contracts constitute paid-in surplus. — Ruling. Paid-in surplus must consist of tangible property trans- ferred to the corporation, either as a gift or at a value which is less than its actual cash value; and in practically all cases where allow- able, involves no substantial change of beneficial interest. Contracts which are regarded as tangible assets can only con- stitute paid-in surplus when such contracts are made between outside parties, and the rights of either of such parties are transferred to the corporation without adequate compensation. Contracts to which the corporation itself is a party may not be so included. (C. B. 3, page 347; A. R. R. 233.) Amended returns resulting from increase in book values of assets. — Ruling. Where a corporation claims as an addition to its in- vested capital for 1917 and subsequent years the excess of the value of its patterns over the value at which they have been carried on its books, and such claim comes within the provisions of articles 840 (2) and 841 (i) of Regulations 45, amended returns may be filed for each year for which an erroneous return has been made both before and after March i, 1913. Any overpayment of taxes for the years 1917 to 1920 shown on the basis of the amended returns may be made the subject of a claim for refund. (C. B. 4, page 391; O. D. 901.) i6oo EXCESS PROFITS TAX PROCEDURE— 1921 Page 162 Reduction of surplus because of alleged failure to charge off sufficient depreciation.— In the 192 1 edition of Excess Profits Tax Procedure, the author questioned the growing practice of revenue agents of going back (sometimes fifty years) and restating plant accounts "with a result on Januar)'^ I, 19 1 7, which is absurd." The further statement was made that the burden of proof was not on taxpayers to establish the propriety of the January i, 191 7, book values of plant assets. The author's contentions have been fully recognized in the following rulings. Ruling. The Committee is in receipt of a request for advice relative to the practice of field agents in reducing earned surplus by deductions for depreciation where none have been claimed in the past, or where a lower rate has been claimed than is ordinarily al- lowable with respect to the depreciable assets in question. It is the judgment of the Committee that there is no warrant for reducing earned surplus because of alleged failure to charge off sufficient depreciation in the past, unless the depreciable assets of the corporation are valued on its books at the beginning of the taxable year at an amount in excess of their actual value at that time. This is particularly true where the corporation in prior years earned positive income from which larger deductions for deprecia- tion might have been taken, if in the opinion of the officers and directors of the corporation such larger charges had been justified. Nothing herein is to be construed as precluding the Income Tax Unit from adjusting depreciation, either by way of increase or de- crease, where there is at hand affirmative evidence that as at the be- ginning of a taxable year the amount of depreciation written off in prior years was insufficient or excessive. The correct attitude of the Bureau and the proper conduct of its field agents, in particular, are plainly set forth in that part of Art. 839 of Reg. 45, which reads: "Adjustments in respect of depreciation or depletion in prior years will be made or permitted only upon the basis of affirmative evidence that as at the beginning of the taxable year the amount of depreciation or depletion written off in prior years was insufficient or excessive, as the case may be." (C. B. 4, page 390; A. R. M. 106, dated February 26, 1921.) This very important memorandum was followed by an almost equally important statement defining "actual value" and explaining very specifically how depreciation shown on the I EXCESS PROFITS TAX PROCEDURE— 1921 1601 books is to be compared with the actual assets. The text of the memorandum is as follows : Ruling. Specific inquiry lias been made as to the meaning of the words "actual value" as used in Committee on Appeals and Review memorandum No. 106. For the purposes of taxation de- preciation is based upon cost. Accordingly, the words "actual value'' mean "sound value", which is "original cost" (or value as of March I, 1913, if applicable), including additions and betterments charged to capital account, less depreciation sustained. Article 161, Regulations 45 (1920 edition) defines the proper allowance for depreciation as "that amount which should be set aside for the taxable year in accordance with a consistent plan by which the aggregate of such amounts for the useful life of the property in the business will suffice, with the salvage value, at the end of such useful life to provide in place of the property its cost, or its value as of March i, 1913, if acquired by the taxpayer before that date." It follows from this definition that any action on the part of a particular taxpayer which extends the useful life of a depreciable asset beyond the normal or usual terln, and any circumstance which serves to increase the salvage value of a depreciable asset, operates to justify a reduction in the normal rate of depreciation. The de- preciation of an asset is arrested where it is maintained at a high standard of efficiency either by the exercise of unusual care in its use or by unusual maintenance expenditures. Invested capital, as defined in the Excess Profits Tax Law, is a statutory concept and is composed of two elements: (a) original contribution, and (b) earnings of the corporation available for dis- tribution but not distributed and not dissipated by subsequent oper- ating losses. The exhaustion of this capital through use, wear and tear has, for the purpose of computing invested capital, the same effect as an operating loss and unless this loss is properly taken care of out of earnings in one way or another, earned surplus must be adjusted in accordance with the provisions of the regulations. There are two ways of taking care of this loss out of income. One is by charging ordinary repairs directly to expense and setting up a de- preciation reserve against which are properly chargeable all re- newals and replacements ; the other is where renewals and replace- ments, as well as repairs, have been charged directly against gross income. Either way has the effect of reducing the amount added during the year to earned surplus. Consequently, the mere fact that no depreciation, or a minimum depreciation, has been charged as such, is not sufficient reason for reducing the earned surplus, where renewals and replacements sufficient to care for the decrease in value of capital assets have been charged directly to expense, or l602 EXCESS PROFITS TAX PROCEDURE— 1921 where for any of the other reasons hereinbefore suggested less than the normal rate of depreciation is properly chargeable. When a tax- payer makes this claim there are two methods of verifying it. One is by determining the plant efficiency and the other is by determining the value of the capital assets remaining. From an administrative standpoint the latter is probably move practical even though it may be said that the former is more accurate. Many cases have been l^rought to the attention of the Committee where corporations have been in existence for a long period o years, some of which corporations have been in existence severai times the ordinary estimated life of the depreciable assets, and yei those assets are today in first-class condition and worth the figur at which they are carried on the books, although no depreciatio has been charged as such and no additions to capital account have been made. In such cases it is obvious that depreciation has been adequately cared for by charges to expense, although it frequentlyj happens that it is impossible at this late date to segregate and specif such charges and there is no warrant in the law or the regula tions for requiring the depreciable assets in such cases to be writte down below the figure at which they are carried on the books, sine to do so is to reduce earned surplus twice, once through the origina! charge to expense (whether proper or improper), and again througl an arbitrary depreciation charge required by the Bureau to be se up against earned surplus for the purpose of computing investe capital. The controlling rule in this matter is found in that part of Articl 839 of Regulations 45, which reads: "Adjustments in respect of de preciation or depletion in prior years will be made or permitted onl upon the basis of affirmative evidence that as at the beginning o the taxable year the amount of depreciation or depletion written o in prior years was insufficient or excessive, as the case may be.' Mere fail-lire in prior years to have zvritten off on the book's th tnaxinnitn or ordinary rate of depreciation, is not in itself "affinnativ evidence." There is no warrant for reducing earned surplus becaus' of alleged failure to charge off sufficient depreciation in the pa.^t unless the depreciable assets of the corporation are valued on it books at the beginning of the taxable year at an amount in exces of their sound value at that time. (B. 30-21-1748.) This meniorandum explanatory of A. R. M. 106 was fol- lowed by an office decision, signed by Commissioner David H^ Blair, reading as follows : Ruling. Reference is made to Committee on Appeals anc Review Memorandum 106 (C. B. 4, p. 390) and explanatory mem-i orandum of the Committee dated July 6, 1021 (Bui. 30-21-1748.) i EXCESS PROFJTS TAX PROCEDURE— 1921 1603 'J"he attention of the Commissioner's office has been called to the fact that article 839 of Regulations 45 as interpreted by Committee Memorandum 106 and the memorandum of July 6th has not been properly followed. When the Regulation (art. 839 of Reg. 45) was being drafted it was the intention of the draftsmen that a corporate surplus ac- count was not to l)e disturbed lightly and that no change should be made in it either by the Government or by the taxpayer except upon adequate evidence that the surplus account was incorrect. It was the view of the draftsmen that unless the taxpayer could show a state of error the Government should deny a claim for an increase in the surplus shown by the taxpayer's books ; conversely, before a deduction could be made from the taxpayer's surplus account, the Government must show that such an adjustment is necessary to correct the account. The view was also held that such proof must be in the form of affirmative evidence ; that it could not rest upon mere assertion or the working out of the theoretical formula. It is my opinion that no doubt ever should have existed as to the correct interpretation of article 839. A taxpayer's corporate sur- plus should not be reduced by the arbitrary adjustment of deprecia- tion and depletion for past years. Surplus accounts should, however, always be carefully scrutinized and checked up for the purpose of preventing the inclusion therein of appreciated values of property In case of doubt in such case the burden should be cast upon the taxpayer to prove that no appreciated values were included in the surplus. A presuinption should always exist that a taxpayer's books of account reflect actual facts. The burden of proof is upon any one who attempts to impugn the correctness of the books of account — upon the Government if it seeks to reduce its surplus account by charging off depreciation and depletion which have not been claimed by the taxpayer and upon the taxpayer where he claims that too much depreciation and depletion have been charged off in prior years. (B. 46-21-1926; O. D. 1 104.) The practical value to taxpayers of A. R. M. 106 was much reduced by the decision of the Supreme Court in the La 13 die Iron Works case."* In that decision the right of taxpayers to include in invested capital at January i, 19 17, the cost (less actual depreciation to date) of all assets on hand at that date was definitely established. Whether such is per- mitted by A. R. M. 106 is more or less irrelevant. '41 Sup. Ct. 528. l6o4 EXCESS PROFITS TAX PROCEDURE— 1921 All insistence on its rights as to the inclusion in invested capital as at Januan- i. 191 7, of the cost of all its assets, does not preclude a taxpayer from claiming depreciation on the March i, 1913, value of its assets, cpiite independent of the fact that the latter value includes appreciation. The bases for iiiz'cstcd capital and for depreciation are entirely distinct. When appreciation has been included in invested capital, amended returns are required. — The United States Supreme Court in the La Belle Iron lJ\)rks case'"^ has decided once for all that the formula for the computation of invested capital, set forth in the 191 7 and 1918 laws, is legal and must therefore be enforced. From the time of the enactment of the 1917 law the author has contended that the cost basis is arbitrary and inequitable in many cases, but that it is legal and more workable than if the proposed basis of value (irrespective of cost) had been adopted. There was no justification under the laws for including unrealized appreciation of tangible or in- tangible assets. So-called "experts" who widely advertised their ability to compel the Treasury to accept such bases have deceived their victims. In cases like that of La Belle Iron IVorks, the law'S afforded reasonable relief. It is obvious that an invested capital of less than $190,000 for an ore body worth $10,000,000 would have brought the company within the relief sections of the 191 7 and 191 8 laws. The Treasury, following the decision referred to above, issued the following decision on August 26, 192 1. This re- c[uires the submission of amended returns in all cases where appreciated values were used in computing ini-ested capital. Ruling. An examination of income and excess profits tax re- turns for 1917 and subsequent years has disclosed that many tax- payers have used appreciated and inflated values in determining ^ La Belle Iron IVorks v. U. S.. 41 Sup. Ct. 528. EXCESS PKOl ri\S 'I'AX PROCEDURE— 1921 1605 invested capital shown in such returns contrary to Section 207 of the Revenue Act of 191 7 and Section 326 of the Revenue Act of 1918. This office has held consistently that the use of appreciated or inflated values in determining invested capital is not permissible and this ruling has been sustained by the United States Supreme Court in the case of the La Belle Iron Works v. The United States (41 Sup. Ct. 528; T. D. 3051.) All taxpayers who, in the preparation of their income and excess profits tax returns for 1917 and subsequent years, have used appre- ciated or inflated values in determining the amount of their invested capital are required to file with the Collector of Internal Revenue within 90 days from date of this decision amended returns for each of such years, in which the invested capital shall be computed strictly in accordance with the law and regulations and without the use of appreciated or inflated values. It is not required that such amended returns shall include the figures shown in the original returns which are unaffected by this decision. Only such figures as are necessary to show the correct values used in the computation of invested capital and such totals as are necessary to a redetermination of the tax need be shown. Payment of the additional tax shown to be due on such amended returns must also be made at the time the returns are filed. Failure to file amended returns within the time specified will sub- ject taxpayers to the penalties provided for in Section 3176, United States Revised Statutes, as amended. (B. 37-21-1822; T. D. 3220.) The intention of the government in requiring amended returns within ninety days from the date of the Treasury de- cision (i.e., on or before November 24, 1921) was to have the tax due as the result of appreciated values paid imme- diately, rather than to allow it to wait until the returns were finally reached in the course of audit. An extension of time from November 24, 192 1, until January 15. 1922, was after- wards granted in which to file the amended returns and make payment of the tax due.'" The fact that no further tax may be shown to be due on the amended rettirns in such cases is not sufiicient to waive the filing of such returns.'' Amended returns not required in certain ca.se.s. — The Treasury has excepted certain cases from the requirements of T. D. 3220. '" T. D. 3243. " B. 49-21-1968; O. D. 1 131. l6o6 EXCESS PROEJTS TAX PROCEDURE— 1921 Rulings. WJiere for the year 19:8 returns were filed and the war and excess profits tax paid was equal to 50 per cent of the net income, relief having been requested under sections 327 and 328 of the Revenue Act of 1918, or where for the year 1917 returns were filed under article 64 of Regulations 41, and full disclosure was made on the return of the inclusion therein of restorations to invested capital, amended returns will not be required under T. D. 3220 (Bui. 37-21, p. 18) and T. D. 3243 (Bui. 48-21, p. 18). However, in cases where returns were filed under article 64 of Regulations 41 and no disclosure was made of the inclusion therein of restorations to in- vested capital, the requirements of T. D. 3220 and T. D. 3243 must be complied with. (I-2-25, I. T. 1163.) In determining invested capital for 1917 and subsequent years the taxpayer, an insurance company, used security valuations demanded and furnished by the insurance department of the State and, as re- quired, filed a copy of its State report with this office. Owing to its inability to furnish cost values of securities, advice was requested as to what action should be taken in order to comply with the provisions of Treasury Decision 3220 (Bulletin 37-21, p. 18). Held, that as the invested capital of insurance companies is ad- justed by this office on the basis of cost from annual statements ren- dered to the insurance departments at the close of the previous year, it will not be necessary for insurance companies to file amended re- turns under the provisions of Treasury Decision 3220, if in the origi- nal returns securities or real estate have been valued on the basis of book or market as reported to the insurance department of the State. ( 1-6-82; I. T. 1201.) Page 164 Intangible property acquired for tangible property. — Ruling. Held, that intangible property when acquired fur tang- ible property must be taken into account at the value of such in- tangible property at the date of acquisition. It being assumed that the tangible property before and after transfer had an immediately realizable market value, the value of the intangible property is measured by the then fair market value of the tangible property ex- changed therefor and not by the original cost of such tangible property. (C. B. 4, page 395; A. R. M. 131.) If tangible property, under the foregoing ruling, costing $100,000 in 1914, was worth, in 19.20, $50,000, and was ex- changed for intangible property, the "cost" to the purchaser of such intangible property would be $50,000. It is assumed EXCESS PROEITS TAX PROCEDURE— 1921 jGo/ tliat $50,000 has been lost and slioukl be debited to surplus. If the transaction occurred after January i. 1917, taxpayers would hardly object to the ruling; if before 1917, it would result adversely to taxpayers unless it could be shown "that there was no readily realizable market value, in which case the intangible property could be carried at the book value of the tangible property. Page 175 Improvements in leaseholds. — Ruling. In 1904 the M Company as lessee leased certain property for a term of ten years. Under the terms of the lease the M Com- pany made certain improvements which became the property of the lessor. The lease expired in 19 15 and was again renewed. Held, that the amount invested by the M Company in improve- ments, if paid- out of original capital or surpkis, constituted invested capital for the taxable year in which expended, such invested capital to be reduced at the beginning of each subsequent year by an amount equal to the result obtained by dividing the total cost of such improve- ments by the number of years the lease was to run. Since the lease under which the improvements were made ex- pired in 191 5, the taxpayer had no right nor title under the lease to any asset which constituted a part of such improvements subse- quent to that year, not even the right of usage. Therefore, subse- quent to 191 5 it possessed nothing therein which could be said to con- stitute invested capital for the purpose of computing excess profits tax under the provisions of the Revenue Act of 1917 or 1918. (C. B. 4, page 366; A. R. R. 384.) In the foregoing case the lessee, upon renewal in 191 5, became the owner, for a limited term, of the improvements. The cost of such improvements, less depreciation to January I, 191 7, w-as a capital investment. Under the La Belle Iron IVorks case, it would seem that such investment could be in- cluded in invested capital. If the improvements were charged off after 1909, it might be in order to file amended returns. Page 176 Cash surrender value of insurance policies. — It has been held'" that the surrender value of an insurance policy taken out B. 47-21-1938; (). D. I UK). l6o8 EXCICSS PROFITS TAX PROCEDURE— 1921 by a corjjoration on the life of a guarantor of a debt cannot be included in invested capital. This ruling is apparently based on the fact that the policy has no asset value in addition to the face value of the debt which is still being carried at its face value. If the debt becomes bad. a claim against the guar- antor would replace it. Such insurance is a mere protection and has only a potential value. If the debt has been charged off and no claim against the guarantor is set up in the books, the surrender value of the in- surance policy would be included. Page 177 Discount on bonds. — Ruling. Held, that a corporation which issued bonds at a dis- count in January, 1900, and elected then to charge such discount to profit and loss for the year of issue and the next two succeeding years, may not now revise its accounts and file amended returns for the purpose of reinstating to invested capital the unexpired portion of such discount and claiming as a deduction from income that portion applicable to each year. (C. B. 4, page 391 ; A. R. R. 394.) The foregoing ruling may or may not be sound. It is to be regretted that the Treasury places so much weight on court decisions which are not Relevant. The case cited in support of the ruling^'' was brought under the 1909 law, which was not an income tax law, and it did not refer even remotely to invested capital. The court followed the decision handed down in another case'* in which it was held in effect that discount on l)onds is not an expense until the maturity of the bonds. If the lan- guage of the court had the slightest connection with invested capital (it has not), it might be urged that the property pur- chased with the proceeds of bonds should be set up at the par of the bonds. This principle at one time was considered good accounting practice and was adopted by the Interstate Com- merce Commission.^"' ''^Chicago & Alton R. R. v. V. S., 53 Ct. Cls. 41. '^ Baldwin Locoinolivc Jl'ks. :: McCoach, 221 Fed. 59, 136 C. C. A. 660. ^■'' Montgomery's Dicksee's Auditing (revised edition), page 50. EXCESS PROFITS TAX PROCEDURE— 1921 1609 What constitutes invested capital is not settled by book- keeping" entries made in 1900, nor by court decisions inter- preting the 1909, 1913, or 1916 laws. In some respects the La Belle Iron JVorks case^"^ is controlling because in that case the court discussed the allowable elements of invested capital under the 191 7 and 1918 laws. It is a fair inference from the decision that any item of capital investment remaining as at January i, 19 17 (excluding appreciation) will be allowed as invested capital even though the cost may have been written off the books. If discount on bonds is an asset at any time after January i, 191 7, logically it should be such at January, I, 19 1 7, because prior thereto taxpayers were not on notice that books should be kept in a certain way. It would be grossly unfair, in 19 18, to penahze a taxpayer who in 1900 did some- thing entirely legal but which might have been done in some other legal way. Invested capital is not a question of book- keeping; it is a question of fact. Page 179 When expenditures for intangibles charged off prior to 1917 may be included in invested capital. — Prior to the hand- ing down of any court decisions dealing with the computation of invested capital, the Treasury took the position that devel- opment, exploitation, and similar expenses when charged off to expense accounts as incurred could not be restored to invested capital.^' In the La Belle Iron Works case^* the Supreme Court said, in speaking of exploration and devel- opment expenses charged off in prior years, "we assume that a proper sum, not exceeding the cost of the work might have been added to earned surplus on that account." It became obvious that the regulations which specifically permitted the restoration of tangible property written off prior to 191 7 were discriminatory. The cost of intangible property of ^641 Sup. Ct. 528. ^■^ Reg. 45, Art. 841. See Exrcsx Profits 'lax Procedure, 1921, pages 159, 179-184. 18 41 Sup. Ct. 528. l6io EXCESS PROFITS TAX PROCEDURE— 1921 one taxpayer which still existed at January i, 1917, was just as much an expenditure for income-producing purposes (sometimes much more so) than the expenditures of another taxpayer for tangible property. It is evident from the La Belle Iron Works case that all forms of appreciation^^ must be excluded from invested capi- tal, but that all forms of cash investment in capital must l>e included. The inadvertent charging ofif of intangible capital items prior to 191 7 cannot ht penalized any more than the charging off of tangible items can be. The changed position of the Treasury is best illustrated in a recent decision whereby publishers who wrote off expenditures to build up subscription lists are permitted to restore all of the items which can be identified. Ruling. The Committee is of the opinion in the matter of the argument of the M Company and the O Company, taxpayers engaged in the publication of newspapers, that moneys expended out of earned surplus or current earnings for the sole purpose of building up the circulation structure may be added to capital invested when proper proof of such expenditures is made and amended returns for prior years have been filed (B. 47-21-1937; A. R. M. 141.) In one case'" a corporation claimed that it had only nominal capital in 191 7 because it had no tangible assets except cash which it did not need. The government claimed that $19,000 expended upon a certain process between 1909 and 191 7 "should be taken as a surplus used and employed in the busi- ness." The process was found to have substantial value. The court held that the corporation had more than nominal capital. The writing off of the expenditures was not deemed to influence the one fact at issue, viz : What n.'os the invested capital as at January i, 191 7? Contracts. — Ruling an unperformed contract to furnish man- ufactured products represents no rights in tangible property which ^9 Except when January i, 1914, values can be used. ^Lincoln Chemical Co. 7: Edwards. 272 Fed. 142, Dist. Ct. So. Dist. N. Y., April 19, 1921. EXCESS PROFITS TAX PROCEDURE— 1921 )6ii would entitle it to be regarded as deriving its value chiefly therefrom. On the contrary, the value of the contract is of an intangible nature, contingent upon the performance of its terms and the realization of the anticipated profit. The intangible rights under such a contract would, therefore, be subject to the limitation contained in section 207 of the Revenue Act of 1917, and section 326 of the Revenue Act of 1918, in the case of intangible property purchased with corporate stock. (C. B. 3, page 324; O. D. 635.) Page 181 Goodwill. — Ruling. Goodwill in a corporation can not be allowed as in- vested capital under a claim that a price paid to stockholders by certain individuals was in excess of corporate book value of the stock. Good will must be acquired by direct purchase; it can not be determined bv a collateral transaction. (C. B. 4, page 379; A. R. R. 413.) If an individual acquires substantially all of the stock of a corporation for a price largely in excess of its book value, such excess does not constitute goodwill acquired by the corpora- tion. There has been no change in the price paid for the original assets by the corporation, but merely a change in the stockholders of the corporation. The transaction might be pertinent in a claim for relief on the ground that the earnings of the corporation were abnormal. It would be necessary to find representative corporations in the same line of business whose invested capital is comparable with the purchase price of the shares. Page 185 Patents. — In a recent case^^ it was held that "the value of certain patents for which stock of a corporation was issued must be measured by the cash consideration paid therefor l)y certain incorporators of the company just prior to incor- poration." The peculiar feature about this case was that the original owner had neglected to develop the patents in question. On sale to a syndicate which actively developed their use, the -^ C. B. 4, page 369; A. R. R. 396. l6i2 EXCESS PROFITS TAX PROCEDURE— 1921 latent value of the patents became apparent, and on this devel- oped value the claim for paid-in capital was based. The claim was disallowed. CHAPTER IX INADMISSIBLE ASSETS The new law defines inadmissible assets in the same terms as the 1918 law. However, the stocks of two types of cor- porations which were formerly inadmissibles are taken out of that class and made admissible assets. The change arises from a new provision in the 192 1 law which affects the deduc- tibility of dividends in arriving at the net income of the recipi- ent corporation. Inadmissible assets are defined as follows : Law. Section 32;. (a) .... The term "inadmissible assets" means stocks, bonds, and other obligations (other than obligations of the United States), the dividends or interest from which is not included in computing net income The deduction of dividends allowed a corporation in com- puting its net income is stated as follows : Law. Section 234. (a) . . . . (6) The amount received as dividends (A) from a domestic corporation other than a corporation entitled to the benefits of section 262, or (B) from any foreign cor- poration when it is shown to the satisfaction of the Commissioner that more than 50 per centum of the gross income of such foreign corpora- tion for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such part of such period as the foreign corporation has been in existence) was de- rived from sources within the United States as determined under section 217; . . . . Dividends received from a foreign corporation which does not derive more than 50 per cent of its gross income from sources within the United States are not deductible. Hence, when the dividends are not deductible the stock of such foreign EXCESS ]'ROI>rrS tax procedure— 1921 1613 corporation becomes an adniissible asset. Under the 1918 law, if even a small part of the income from a foreign corporation was derived from sources within the United States, and thus rendered subject to taxation, the dividends from such foreign corporation were deductible in arriving at the net income of the corporation receiving them, and the stock of such foreign corporation was an inadmissible asset/ The stocks of domestic corporations entitled to the benefits of section 262" are also fully admissible because dividends from such corporations are not deductible by the recipient corporations. Page 193 Bonds not obligations of the United States. — Securities which are in the nature of government bonds, but which are not direct obligations of the United States, are inadmissible assets if the income therefrom is non-taxable. Ruling. Since the income from Federal land bank bonds is tax free and since such bonds are not obligations of the United States, they are inadmissible assets within the meaning of section 325 (a) of the Revenue Act of 1918, and should be so treated in computing the invested capital of a corporation. (B. 42-21-1875; O. D. 1069.) For similar reasons, 4 per cent bonds of the government of the Philippine Islands are held to be inadmissible assets,^ as are bonds of Porto Rico and Hawaii.^ School warrants issued by a county of a state are inadmis- sible assets,^ except where they have been cashed by a bank for the accpmrriodation of teachers and where no remuneration was received for that service)," as is the principal of municipal assessments issued for improvements.' ^ [Former Procedure]. The 1918 law [section 234 (a-6)] permitted as a deduction "Amounts received as dividends from a corporation which is taxable under this title updn its net income " - See page 1324. " B. 40-21-1857; O. D. 10S7. *B. 38-21-1836; O. D. 1044. " C. B. 4, page 363 ; O. D. 929. « B. 4S-21-1915; O. D. 1096. ' B. 34-21-1778; O. D. 999. l6i4 EXCESS PROFITS TAX PROCEDURE— 1921 Page 194 Reserve for bad debts affects computation of admissible assets. — In the case of a corporation reporting for the calen- dar year 1921, the reserve for bad debts at the beginning of 192 1 has not been allowed as a deduction in computing net income, and should therefore not be deducted from accounts receivable. At the end of 1921, however, any addition to the reserve during 1921 which has been allowed as a deduc- tion from gross income must be deducted from accounts re- ceivable. Since 192 1 is a year of transition, so far as the reserve for bad debts is concerned, the reserve must be treated differently at the beginning of 1921 than at the end of 1921. However, in subsequent calendar years, no computation of inadmissibles will be necessary, because the excess profits tax law is not in effect after December 31, 192 1. Valuation of assets for purposes of inadmissible compu- tation. — The new \a.w^ provides for valuation of assets in accordance with sections 326 and 331. The 1918 law provided for the valuation of assets in accordance with sections 326, 330, and 331 of that act. Reference to section 330 in the 19 18 law is not carried forward, since section 330 was elim- inated in the new act. Section 330 of the 19 18 law provided for the valuation of assets on the same basis in the prewar period and taxable year, but as no computation of prewar invested capital is necessary in determining excess profits tax^ at 1 92 1 rates, the section is no longer necessary. This method of valuation would still apply, however, in the case of any corporation which received net income of $10,000 or more from government contracts in 192 1. In such cases the provisions of the 1918 law are to be followed and it becomes necessary to compute the prewar invested capital.' I 8 Section 325. 3 Section 301 (b). EXCESS PROFITS TAX PROCEDURE— 1921 jf,[5 Page 211 Fiscal year corporations — changes in admissibles due to computation under two laws. — The percentage of average inadmissible assets to average total admissible and inadmis- sible assets is to be applied in determining the reduc- tion of invested capital necessary because of the possession of inadmissible assets. The total average assets will ordinarily be ascertained from the balance sheets at the beginning and end of the taxable year. In the case of a corporation report- ing for a fiscal year ending in 1921, however, two computa- tions are made,'*' one under the 19 18 law and one under the 1921 law. Due to a different classification of assets under the two laws (such as stocks-of certain foreign corporations and those under section 262^'). the average inadmissibles will be different in the two computations, the resulting per- centage will be different, and the adjustment of invested capi- tal required will also be different. Under the 1918 law additions to a reserve for bad debts were not deductible. Accordingly, since such reserve, for tax purposes, was considered as a part of surplus, accounts receivable were not reduced by the amount of such reserve in making the computation of admissible assets. ^^ However, the 1 92 1 law permits additions to a reserve for bad debts to be deducted in computing net income. Therefore, in the com- putation of admissible assets under the 192 1 lav^r, the reserve for bad debts would be deducted from accounts receivable, the converse of the procedure followed in making the com- l)Utation under the 1918 law. Inadmissible assets of dealers in securities. — Dealers in securities cannot include in invested capital any securities which come within the definition of inadmissible assets, even though their business consists of dealing in such securities. "» Section 335 (a). *' Sec page 1324. '- See Excess Profits Tax Froccdun 1921, page ic i6i6 EXCESS PROFITS TAX PROCEDURE— 1921 Ruling. A corporation which is a "dealer in securities" within the meaning of article 1585 of Regulations 45 is not entitled to include in invested capital amounts invested in inadmissible assets, even though such assets are held as merchandise, except under conditions entitling it to the benefits of article 817 of Regulations 45. (T-1-14; I. T. 1155.) CHAPTER X ADJUSTMENT OF CAPITAL, SURPLUS, RESERVES AND LL\BILITIES Page 226 Capital stock paid for in instalments. — Ruling. Subscription payments made in instalments^ when a corporation increased its capital stock, are properly included as in- vested capital from the date of receipt. So-called interest paid to the subscribers on the installment payments from the . date of receipt to the date of issuance of the stock certificates • is not deductible. (B. 32-21-1765; O. D. 991.) Page 238 Surplus arising from revaluations. — The opinion of the Solicitor of Internal Revenue ( B. 43-21) is fully discussed on page 1620. The author's contentions as to the date when realized appreciation should be included in invested capital, and the illegality of taxing distributions of surplus accrued prior to March i, 1913. are unchanged. This subject, includ- ing the Supreme Court decision in the La Belle Iron Works case, is discussed -further on page 1620 et seq. Page 233 Reserves for bad debts. — The 192 1 law includes among alKJwable deductions additions to reserves for bad debts. This has little effect on the excess profits tax, since the tax is re- pealed effective December 31, 1921. Reserves for bad debts at the beginning of the taxable year 1921 are includea in in- EXCESS PROFITS TAX PROCEDURE— 1921 1617 vested capital. The effect on the computation of the deduction for inadmissible assets is dealt with in Chapter IX of this appendix. Page 239 Deductions for depletion. — Ruling. Held, that a mining corporation, in computing its in- vested capital for the purpose of the war excess profits tax, is re- quired to reduce its earned surpkis by the amount of its sustained depletion to the beginning of the year for which the tax is computed. In the ruling of the Committee on Appeals and Review, there appears the following opinion of the Solicitor of In- ternal Revenue, dealing with the taxpayer's contention : It is contended by the taxpayer that, owing to the peculiar char- acter of mining properties, there is no depletion so long as "discovery and development outrun depletion,'' and that any actual prior de- pletion is taken care of by the provision for the valuation of tangible property paid in as of January i, 1914. The peculiar character of mining property was well stated in StrattO'ii's Independence v. Hozvbert, 231 U. S. 399, 413, as follows: The peculiar character of mining property is sufficiently obvious. Prior to development it may present to the naked eye a mere tract of land with barren surface, and of no practical value except for what mav be found beneath. Then follow excavation, discovery, development, extraction of ores, resulting eventually, if the pro- cess be thorough, in the complete exhaustion of the mineral con- tents so far as they are worth removing. Theoretically, and ac- cording to the argument, the entire value of the mine, as ultimately developed, existed from the beginning. Practically, however, and from the commercial standpoint, the value — that is, the exchangeable or market value — depends upon different considerations. Beginning with little, wheri the existence, character, and extent of the ore deposits are problematical, it may increase steadily or rapidly so long as discovery and development outrun depletion, and the wiping out of the value by the practical exhaustion of the mine may be deferred for a long term of years. This statement contains the answer to the contention of the taxpayer. The reason that in the case of mines the Supreme Court has consistently held that no deduction for depletion or depreciation in computing net income can be allowed, in the absence of statutory authority, is that by reason of the fact that discovery and develop- ment may outrun depletion there is not necessarily any actual de- crease in the value of the taxpayer's property, and, therefore, the entire net receipts may well be considered income. The rule is not new but has come down to us from the common law of England. i6i8 EXCESS PROFITS TAX PROCEDURE— 1921 i'liis, however, does not negative the fact that the removal of each ton of ore depletes pro tanto the ore originally known to exist in the mine and which was originally valued. The maintenance or in- crease of the original value is solely due to the fact that the loss of value through depletion is equalled or exceeded by the appreciation in value through discovery or development. To treat the entire net income as earnings and as constituting earned surplus in the succeeding year when not distributed by the company would, there- fore, to the extent of the depletion actually sustained during the year, be to permit the inclusion of appreciation in the value of the mine, by reason of development and discovery, in invested capital, a thing which is not contemplated by the statute nor permitted by the regulation. (C. B. 4. page 385; A. R. R. Si/.) The foregoing- opinion is sound in so far as it relates to 1918 and subsequent years. It would appear, however, that an attempt is made to apply old court decisions and the pro- visions of the 1918 law to a specific section of the 191 7 law. Section 207 of the 19 17 law^ provides that appreciation at January i, 19 14, may be included in invested capital up to the par value of stock specifically issued for tangible property. Assume that a mining company issued $1,000,000 in stock for property worth $500,000; that on January i, 1914, one- half of the mineral content was exhausted; that the value of the remaining half was $1,000,000. There is nothing in the law to indicate that in computing invested capital for 191 7, depletion of $250,000 (that being one-half of the original cost) must be deducted from the value of the property on January i, 1914; on the contrary, the framers of the law went to a great deal of trouble to insert a specific provision that appreciation up to the par value of the stock should be included in invested capital. If they had intended that depletion should be deducted, it would have been extremely easy to provide for it. The section is perfectly clear as it stands and is not afifected by the decision in Strattons Independence 1'. Howhert,^ wliich was handed down in 19 13 under the 1909 (cash basis) law^ The change made in the 19 18 law merely carries out the inten- '231 U. S. 399, 58 L. Ed. 285, 34 Sup. Ct. 136. EXCESS PROFITS TAX PROCEDURE— 1921 i6iy tion to eliminate appreciation as an element in invested capi- tal. The Treasury cannot change the 19 17 law in one of its few unambiguous sections. Page 240 Reserves for depletion. — A further illustration of the use of the depletion reserve and of the surplus arising from the revaluation of mines, is given in Chapter XXXIII of the in- come tax section of this volume. Page 248 Decrease in invested capital by payment of federal taxes. — The author wishes to reiterate the comment made in the 192 1 edition of Excess Profits Tax Procedure. The position of the Treasury is equivalent to the imposi- tion of a tax in a past year which was not authorized by Con- gress. The law defines invested capital in a specific and tech- nical manner. The deductions are limited. If any doubt exists, the Treasury cannot successfully decide the doubt in favor of the government.^ If in 192 1 the government claims that an additional tax is now due, arising from net income for 191 7, it cannot also be claimed that as of some date in 1918 the amount was due and payable and that there was an actual diminution in invested capital at tJiat time. There was no diminution until 192 1. The corporation had in hand, without restriction or lien, the full amount until some time in 192 1. To say that it did not have it, is to run counter to the spirit and letter of the law. It is a decrease of invested capital by fallacious construc- tion and not by fact. Page 250 Tax overpaid — included in invested capital. — Ruling. A taxpayer made an overpayment of income taxes for the year 1917 in 1918, which amount was refunded to him in the year 1921. Gould V. Gould, 245 U. S. 151, 62 L. Ed. 211, 38 Sup. Ct. 53. l620 EXCESS PROEITS TAX PROCEDURE— 1921 The question presented is whether the taxpayer may include in its invested capital the amount so refunded for the calendar year 1921. Held, that under the provisions of article 845 of Regulations 45 the amount of tax overpaid for 1917 and refunded may be included in the invested capital of the taxpayer for 1918 and subsequent years. (B. 43-21-1889; O. D. 1079.) The principle followed in the foregoing ruling must be, that as of the time of overpayment a correcting entry would debit the government and credit earned surplus. It is ques- tionable how far corrections in the accounts of past years should he carried. Reserves of insurance companies. — Article 870 of Regu- lations 45 was amended by T. D. 3153, 'dated April 9, 192 1, to read as follows : Regulation. The reserve funds of life insurance companies, the net additions to which are deductible from gross income under the provisions of section 234 of the statute, can not be included in computing invested capital. The like reserve fimds of insurance companies, other than life insurance companies, may be included in computing invested capital. See sections 325 and 326 (a) (3) and (b) and articles 569 and 814. (Reg. 45, Art. 870. as amended bv T. D. 3153.) In view of the change of the method of taxing the income of life insurance companies for 192 1 and subsequent years, this regulation will be no longer effective. For further dis- cussion of this change, see Chapter XXXVUI of the income tax section of this volume. CHAPTER XI CHANGES IN INVESTED CAPITAL Page 256 Surplus from sale of capital assets may be additions to invested capital during year. — In a recent ruling^ the Treas- 1 B. 43-21-1878; L. O. 1073. See page 71? EXCESS PROFITS TAX PROCEDURE— 1921 1621 ury reiterates its position that realization of appreciation of assets accrued before March i, 1913, are earnings or profits of the year wlien reahzed, rather than reaHzations of capital. Ilie riiHng is fully discussed elsewhere. In the La Belle Iron \W)rks case" the Supreme Court declined to permit the inclu- sion of unearned or unrealized increment, in invested capital, but emphasized the right of taxpayers to include all items of cash or equivalent. The Treasury, in effect, says that appre- ciation at March i, 191 3, cannot be included in invested capi- tal until the first day of the year following its realization. "A" sells capital assets on January 2, 1918, and realizes v$ 1 00,000 above March i, 191 3, value. The excess is not taxable. It is allowed as invested capital from and after January i, 1919. "B" sells and realizes on December 31. 1917, and may add $100,000 to invested capital the next day. The Treasury's position is not in line with the definition of invested capital in the laws and as discussed by the Supreme Court in the La Belle Iron Works case. Invested capital must be paid in or arise from earned sur- plus. Earned surplus is taxable surplus, that is, it arises from current earnings. Realization of appreciation is not earned surplus. The only limitation on the dates when the items of invested capital are to be included, refers to earned surplus. All other' items are included on the dates when paid in. In a recent case^ a taxpayer paid $500 for property which was worth $695 on March i, 1913, and wdiich was sold in 1916 for $13,931.22. The court referred to the March I, 191 3, value as "his capital investment." If it had been a corporation and the sale had taken place in 191 7, can it be assumed that the $195 appreciation prior to March i, 19 13, referred to as "capital," would follow the same course as the $13,236.22 taxable gain arising after March i, 1913? Is it not more reasonable to assume that the court would direct -41 Sup. Ct. 528. ^ Goodrich v. Edwards, U. S. Supreme Court, March 28, 1921. l622 EXCESS PROFITS TAX PROCEDURE— 1921 that there be credited to capital account on the day of reaHza- tion, $695, and to current earnings, the sum of $13,236.22? Invested capital would be increased by $195 on day of realiza- tion, and by the net earnings at the end of the year, including the $13,236.22. The inhibition against the inclusion of unearned increment or appreciation in invested capital ceases the moment the appreciation is converted into the equivalent of paid-in capital ; when it becomes actual instead of prospective. Furthermore, no formula has been devised which reason- ably can be applied to the segregation of March i, 191 3, values into capital and accumulated profits. The revenue laws and the courts use the words, "gain, profits and income," inter- changeably. It has been immaterial whether a taxpayer's capi- tal on March i, 1913, represented cost to him or whether it included appreciation. But if the Treasury is right in its contentions, it is important to revise all values at March i, 19 13, in order to reduce the apparent appreciation, at that date, and set up the maximum amount as cost. In many cases, so-called appreciation at March i, 1913, is merely restoration of capital assets theretofore charged off. When taxpayers are not able to sustain the written-up figures, invested capital is limited to the book values. The segregation of subsequent realiza- tion of all or any part of the appreciation* is not justified by the law. If an asset at March i, 19 13, is not allowed as in- vested capital because it represents unrealized appreciation, the theory of invested capital requires that on the date of realization it automatically be included in invested capital. It is not a gain or profit to be related to the period after March I, 1913; what it was before that date is not an element in the computation of invested capital. In this connection, too, it is important to consider Section 201 of the 1 92 1 law and article 1543 of Regulations 62 inter- preting that section. The regulation after stating that "Any distribution by a corporation out of earnings or profits ac- cumulated prior to March i, 191 3, or out of increase of value EXCESS PROFITS TAX PROCEDURE— 1921 1623 of property accrued prior to March i, 19 13 (whether or not realized by sale or other disposition) is not a dividend within the meaning of the Act," goes on to state that "the provisions of the preceding sentence shall be appHed uniformly to cases arising under the Revenue Act of 1916, the Revenue Act of 191 7, the Revenue Act of 19 18, as well as the Revenue Act of 192 1." It is clear from the law, and Regulations 62 as above quoted, evidently so hold, that appreciation in value of property prior to March i, 191 3, is deemed to be capital at that date and that subsequent realization does not represent a profit of the year of realization. Consequently, the 1922 regulations would appear to overrule A. R. M. 51 (C. B. 2, page 297), quoted on page 256 of Excess Profits Tax Pro- cedure, 192 1, and appreciation accrued prior to March i, 191 3, would therefore be allowable as an addition to invested capital from the date of realization and not merely from the beginning of the following taxable year. Page 259 Computation of average invested capital. — It should be noted that, as 1920 was a leap year, adjustments of invested capital should be made on the basis of 366 days.* Page 264 Effect of ordinary dividend. — Ruling. Held, that the expression, in a declaration by the di- rectors of a corporation, that a dividend is ''payable as convenient to the funds of the company" creates a condition precedent. Divi- dends so declared are not necessarily to be considered payable as of the date of the declaration, and in such a case the invested capital should be adjusted as of the date the dividend is made payable rather than the date it is declared. (C. B. 4, page 396; A. R. R. 408.) Article 858, of Regulations 45, states that when no date is set for the payment of dividends, the date when they are declared will be considered also the date when they are payable. The date of declaration can hardly be regarded in determin- *C. B. 4, page 396; O. D. 822. l624 EXCESS PROFITS TAX PROCEDURE— 1921 ing tax liability. If a dividend is declared "payable as con- venient," an administrative decision by the officers of the company is necessary before stockholders have the right to demand payment. Until such decision is made, the dividend is not taxable to the stockholders, and it has no effect on invested capital. Dividend paid in interest-bearing notes. — Ruling. Where a corporation issues interest-bearing notes to its stockholders in lieu of a cash dividend, invested capital should be reduced as of the date of the notes, provided the dividend was not declared from current earnings. (B. 42-21-1876; O. D. 1070.) If the notes were subordinated to all the liabilities of the corporation and interest payments were conditional, it is pos- sible that invested capital might not have to be reduced. Page 271 Accruals of taxes should not be deducted from invested capital. — 111 Bulletin 30-21, the Treasury merely reiterates the principle laid down in article 857^ and attempts to justify it under accounting principles. It cannot be disputed that "ex- penses of a year should be charged against the income of that year," but it is difficult to see what this has to do with the computation of invested capital. In the La Belle Iron Works case, the Supreme Court observed that book entries could not affect the highly technical and arbitrary definitions of invested capital which are found in the laws. The court says that invested capital consists of "investment" plus accessions, and emphasizes the element of cost as distinguished from ac- cruals of value. Certainly an estimated accrual of a future liability which is not, for tax purposes, deductible from the current earnings, is not a reduction of invested capital. The court wisely disallowed unrealized appreciation as an addition to invested capital; it is a fair assumption that it will be ^Excess Profits Tax Procedure, 1921, page 266. EXCESS rJ 1917- If this question were to be determined separate and apart from the act levying this excess profit tax, then it would be of easy solution. Money invested in a partnership business, whether paid in by the partners or borrowed from a partner or a bank, in the absence of leg- islation to the contrary, would constitute invested capital in the or- dinary meaning and acceptation of that term. Congress, however, evidently for the purpose of protecting the government from claims of inflated capitalization, thought it w-ise and necessary to define the term "invested capital," which is made the basis of the computation of the tax to be levied under the authority conferred by this Act. To that end Section 207 provided among other things the following: "As used in this title 'invested capital' does not include stocks, bonds (other than obligations of the United States), or ' Charles E. Carticr and Edzvard M. Holland v. Doyle, Collector, U. S. Circuit Court of Appeals. Sixth Circuit (December 15, 1921). EXCESS PROFITS TAX PROCEDURE— 1921 1665 [Former Procedure] other assets, the income from which is not suhject to tlie tax imposed hy this title nor money or other property borrowed, and means, subject to the above limitations : "(a) In the case of a corporation or partnership: (i) Actual cash paid in, (2) the actual cash value of tangible prop- erty paid in other than cash, for stock or shares in such cor- poration or partnership, at the time of such payment (but in case such tangible property was paid in prior to January first, nineteen hundred and fourteen, the actual cash value of such property as of January first, nineteen hundred and fourteen, but in no case to exceed the par value of the original stock or shares specifically issued therefor), and (3) paid in or earned surplus and undivided profits used or employed in the business, ex- clusive of undivided profits earned during the taxable year : In the construction of the Act of Congress of which this defini- tion is a part, this legislative definition of the term "invested capital" must be accepted as final and conclusive, regardless of any precon- ceived notion the public generally, or this court, may have as to the meaning of that term. In the construction of this statute it must also be remembered that it is the settled rule not to extend the provisions of taxing statutes by implication, or to enlarge their operation, so as to embrace matters not specifically covered thereby. Gould v. Gould, 245 U. S. 141. The trial court based its judgment for the defendant upon the conclusion of law that the collateral deposited by Cartier as security for his liability as an indorser of the partnership notes became a part of the working capital and was used and employed in the busi- ness of the company to the same extent as if it had been paid directly into the partnership funds. This conclusion of law is not supported by the facts found by the court or by any evidence in this record. The articles of co-partner- ship provide that the paid-in capital of the partnership is to be $30,- 000.00, any or all portions of which amount is to be furnished to the partnership, upon notes signed by it, and to be paid at the earliest practicable opportunity out of the net earnings of the partnership. It would seem unnecessary to say that a private contract between these parties would not change or affect, in the slightest degree, the plain and positive terms of the statute, declaring what shall be included and what shall not be included as "invested capital," for the purpose of this tax. If the articles of co-partnership had provided that the paid-in capital of the partnership should be $30,000.00, one-third of which should be paid in cash or in property by the partners, and 1 666 EXCESS PROFITS TAX PROCEDURE— 1921 [Former Procedure] $20,000.00 to be borrowed from a bank upon the notes of the partner- ship, indorsed by the partners, and further secured by the deposit of such collateral as the bank might demand, the money borrowed in pursuance of such partnership agreement, fixing the total capital of the partnership at $30,000.00, would necessarily be rejected as in- vested capital in the computation of surplus income taxes levied under this act. It logically follows that, if under this statutory definition of invested capital, money borrowed could not be included as capital where some substantial amount of cash had actually been paid into the partnership fund by the partners, such borrowed money can not be reckoned as invested capital where the partners contributed neither cash nor property to the partnership capital. The original plan of operation written in the partnership agree- ment was abandoned as early as 1914, and thereafter the money used in the partnership business w-as borrowed directly from the bank upon the notes of the partnership, payable unconditionally and at certain fixed times, regardless of net earnings or any other contingency. While these notes were indorsed by the individual partners, neverthe- less the money was borrowed by the partnership for partnership pur- poses, and it was primarily liable for the payment of these notes. Collateral held by the bank, a stranger to the partnership, whether the property of one or of both partners, was a mere incident to the loan, and can in no wise affect the character of the transaction. It is therefore wholly unnecessary to determine whether under the original agreement the money to be furnished by Cartier, to be re- paid out of the partnership earnings, would or would not be borrowed money w^ithin the meaning of this act. Nor is it important at whose suggestion this plan of operation was changed and the new plan adopted. It is sufficient for the purposes of this opinion to determine the legal effect of these transactions as they occurred during the tax- ing period of 191 7. The evidence in relation to these transactions permits of no conclusion other than that the money borrowed from the bank upon the notes of the partnership was ''borrowed money," with- in the meaning of Section 207 of the Act of Congress approved October 3, 1917. The clear, positive and unambiguous language of Section 267 of this act is not subject to any other construction, regardless of the exigencies of any particular case. First it provides that borrowed money or other property shall not be included in the term "invested capital" as used in that title. Paragraph "A" of that section then specifically states what shall be included in determining the "invested capital" of a corporation or partnership as follows: "(1) Actual cash paid in." There is no claim made by the government that there was EXCESS PROFITS TAX PROCEDURE— 1921 . 1667 [Former Procedure] any "actual cash paid in" to the- partnership funds other than the money borrowed from the bank on the notes of the partnership, en- dorsed by the partners, the endorsement of Cartier being secured by collateral deposited by him. "(2) The actual cash value of tangible property paid in other than cash for stock or shares in such cor- poration or partnership." In this case there was no tangible property paid in by either partner for the purpose named or for any other purpose. The collateral deposited by Cartier could not upon any reasonable hypothesis be held to be "tangible property paid in" to the partnership. It was not deposited with, transferred or assigned to the partnership and the partnership never acquired any right, title or property interest therein, legal or equitable. This collateral was deposited with the bank as part of the loan transaction. Cartier never parted with the title of ownership therein. The bank held it, not as owner but as pledgee merely. "(3) Paid-in or earned surplus and un- divided profits used or employed in the business exclusive of undi- vided profits earned during the taxable year." Whether this partnership used or employed in its business paid-in or earned surplus and undivided profits exclusive of undivided profits earned during the taxable year is a question of fact. The trial court found as a fact that at the beginning of the taxable year the liability of the firm exceeded its assets by the sum of $7,218.85. This court has no authority to determine the weight of the evidence. R. S. Sections 649 and loii. If the finding of fact made by the trial court is sus- tained by some substantial evidence, then it must be accepted by this court as a final determination of the facts in issue. There is practically no dispute in the evidence upon which the trial court made this finding of fact. It had been the custom of each partner, with the consent of the other, practically from the time the partnership was organized, to withdraw earnings of the partnership in advance of the ascertainment of the exact profits and a formal di- vision of the same. These withdrawals were charged against the part- ners respectively on the partnership books of account, and whenever there was a formal division of the profits the amount due to each partner was credited to his account as against amounts that were withdrawn by him. On the first day of January, 1917, it appeared that Cartier had withdrawn in the aggregate, during the life of the part- nership, the sum of $11,556.37, in excess of all sums credited to him. Holland had also withdrawn $18,106.28 in excess of his credits. The evidence further shows that these withdrawals were made in anticipa- tion of a distribution of the profits, to be credited to them as against these withdrawals, that would finally balance their accounts. That this was the purpose and understanding of the partners fully appears l668 EXCESS PROFITS TAX PROCEDURE— 1921 [Former Procedure] by their testimony, and particularly the testimony of Holland, as follows : "The Court : It would be liquidated by dividends you declared ? ''A. Eventually. "The Court: And credited yourself with? "Yes." In the absence of an express agreement to the contrary, the part- nership could not require a partner to return to it his share of the actual profits anticipated by these withdrawals. The strongest infer- ence which anything in this record would justify as to the duties of the partners to each other to repay these items charged against them is that each should repay the amount he had withdrawn in excess of his share of the profits. This would mean in the aggregate $7,218.85, just enough to pay the general debts and leave no surplus. In any event, these profits were drawn by the partners and were not used in the partnership business. The claim that they were used in the partnership business as bills receivable, so they would furnish a basis of credit, is not tenable. These partners were the sole owners of the partnership business and in full control of its affairs: they were each individually liable for all the debts of the partnership, so that whether they were liable to the partnership for the full amount of these with- drawals, regardless of profits, could in no wise affect the security of creditors for the payment of their debts. It w'ould therefore appear that this finding of the trial court is fully sustained by substantial evidence. Section 9 [209] of this act provides that in the case of a trade or business having no invested capital (and, of course, that means in- vested capital within the meaning of the act), or not more than a nominal capital, there shall be levied, assessed, collected and paid, in addition to the taxes under existing law and under this act, in lieu of the tax imposed by Section 201, a tax equivalent to eight per centum of the net income. This section of the act w^ould appear to have been intended to cover just such conditions as are here presented. For the reasons above stated, this judgment must be reversed and the cause remanded for a new trial in accordance w^ith this opinion. Page 427 Definition of "trade or business." — Ruling. Royalties received in 1917 by a taxpayer from a license under a license contract to manufacture, use, and sell certain auto- mobile inventions did not result from a mere ownership of property. The time and attention devoted by the taxpayer during that year and prior years to the invention of automobile devices, the placing of same on the market, and the protection of same were sufficient to constitute EXCESS PROFITS TAX PROCEDURE— 1921 1669 [Former Procedure] a trade or business within the meaning of section 200 of the Revenue Act of 1917. The royalties were therefore subject to excess profits tax under the provisions of section 209 of the Act. (B. 42-21-1874; A. R. R. 425-) Where a taxpayer received an amount from a decedent's estate as compensation for services rendered in boarding, car- ing for, and nursing members of the decedent's family, this compensation was held not to be from a vocation, trade, or business when this was not the regular occupation of the re- cipient. The opinion of the Solicitor of Internal Revenue quoted in the ruling is as follows : Ruling. The facts do not fully appear on the record, but it seems that the taxpayer received 35^- dollars in 1917 in payment of a claim against the estate of B, his relative, covering services, etc., which ex- tended over a period of years from 188- to 190- and from 191 1 to 19 16. The Unit .... holds that of this amount 23 ^^a" dollars is subject to both income tax and excess-profits tax at the 1917 rates, the difference between the amounts being deductible. I concur in the view that this was not a claim on March i, 1913, because the under- standing between the parties was too indefinite and intangible and it does not even appear that accounts were kept. It appears proper, therefore, to subject the 233/2^ dollars to income tax. I believe, how- ever, that this income was not derived from a trade or business or vo- cation within the meaning of the statute and the regulations and therefore is not subject to the excess-profits tax. Analyzing the taxpayer's statement reproduced on page i of the recommendation, which seems to be the only statement of the facts in the record, the claim embraced the following principal items: (l) Services rendered in boarding, caring for, and nursing members of B's family; (2) boarding and caring for teams; (3) use of automo- biles, teams, wagons, carriages, servants and employees; (4) expenses incurred at his relative's direction. The taxpayer was permitted to deduct Sx dollars representing item (4) and also the expense of col- lection of claim. The remaining items seem to me to come within clause (a) of the second paragraph of article 8, Regulations 41 ("gains or profits from transactions entered into for profit but which are isolated, incidental, or so infrequent as not to constitute an occupa- tion"), and therefore not to be subject to excess-profits tax. The conclusion is based upon the assumed facts that the taxpayer per- formed the above kind of services only for his relative, and not for others, had no agreement as to prices or charges, and kept no ac- 1670 EXCESS PROFITS TAX PROCEDURE— 1921 [Former Procedure] counts, but expected to be recompensed in some way and to some extent on his relative's death. If, however, it is true of any of the three items that he performed similar services for others in addition to the services casually and incidentally rendered his relative, it might be held that he was engaged in that particular business, but I find nothing in the record to warrant such finding. Certainly in the absence of any definite agreement between the parties nursing and -caring for relatives would not ordinarily be considered a vocation, trade, or business of a person whose regular occupation is that of a farmer. (B. 52-21-1996; A. R. R. 706.) APPENDIX B FORMS APPENDIX B FORMS On the following pages will be found reproductions of the forms listed below : Form No. Pages Abatement, Credit and Refund— Claim for 843 1675-1676 Taxes erroneously or illegally assessed (but not paid), claim for credit against the tax due under any other return and refund claim for taxes errone- ously or illegally collected. Old forms 46, 47 and 47A are combined into this new one. Alien, Certificate of, Claiming Residence in the United States 1078 1677 To be filed with withholding agent (employer) by alien residing in the United States, for the pur- poses of claiming the benefit of such residence for income tax purposes. Bond, Income and Profits Tax 1 127B 1678 To be filed in connection with an extension of time under section 250 (f). Extension of Time, Application for, Payment of Defi- ciency in Tax [section 250 (f)] 1127 1679-1680 Application for extension to pay deficiency in income and profits tax on account of understatement not due to negligence or fraud. Farm Income and Expenses, Schedule of 1040F 1681-1684 To be filed with form 1040 or 1040A when income is derived from farming. Guide Form for Calculation of Amortization 1007M 1685 To support claim for amortization. Ownership and Exemption Certificate — Foreign Cor- poration 1086 1686 To be filed by foreign corporations having an office or place of business in the United States. Personal Exemption, Non-resident Alien — Claim for.... 11 15 1687 To be filed by non-resident alien claiming benefit of personal exemption of $1,000. Report of Income of $1,000 or More Paid during the Calendar Year 1921 1099 1688 These forms are summarized on form 1096 and are filed with that return. Return, Annual, Information 1096 1689-1690 Payments of interest, salaries, rent, etc., of $1,000 or more to be filed annually, accompanied by returns on form 1099, by every individual or organiza- tion making such payments. 1673 Form No. Pages Return, Capital Stock Tax — Domestic Corporation 707 1691-1694 Return, Corporation Income and Profits Tax — Calendar Year 1921, or for Fiscal Year ended in 1921 1120 1695-1700 Return, Fiduciary Income Tax 1041 1701-1706 Where net income of estate is $1,000 or over and is distributed periodically, or if a beneficiary is a non-resident alien. Return, Individual Income Tax 1040 1707-1712 Where net income is more than $5,000 for taxable year. Return, Individual Income Tax 1040A 1713-1716 Where net income is not more than $5,000 for tax- able year. Return, Information — Subsidiary or Affiliated Corpora- tion 1122 1717 Return, Partnership and Personal Service Corporation • Income Tax — Calendar Year 1921, or Fiscal Year Ended in 1921 1065 1718-1721 Statement of Income Received by Non-Resident Alien from Sources within United States (Personal Exemption Claimed) lOOiB 1722 To be filed with withholding agent by non-resident alien owning bonds of a domestic corporation which contain a tax-free covenant clause. 1674 IMPORTANT Fill ullh Cotteclor of Internal Recenue where asieismenl wai made. Not aeccfytMe unleu- completely fiUeJ In. State of .... County <^ . CLAIM FOR J ABATEMENT OF TAX ASSESSED 1 CREDIT AGAINST OUTSTANDING ASSESSMENTS J REFUND OF TAXES ILLEGALLY COLLECTED J REFUND OF AMOUNTS PAID FOR STAMPS USED IN ERROR OR EXCESS NOTICE TO COLLECTOR I COLLECTOR'S NOTATION DMrlct TYPE OR PRINT (N'amo of taxpayer or purchaser o( stamps.) Ceilmtot af tntunai Retmui (Re3idenco—gl\ 6 street aoil number as well as city or town and State.; (Business address.) This deponent, being duly sworn according to law. deposeo and aays that this statement is m&de on behalf of the taxpayer i that the facta given below with reference to said statement are true and complete: s ossessad or the stamps alTixcd.) 1. Buaineaa in which engaged 2. Character of aaeesement or tax ' (State for or upon wtut the tax 3. Amount of asaeaement or stamps purchased _ 4. Reduction of Tax Liability requested (Income and Profits Tax) .; $ 5. Amount to be abated _ _ „ _ „ $. 6. Amount to be refunded (or such greater amount a^ is legally refundable) $. 7. Dat«8 of payment (see Collector's receipts or indoraomenta of canceled checks) (If statement covers income tax liability, items 8-11, inclusive, must be answered.) 8. District in which return (if any) was filed _ 9. District in which unjl)aid assessment appears 10. Amotint of overpayment claimed as credit „ „ „ 5, 11. Unpaid assessment against which credit is asked; period from to $. Deponent verily believes that this application ehoukl be allowed for the following reasons: PEDIOO YEAR Fro-i: IB » To; (Attacb adaitlonal sbeets If necessary.) Sworn to and subscribed before me thifl ..„,_ „ day of . 19 Signed: iTi}^»im»^t may be sworn to before a Oepaty Collector of iDtcraal BeTeaae or ReT«nne Agent vltb«at charge.) rt— ii7M 1675 CERTIFICATES a I certify that an examination of the .records of the Bureau of Internal Revenue shows the following facts as to g_ the assessment and payment of the tax: c. Name or ta^tates. Character of assessment j^j^^ y«ar. UanUt Pag.. Line. Amount. Dslepsld. District hi vhlehpud. $ --- " 1 "'" Collector of Internal Reraiue. Assessment Clerk, Commiiatojifr's Office. I certify that the records of my office show the following facts as to the purchase of stamps: Number. Dcsonunati aa . Viie of sale or issue. Amormt. If Fpecial tax stamp, state: To -WHOM BOLD OB ISSUED. Kind. Serial oumbeT. Period commenciDS— \ s. 1 — jZZ. 1 Schedule Number Allowed or Rejected Number. Claimant Address claim examined by- Claim approved by— Dislrict- District . (Nacunortax.) Examined and submitted for action _ _ _ , 19_ COMMITTEB OIT CLAIMS Amount claimed..^ $.. Amount allowed... $.. Amount rejected $.. 1676 CO o 5 s 00 g u S ES o -as S &^ —J OQ K . c4 2 ^ ■^ -*-> ^ a O OS Pi 13 "So 4) a "5 '^ -S © II .J i-^ a o >> a *3 «; *< 3|| 00. O 03 q OwO o >^ — IIHO i68i Page 2. FARM roVENTORY FOR INCOME COMPOTED ON AN ACCRUAL BASIS. Description. (KlDd of animals, crops, or other products.) Om Hakd at Beoowdio or Ye»b. PuBcnisED During Raised Duking Yeah. CONSimED TiR LOST During Year. Sold Durmo Year. Oh Hahd at Ehd or YEiE. Quan- lily. Invonlory value. QlUD' Illy. AnioiiDt lily. laventory value. QlUB' Inventory vaJue. Quan- lily. Amount received. Quan- lity. InTOTtarj value. $ $ $ $. — $._ $ — 1 ' Totals $ $ $ s...... % $ 1 line 4) (Emer on hne 6.) (Enter on liDe 2.) SUMMARY OF INCOME AND EXPENSES COMPUTED ON AN ACCRUAL BASIS. 1. Inventory of live stock, cropa, and products at end of year . 2. Sales of live stock, crops, and products during year 2a. Other miscellaneous receipts 3. Total ; 4. Inventory of live Block, crops, and products at beginning of year 5. Coetoflive fatock and products purcha/;ed duriug year fi. Gross profits (Item 3 minus the sum of Itema A and 5) — 7. Expenses (column l,page3). 8. Expenses (celumn 2, page 3). 9. Repairs 10. Depreciation Total Extehses . 12. Net farm profit to be reported in Item 5, Form 1040A, or Form 1040 (Item 6 fliinus Item 1 1 >.. 1682 Page 3. FARM EXPENSES FOR TAXABLE PERIdO. ITircd help for farm Feed, liay, straw, etc — Seed, plants, etc Threshing and baling Cotton ginning Silo filling Milling and grinding feed _ Fertilizers and spraying materials Blackarailhlng — Fuel and oil for farm vrork Barrels, bags, crates, and twino — Taxes (except Federal income ta.^es) loGniute oa prcpertj olbor than joar jffoHmg and pcrsond cIImIs.. Interest on farm notes and mortgages Water rent - Rent for farm (I) Amount. (Enter on lino 7.) REPAIRS AND DEPRECMTION. (Enter on lino 8.) Descp-iptiov. (It builJing!;. slato the material ol which constructed.) Ace When ActjUUlED. Date AcQimiED COST, OBtFACQUIKED PRIOR TO March 1,1913. THE Fair Uaeeet Valux ON That Date. Repairs. Depreoatioh. Farm buildings - ? :- ?— ^ .„•. 1 1 TOTAI.3 - - $ 5 $ (£ateroiilme9.) (Enter on line 10.) 1683 P«ge4. INSTRUCTIONS. Pases 1 and 3 arc to be (llled In by farmers who either keep no recorils or only records of rash receipts and dislmrse- raenls. Pases 2 and 3 are to he tilled in hy farmers who keep comi)letG aeconnls on an aoerual basis with invoulories to deteriuino net prolits. Returns on an inventory basis are not acceptable unless the inventories were actnally taken and so recorded at the beginning and end of the taxable period. H you do not, as a matter of settled practice, keep books of accouut upon an accrual basis, no attempt should be made to fill out the items in the form relating to inventories, and the omission of those items in that case will not result in an incorrect computation ' of your farm net profit. If, however, you regularly keep books of account upon an accrual basis, which clearly reflect your net income, you should report the value of yoiu- crops and stock on hand at the end of the year in gross profits, as provided on the form. This schedule may be used by farmers who work their own farms or rent them out on shares, and if two or more farms are owned it may be desirable to fill out a separate schedule for each farm. Attach this schedule to your income tax return (Form 1040.\ or Form 1040). You should keep a copy for future reference. When you have determined the net farm profit, transfer the amount to Item 5 of the income tax return Form 1040A, or Form 1040. Cash Receipts and Disdursemests Basis. A farmer reporting on the basis of cash receipts and disburse- ments shall include in his gross income for the taxable year the amount of cash or the value of merchandise or other property received from the sale of live stock and produce which were raised during the taxable year or prior years, also the profits from the sale of any stock or other items which were purchased. The farm expenses will be the actual amounts paid out during the taxable year. Accrual Basis. If your farm books of account are kept on an accrual basis, the filing of this form is optional. For those reporting on the accrual basis, the gross profits are obtained I)y adding to the inventory value of live stock and products on hand at the end of the year the amount received from the sale of stock and products and other miscellaneous receipts, for hire of teams, machinery, etc., during the year, and deducting from this sum the inventory value of stock and products on hand at the beginning of the year plus the cost of stock and produce purchased during the year. The farm expenses will be of the actual expenses incurred during the yeai. whether paid or not. hientory. — If you render a return for the taxable period of 1921 upon an accrual basis, you may value the closing inventory for 1921 according to the farm pric« method, which contemplates valuation of inventories at market less cost of marketing. In the event the use of the farm price method of valuing your closing inventory for 1921 represents a change in method of taking inventories from that employed by you for 1920, the opening inventory for 1921 should be brought in at the same value as the closing inventory for 1920 (this being the same in effect as valuing the opening inventory on the new basis and crediting income with tlie excess valuation brought in). If such treatment of your opening inventory for 1921 results, however, in an abnormally large income for 1921. then adjust- ments in the form of an adjustment sheet attached to your 1921 return may be made of your taxes for 1917 and each succeeding year to 1921. based on the new method of taking inventories (using lor each of such years prior to 1921 the same method employed for 1921). Farmers may change the basis of their returns from that of receipts and disbiusements to that of an inventory basis, which necessitates the use of opening and closing inventories for the year in which^he change is made. There should be included in the openinginventory all farm iJroducts (including live stock) purchased or raised, which were on hand at the date of the inventory, and there must be sub- mitted with the return for the current taxable year an adjustment sheet for 1917 and each year thereafter (prior to the year in which the change is made) based on the inventory method; upon the amount of which adjustments the Lix shall be assessed and paid (if any be due) at the rate of tax in effect for each respective year. Where it is impossible to render complete inventories from the begin- ning of the taxable year 1917, the Department will accept estimates whuh, in its opinion, substantitallv rcllect the income on the inventory b.asis, for the year 1917 and thereafter; but inventories must not include real estate, buildings, permanent improvements or any other aaseta subject to depreciation. Income. All the farm income from whatever source must be reported in this schedule. Anything of value received instead of cash must be treated as income to the extent of its cash value. Thus, the total value of groceries, merchandise, etc., received in exchange for cgs, butter, or other produce must be reported as income. ° 1 Hail and fire insurance on giowing crops should be included in pross income to the amount received in cash or the equivalent fo- the crop destroyed. If you sold your farm or any part of it, report the profit iii Item G of Form 1040A or Form 1040. The yahie of farm produce which is consumed by the f.irmer and his family need not be reported as income; but expenses incurred in raising produce thus consiuned must not be claimed as deductions. The term "farm" embraces the farm in the ordinarily accepted sense, and includes stock, dairy, poultry, fruit, and trucl: farms, also plantations, ranches, and all land used for farming operations'. All indiWduals. partnerships, or corporations that cultivate, operate, or manage farms for gain or profit, either as oimers or tenants, are designated farmers. A person cultivating or operating a farm for recreation or pleasure is not regarded as a fanner. Expenses and Other Deductioxs. Labor. — Only that part of the board of hired labor which is pur- chased should be included as a deduction. The value of products furnished by the farm and used in the board of hired labor is not a deductible expense. Rations purchased and furnished to laborers or share croppers are deductible as a part of the labor expense. Do not deduct the value of your own labor or that of your wife or dependent minor children, unless you report such value as income in Item 1, Form lO-lOA or Foim 1010. Do not deduct amounts paid to persons engaged in household work, except to the extent that the services of such employees are used in boarding and other- wise caring for farm laborers. Services of such employees engaged in caring for the farmer's own household are not a deductible expense. Fertilizers, manures, etc. — The cost of manures, commercial fer- tilizers, lime, raw rock phosphate, etc., that were bought during the year may be deducted as an expense. Taxes. — Do not deduct Federal income taxes nor taxes for any improvement or betterment tending to increase the value of the property. (See Articles 131 to 135, Income Tax Regulations, 1922 edition.) Be ready to show tax receipts for taxes claimed as a deduction. Taxes on yo\ir dwelling or household property should be reported in Item 11, Form 1040A, or Item 13, Form 1040. Interest on indebtedness. — All interest paid on farm mortgages, notes, and other obligations incurred to carry on the farm business sh(Tuld be deducted. Bud debts. — Report only debts, or portions thereof, arising from sales that have been reported as income, which have been definitely proved within the year to be worthless, or such reasonable amount as has been added to a reserve for bad debts within the year. If you report your farm income on a cash basis, bad debts arising from sales are not an allowable deduction. Repairs and depreciation. — Depreciation claims should not exceed the actual cost of buildings and equipment (or it acqxiired prior to March 1, 1913, the fair market value on that date) di\'ided by its prob- able life in yearssince acquisition. In computing depreciation do not include the value of farm land nor the land on which farm buildings are located. Do not deduct repairs or depreciation on the dwelling you occupy or on your peraonal or household equipment. Do not claim as a separate item depreciation on live stock or any other property included in yoiu- inventory, as such depreciation is taken care of la the reduced amount of the inventory at the close of the year. Depreciation, however, may be claimed on draft or work animals and animals held for breeding pmposes which were pur- chased and which are not included in your inventory of stock bought or raised for sale. Losses. — You may deduct in Item 12, Form 1040A, or Item 14, Form 1040, losses of buildings, machinery, and other property not included in your inventory, resulting from fires or other casualties and not compensated for by insurance or otherwise. Losses of prop- erty included in your inventory are taken care of by the reduced amount of the inventorv at the close of the year. The loss of growing crops hy frost, storm, flood, or fire, or the loss of animals raised, is not deductible. Tools, machincrij, and equipment. — The cost of small tools of short life, such as shovels, rakes, etc., may be deducted as an expense. You may deduct expenses of operation, repairs, and depreciation on automobiles used exclusively in fann business. If an automobile is used in farm business for a part of the time only, a corresponding part of the expense may be deducted. Amounts expended for automobiles, fann machinery, farm buildings, or other farm equip- ment of a permanent nature are not deductible as expenses, as such expenditmes are regarded as investment of capital which is re- turned to the owner through depreciation allowances prorated over the useful life of the property. Rent paid in crops. — ^Tiere a tenant farmer pays his rent to the landlord in form of crops raised on the farm (the agreement being on a crop-share basisV the tenant may not deduct as rent the value of the croj) given to the landlord, but he may deduct all amounts paid by him in raising the crop. 2— iieM 1684 o5 1 i ill IJ? il! f J •< 1 3^-1 111' J.l If! iii |9 . ■2|S 1 i J ? il:" ft - Releronce or voucber No. Date on which completed tor operation ° i 8 " " CL. O i ^ if 1 1 fill III! liil * Sr-3 gill Hit t685 a* S o u j^ a > u 'J u u o H a Ed >J H ,.— V H s Z ■§ H S3 M, 55 •C i 1 '3 - o r" ^ 2: H" .5 o frza H LJO^ Pj "hi 2 Z<5 oc-s ^^= gp x^a UiZS q9| zus .03 .S w cs2S a^« fc( »>j tt« g 03 & ■^ -r; _> ^ S '5b ^ •=> a Poo W. ]s.-a a T3 •0 13 03 z O c? 1 a ■43 ^ 03 -^ 0. B s |.g 8 .3 Yi a -9 i a z '3 3 ~ ja 5I c? |o. a A S -^ £ 8 SS 11 .3 9 2 1 :i A 1 3 -s § 1 ■« >-< ^ J k .2 5 g HH 1 >> 5 ^ 1686 K nomwldent alien who deslrw to data tho nersnnol fxempllon o( $1 ,000 with resp»-t to saliries or wajres received In poyme nt (nr Mrvtcea rendered In the tJnlted St«to should file this lorm with his employer not later than February 1 succeeding the year during which the Income was received . THE WITHHOUJINC AGENT OR COLLECTOR RECEIVING THIS CLAIM SHALL ENTER DATE OF RECEIPT IN THIS SPACE. CLAIM BY NONRESIDENT ALIEN INDIVIDUAL FOR BENEnT OF PERSONAL EXEMPTION OF $1,000 FOR TAXABLE YEAR 1921 DO NOT WRITE HERE (Name of withholding agent.) (Street and number.) Claim is hereby made for benefit of the personal exemption provided xmder section 216 of the Revenue Act of 1921 by (or for)- Name of claimant - Address in the United States. 1. Of what country are you a citizen or subject? (Name of country. ) 2. State or Province? — 3. Are you single? (Name of State or Province.) 4. If married, has your wife or husband derived income during the taxable year to date from sources in the United States separate from your own? 5. If so, is such income included in the income stated below?. 6. Have you filed a return of net income for all or any of the past four years ? ;... 7. If so, state for which years and the Internal Revenue Districts in which fiJed. INCOME OF CLAIMANT, DURING TAXABLE YEAR TO DATE, FROM SOURCES WTTHIN THE UNITED STATES. (1) Salary on Wages. Name ov Emploteii. Addbess. Peiuod. AMOtTOT. 1- . . $ 1 (2) Other Income. $ $ Name or SotTRcs. Address. Period or Date. AMOUNT. $ Total income of claimant, during taxable year to date, from sources within the United States (X) STATEMENT OF PERSONAL EXEMPTION CLAIMED. Amount of personal exemption to which entitled (Y) $ 1,000 00 Total income of claimant, during taxable year to date, from sources within the United States (item X from above) Balance of credit (item Y minus item X) $ « I swear (or afiirm) that the above is, to the best of my knowledge and belief, a true and complete state- ment of facts in connection with the claim for credits above made. (U claim is made by agent the reason therefor must be stated on this line.) Sworn to (or affirmed) and subscribed before me this day of 192 (Signature of Individual or agent.) (Official capacity.) COVUWHINT raiNTWC (Address of Individual or agent.) 1687 so SO is oe; us X X h bJ o O OS Ho Si o fiti z En 0£->T3 P b< ' 1 Q I ! i j < ; ; leu ; ; H i ] z ! 1 iD \ \ s 1 1 ,< bi [ i i ! 1 Q K> C/> - eft b 1- b i 1;; z rward with return Form ! r of Internal Revenue, So before March 15, 1922. o not report on this form ds of domestic or foreign c other obligations of tho U FOR FURTHER INSTRVCTI b >. Ep .2 Q 2 < g H 2 el Z U ) u m-O !0 O XI et 1 688 UNITED STATES INTERNAl REVENUE SERVICE ANNUAL INFORMATION RETURN OF PAYMENTS OF INCOME. ETC., REQUIRED TO BE REPORTED UNDER REVENUE ACT OF 1921 FOR CALENDAR YEAR 1921 (Return for Fiscal Year Can Not Be Accepted) FOR INSTRUCTIONS SEE REVERSE SIDE THIS RETURN, ACCOMPANIED BY REPORTS ON FORM 1099, MUST BE FpRWARDED SO AS TO REACH THE COMMISSIONER OF INTERNAL REVENUE, SORTING SECTION, WASHINGTON, D. C, ON OR BEFORE MARCH IS, 1922. (Name o( person or organization rendciing this rctnrn.) (Street and number or rural route.) CHARACTER OF INCOME PAID. NUMBER OF REPORT FORMS 1099 ATTACHED. Interest, rent, salaries, wages, prcroiumj, anniaties, compensation, remuneration, emoluments, or other fixed or determinable gains, profits, and income of $1,000 or more (DO NOT WRITE IN THIS SPACE.) IMPORTANT NOTICE Returns of Information »re required to be rendered on the basis of the calendar year. Returns for any other period of time will not be accepted. If list showing names and addresses of payees is compiled or an adding machine tape used in executing Forms 1099. it should be submitted with forms. The name of the individual, corporation, partnership, etc., using Form 1099 may be printed or stamped on each form, if so desired. Returns -of individuals on this form must be signed and sworn, to by the individual or his duly authorized agent. Retimis of corporations, partnerships, etc., must be signed and sworn to by an officer of the aorporation or member of firm. I' Swear (or affirm) that to the best of my knowledge and belief the foregoing return and the accompanying reports constitute a true and complete statement of payments of the above-described classes of income made by the person or organization named at the head of this return during the calendar year 1921 Sworn to and subscribed before me this day (State address of person signing ifdiflerent from that ^ven at head of n (THIS RETtIRN MUST BE SIGNED AND SWORN TO) 1689 INSTRUCTIONS Forms 1096 and 1099 (Interest, Rent, Salaries, etc., of $1,000 or more) must be made by every individual, corporation, partncrehip, personal service corporation, association, or insurance company, including lessees or mortgagors of real or personal property, trustees, executors, administrators, receivers, employers, and all officers and employees of the United States who paid interest, rent, salaries, ete,, to another individual, partnership, personal service corporation, or fiduciary during the calendar year 1921. A separate report on Form 1099 must be made (and forwarded with this return) for each indi\'idual, partnership, personal service corporation, or iiduciar}' to whom such income was paid, credited, or distributed. Interest, rent, salaries, etc., regardless of amount paid to nonresident alien individuals, should not be included in this return buc should be reported on return Form 1042. In executing Form 1099, an employer who is required' to withhold fax from an employee under a State income tax law, shouH report on each form the amount of salary paid to the employee plus the amount of tax withheld. The employee should report the same amouat on Form 1040 or Form 1040A, as the case may be. ORGANIZATIONS HAVING A MAIN OFFICE OR PLACE OF BUSINESS, AND ONE OR MORE BRANCH OFFICES, SHOULD FILE COMPLETE RETURNS ON FOR5IS 1096 AND 1099 SHOWING ALL PAT3IENTS MADE BY MAIN AND BRANCH OFFICES. THIS RETURN SHOULD BE MADE FROM THE MAIN OFFICE AND THE LOCATIONS OF ALL BRANCH OFFICES COVERED BY THE RETURN SHOULD BE NOTED THEREON. Reports on Form 1099 are not requirerj in the folloxping cases: Interest on the obligations of the United States, of States, Territories, or political eubdlTiaions thereof or of the District of Colimibia, and compensation paid officers and employees by a State or political subdivision thereof for personal senieee. Bills paid for merchandise, telegrams, telephone, freight, storage, and similar charges. Amounts paid to employees for expenses incurred in businees. Premiums paid to insurance companies. Annuities representing return of capital. Interest accrued on bant deposits if not credited. Payments made by domestic establishments or foreign branch houses thereof to nonresident alien employees for serviceB performed entirely in foreign countries. Interest on bonds of domestic and foreign corporations. (See Forms 1012 and 1096A.) .Salaries, wages, etc., paid to nonresident alien individuals and foreign corporations. (See Form 1042.) The rental value of a dwelling house and appurtenances thereof furnished to a minister of the gospel as a part of his compeiMation. Distributions to members of a partnership, personal ser\'ice corporation, and beneficiaries. (Distributions made to members of partnerships, personal service corporation, and to beneficiaries of estates or trusts must be shown on Partnership and Fiduciar)' Retunw.) TENANTS ARE NOT REQUIRED TO REPORT PAYMENTS OF RENT MADE TO REAL ESTATE AGENTS OR REPRESENTATIVES, BUT AGENTS OB REPRESENTATIVES ARE REQITRED TO REPORT PAYMENTS TO LANDLORD OR OWNER IF THEY AMOUNT IN THEAGGBEGATE TO $1,000 OR MORE FOR THE YEAR. 2— IIMS 1690 Fornx 707— Ucvised Fub., 1021. 1922 RETURN CAPITAL STOCK TAX RETURN FOR DOMESTIC CORPORATIONS (Page.) Audita! by: e of corporatloa, Joint-stock company, or association.) (Sbcw former n CI pal i>liioo of bu^ioti^s. 3. Name of parent ( i number," "City or towu," and "Si. (Diatrict filed.. (District Clod., 6. Nature of busineas in detail - G, Incoiporated or org:aiiized in State of Month. (June 30, 1921, \ Firo inaurance carried, if any, $.. 9 Special Instructions No. 2, page 4 hereof.) (Nearest earlier dtiic) Cum. or DMdesd 1 Number of Par Talua per Bhare. Total par valoa. ToiaL Capital stock outetanding: ry s $ X X XX zxx _ft, (1) 1691 EXHIBIT A. (See Special Instructions No. 4, page 4.) CONDENSED BALANCE SHEET AS OF (8ftm« d*t« u lt«iii 7, pa^ 1.) DEBITS AA'D ASSETS. BCX)ES OF ACCOUNT. lAIE VALUE. DlTTEREnCE. * (iiiplatn any laxg« unsiuiti.) 1. t t . Tftflh Totals .„ 1 ---..-.. ...._ i. .._.. CREDITS AND LIABILITIES. BOOKS OF ACCOUWT. TAISVALUB. SIFFES£1TCE. Bonded debt $ % ( J. Capital Block; — Common, $ " Totals 1 , ! , _J._.._ 1 L._ RECAPITULATION OF EXHIBIT A Thla calnnui for tue of (uparer. This cohinm tor use ot Domestic Corpofu ToUl of dehili ud usetJ after deJaeifng ttoTU rwt actual Lets loUl ef truSts and Cabi&ties cfler itJucUng capi .cs. S •-- S al stoc^, surplus, and other Hans not Stock iNsraANCE Compantes - 5 t * lC»t«ri»l diSoranoN wUl not b« tUowed aDl«sa satialftctorll; explained. (SXX l59TSUCnOKS OS f 40S 4.) (2) 1692 EXHIBIT B. (Se QUOTATIONS OR OUTSIDE SALES 3 Special Instructions No. 5, page 4.) .-^■:— SPECIAL INFORMATION. (Give oaiuo of exchoDge or specify " Outaldt Manufacturing and trading corporation* COMMON. FIRST PKEFEREED. will report annual gross sales for the five years shown under Exhibit C. MOKTH. Hiimbcir ot rfuiea Prlc«. Numbor ot shares Pric. TEAS ENDED— $-_ $ BALES. - 191 .... 191 191 19 19 .... Total Average i x x i i x X X X X X X RECAPITULATION OF EXHIBIT B. | This ulunm lor um ot Uxpayer. ■mi. column lor use ol D«p«tme«t Average sale value of common stock per sh by number of sbares Average sale value of firat preferred stock by .. number of shares Average sale value of second preferred stoc $ outstanding. per share, $ , multiplied k per share, $ , multiplied Total fvalue of total capital stock reflected by Exhibit B) ..„.—.- Preferred . Preferred . Approximate numTjer of shares traded in during tho year; Common Capital stock outstanding as of June 30, 1921; Common __ — . EXHIBIT C. (See Special Instructions No. 6, page 4.) ANNUAL INCOME. FISCAL TEAR Ended- ■ ~ ~~~ NUMBER OF SHARES. DIVIDENDS DECLARED. (Dedclt in red.) DEDUCTIONS. ADDITIONS. INCOME. C«.m.on. Flnl Second prstened. preferred. DEPRECIATION. $ - -56 fi .. .56 ^ ^ /, 5. .. .a 56 fi 19 f. 19 — % % % Total 1, AverBge. $ X X I X X X $ - % ..._..% % $ RECAPITULATION OF EXHIBIT C. TUB eolmim lor use ol tsipayer. This column tor use ot DepsrtmenL =d * - - - $ Capitali hibit zed at 0)..... ... per cen t (value of total capital stock reflected by Ex- State of 1 We, , President, and _ _ , Treasurer, of the above-named company, whone return for sjiecial excise tax is herein set forth, being severally duly sworn, each for himself, deposes and says that the items enlpred in the foregoing report and in any additional list or lists attached to or accompanying this return are, to his best knowledge and belief and from such information as he has been able to obtain, true and correct. Sworn to and subscribed before me this . .day [seal.] (Offldal Mjmclty.) (3) Trcasvrer. rSEB lN3TttucnoN8 ON Page 4.) 1693 SPECIAL INSTRUCTIONS the year preceding the taxable year, whether or not It is organized (or proBt < has a capital atock repreaented by sberei. For domesttc tsatual Insurance companies, see page 1, Form 707, Bevlsed. For the purpose cf this tai the fair ralne of the entira cfipitnl stock as a going concern, re:^rdle89 of stocs ownership or the ability of Individual stock- Boldera to liquidate their holdings. Is required. The sales prices for any num- ber of shares of stock less than a majority Interest are not necessarily ludic- any given date. In order that consideration may be given the various factors affecting fair value, three eihlblta are provided for furnishing information, and the taxpayer win complete each erhlbft or state why the required data are not available. Exhibit A provides for adjusting any overstated or understated values con- tained In the taxpayer's books of account, and Exhibit C provides for showing an adjusted Income, which should be the actual operating Income to be used for capitalizing on a percentage bnsis fixed by its officers as fairly representing : for quotations i of the ex chance from wblcb reported In the space provided therefor, and the of the highest and of the lowest bid price ■— — rage for the year — *" "-- -■-'-■- ■ ' " to thiL _ quoted for each day of the highest and lowest bid price at which stock ' yeer and the average obtained therefrom. If the stock Is not listed end outside sales have been made at prices known or determinable by the Oulcers making this report, such prices will t>e reported herein. A statement of the number of shares Involved and the condllions under which sales were made at other than exchange quotations must accorn- pany this return. Sales to employees or directors for qualifying purposes. ■ capltai stock and should not be Included. In the column *' Number of shares outstanding" should he shown the total number of shares outstanding at the close of each month. The average value per share will be determined as follows: First. Tf no change occurred In the number of shares outstanding during the year, total the quotations or sales prices for the months reported and divide by the cumber of montiis In which quotations or sales prices arc shown. Second. If any change occurred In the number of shares outstanding during ; relied on In support of the valuation claimed must be sabmitted. In any case In which the fair value Is und»rBtat*3 the 1 " ' by the Commissioner and the wlU be asserted. : tax assessed ; alsc shoaid ~oe used annually. Uutual iBsursnc th« closing of the poM •! making Its Tacome-fax return. 3. BxHiBiTs — Tht three exhibits. A, B, and C, , . . provided to Indicate th« iMformation desired and the manner in which It should be famished. 8o far ea adaotable these forms should be completed by taxpayers, but If th«y And It more'convenlent they may cttach to this return fhslr own statements (as In the case of banks and inaorance compaDiea), provided substantlelly the same Information is furnished. In any event, taxpavera should attach any addi- tional stattments that will aid In a comprthenslve anderstaadlsg of the tax- payer's rcturm, so that the Commissioner of. lutemal Bsvenue may equitably determine the correctness of the fair value reported In Item 17 on pace 1 herooiL • 4, EiHiBrP A : Condsnsib Balarcb Sheet. — SSimleh under Exhibit A r condensed balance sheet as of tb« doting d«tw of the flscaJ year glv«a in item T oo page 1 hereof. ** Books of acsynMt'* — ^Th«ia columns mo^t ahow the amonnta as carried U tbe taxpayer's books of accoont ^ Ffiir value" — Refer to article 1 tbove. fleflnlag the valne required, snd In th» tTint that the columns "Books of account'* contain any overstated or under- stated values, stiow hersla the actual Taluca» " Difffrence." — These colocnas will show tbe difference be^wecn the columns been outstanding and divide by the number of months used la the computation. 6. ExHXBrr C: Ankual Imcome. — Furnish under Exhibit C the annca! In- come and other data for the five fiscal years ended with tbe close of the tax- payer's fiscal year as given in Item 7 on page 1 hereof, or for the period daring which the corporation has been engaged In business U for a ahorter period. *' JTef income," — In this column will be shown the Income returned for the purpose of the income tax and excess profits tax. "Deductions" and "Additions." — Refer to article 1 of these Speda! InBtrnc- tions. and show in these columns such amounts as shouJJ be deducted from or added to '" Net income" to arrive at the adjusted incoma which may be capl- tho oearest earlier date of taJisefl te determine the fair valne of the capital rtock. A comprehensive analysis of any amounts reported therein should be attached to this return. SMse of the principal items -frequently requiring adjustment are: Deduciiont: Income and profits taxes not deductlblo In computing Income subject to tax. ,. -- „ J tax. Losses not fully deductible, In computing income subject to tax. Additions: Dividends from other corporations not Included In computing income snb- nicipallty, or of the rolled BUtea. Any 1 I dllTerences i " and " Fair valae.' .snner as to enable the Commissioner of Internal Beven proper and acceptable. For this purpose the dlifer- : be covered by corresponding adJnstmaPEts in the to determine if ' ences shown her' taxpayer's booka of account. *' Treasuiy atock " and " Trraswry "btm^y — In the oreat the taxpayer kolds In Its treasury any of Ita own stock or bonds, advice must be fuinlBhed as to whether sach stock and bonds are pledged or unpledged. "Other atsfta" and "Other ItaUltttee.'* — If material amotints are shewn, a comprehensive analysis of them zaust be attached. *' Profit and Jcta." — Tf the " Profit and loss " balance la a debit, the acBoimt should be Bhown In red. dividend period may be so considered if the dividend has been declared and iMt disbursed. If deducted, show date declared and date of actual payment. 6.' Exhibit B : Otjotations on Otrnitfa Bai^b P»icbs. — Furnish under Ex- hibit B the prices quoted on a recognised stock exehaage or on the New York curb, or the prices at which uutslde sales were made If the stock la not listed, for the period of 12 menths ending with the close of the taxpayer's fiscal jeor glveu in Itam 7 oa page 1 htreof. Income from securltlea of a State, not included In the Income-tax return. Expenditures made for additions and betterments, or reserves for such purposes, made against income, whether direct or through expenses. *'Ad}H9ted income."— This column will reflect the amounts resulting from the adjustment of th« amounts shown in the three preceding columns. " yumher of sTioret." — Herein should he given the total number ot shares of all classes of stock outstancUng at the close of each fiscal year. " Dirtde?tda declared." — Herein ehouM be reported the percentage of divi- dends declared on the par vclue of each class of stock outstanding each year. The amount represented by the percentages shown in this column must not be deducted from the columns "' Net Income " or "Adjusted Income," "Depreciation." — Hereunder will be reported the amount actually charged agulnst Income each year in the taxpayer's books of account for depredation. " Dfpietion." — In the ease of mines, oil and gas wells, other awtural de- [Kislts. and timber, valuittons n^ported ss the basis of depletion in computing : par. In other words, U enter- prises engaged In a similar bnalner ' - "- '" — their Issued capltai stock to keep tt should be caplmlized hj dividing it by .12. 7. Domestic Insurance companies (other than mutual companies) most attach to the return a list of such deposits and reserve funds as they are re- quired by la^ or contract to maintain or hold for the protection of or payment to or apportionment among policyholders, stating the came and amount of each such deposit or fund. 8. Domestic mutual Insurance companies must attach to the return a supple- mentary list showlog the name and amount of each rsserve. the net addlt^ooa to which are included la the nvt Income. GENERAL INSTRUCTIONS ;0, 1922. , Datb of B'iluto WwruaNB. — During the month of July and annually there- 4. Thh Collectoe Hat Make Retd falls to make and file a return withic V. tlon made under authority of I frauduleiit return, the collt -If any corporation i me prescribed by law tviltfplly or otherwise, a falsi 6. SiaHATUttEa and Vebxticatios. — Returns most be signed and Terlfled hf two officers of the corporation, that Is. by the president, vice president, or other principal officer, and by the treasurer or other financial officer, and must be The name of the corporation and the names of the officers slgnlngtbe return should be pUUnJy written or printed on the return. 7. Tax. — From tbe tot" I fair average value of tbe capital stock the sum of 55.000 is deductible and the tax is at tbe rate of $1 for each full $1,000 of any balance except In thu case ot mutual Insurance companies (see lines 16 to 20 on page 1). 8. Penalties. — la case of any failure to make and file a return or list within the time prescribed by lew. or prescribed by the Commissioner of InternsI Eev- his deputy l3 authorized 1 . uch Information as he can obtain tiirough testimony or otherwise. Such return, when subscribed by the collector or his deputy, shall be prima facie good and sufficient for all legal purposes. writing, may alio the collector la pu_. shall add to the tax 25 per filed after such time and 1' reasonable cause and not t( the tax. In case a false < Is shown that the fallore' to file it ' willful neglect, no such addition shall be made to fraudulent return or list Is willfully made, the I the tax 50 per ( of Its time after days after July 1, 1921. bat penalties for noapayment do not attach until .^^ >* notice and demand has been served by the collector upon the taxp.7yer, 9. BEocLAnoKS. — For farther InforoutloQ regarding the tax see Begutatlou No. 60. BeviseO, 1694 Form 1120 V. S iNTEBMiL RnyEND! CORPORATION INCOME AND PROFITS TAX RETURN FOR CALENDAR YEAR 1921 Or for period begun , 1920, and ended , 1921 Page 1 of Return (00 nor WRITE in THEiE SFAIXSl Eunntdbr BE FILED NOT LATER $ """'"""' THAN THE ISTH DAY OF THE THIRD MONTH PRIKT MAIW.V COWORATIONS NAME A,-, BUSINESS ADDRESS (Oahiar'f Stampt FOLLOWING THE CLOSE OF Tl«; TAXABLE PERIOD " (Stmt'iadiiumtaM') " (Pastomooud'Suu'} " " ~ CASH CHECK M.O. CEtT.OfOfO, KIND OF BUSINESS ;......::_:,.;.:;;... is this a consolidated return; . SCHEDULE A~TAXABLE NET INCOME. CROSS INCOME. , Groas Bales, leas relurnsaod allowaocos _ „ y - Leas co9t of goo^la aold, exclusive of it«ma called for eeparately below (from Schedule A2). . Orosa income from operatioDa other ibao trading or manufacturiDg, lese altowanc«8 (from Schedule A3 . Taxable iatcroston Liberty Bonda, etc. (from Schedule A-1) Tjxabie ioterest from all other sourcea iDcotae earDe from all other eources (oot including aoy amount reported in lu t 23, below) (from Schedule AlO).. ) 10.. DEDUCTIONS. . Expenaea (except amouots reported in Item 2 above, or called for separately below CumpousalioD of ofBreredn whalcvei form paid) (from Schedule A13) . R^'paira (inrludiug labor, aupplies^etc ) (from Schedule A14) Inlt-rest (sim? page 2 of InBtnicttone. paragraph 0) . Ta:^e9f(rom Schedule .\16) . Bad debta (from Schedule AK) . Exhauiilou, wear and tear (iDcluding obsoleececce) (from Schedule A1S). . , Depletion (from Schedule AID). , Amortization of war faciltliea (from Schcdul-' \ . ' Total of Items 12 to JO i21 . . Profit or loss on sales of capital awwls and iiiisccllaiieoua investmenta (from Schedule A23) „ '$ . . . I . i I Loeaea by lire, storm, etc (From Schedule A24,) (Extend ditlcrence between or sum of ItemB 23 and 24* | | | . . . I ) , NetincomeexcliieiveofdeductioDafordividendadtemZ". miLua2l. extended) „ 1^ . Dividends deductible under Section 234;a) C. of the Revenue Act of 1021, ((rum .Schedule A26) _ _ Net Income (Item 2^ ininua Item 2ti) (If return in for a period lea.^ Ihjo twelve months, aee page 1 of Instructiona. paragraph 10) . '$ SCHEDULE B— INVESTED CAPITAL. 1 Capital, surplus, aud undivided profits at begiiinint^ of taiuble period (from Schedule E, li' 2 riu9 adjualnicnu by way of additiona (from Schedule F, Item ■)) 3. TOTAI- 4. Li.>e6 adjuslmenta by way of deductions (from Schedule O, Item 7) I'liisor minus changes Total (or Remainder) Lena deduction ou account of inadmiaaibic InveateiJ capital for taxable period eated capital during taxable period (r.et Increase or Decrease from Schedule IIi ») - (from Schedule J) ; SCHEDULE C-EXCESS PROFITS CREDIT. !-ight per cent of invested capital for taxable period (Item 9 of Schedule B) ,,.„.., I^^emption ($3,000) (except for a foreign corporation or a corporation eatUfying the condition*; ]>r.„.», „T.«. et iocomf. not in excess of 20^ of tiiveated capital :::::!:::h:- 't i : 1 ; 1 1 i ■ lataDce of net income . . 1 Mr, i . 1 ' 1 otalB computed under Section 301(o) » ::-4.:....!izz] L....k 1. 1 • 's. !Arlof I'lL'l (»■<) (Item 27. Schedule A) 10 BaUorrfttgm5.lfflaItemfl6. 7,^ld9.o^ll,^nll»6.fl,and9)-■'l.■ ; 2 of lostructiona. fa adop, of 111 ume does Do 9 of S25.000.. .1 . J. An ■meiMJgJ return m uat b« plainly marked "Amended.' Checks and draft* will be accepted only if payable 1695 i"aUyoiitii*Mtn:ai « nlmA in tlu: jchwlul* itioTK of surplus a vt: rreowiled n-itl aby th(r*rT«T»:it |T»r^l7«tpliiD»J. be fTiiertd as Il#t ■•plUlilod;p»lJiipaM»cruallyoulstM SuTplos aixl Diidli-ld«d preAU: S. Feld-Ln lurplos K :"':"' « detailed) » -ADJUSTMENTS B f or ADDITIONS. 3. Schedule F. state jpoaficaUy th ..etn. .,^n,. i^-''pix'".:''itk\'"::\''!"^^^^ si Depffn..tion or dffH-iion "< nirrwl >□ the afrourt^ ot the«i'rT>«»mpm»iwii under period. shall be(^ e basis lof tbe computetioo. uHtandlDt on Maicb 3, 1017, or at tse l*einnloi. o( Uie . ISft.-iy ttnpbU roper.r.p»id.l>r«fs1ocl..M rn*d as an asset by I^< corpomiooT ...__.— BCtualcaih value wben rfceivedT — la HESr ;«;>*ir.LrM^rparti« res," submit a statement sbowlnj (o) kind of propefty, lor. «f) artual fash vb1.» of the property wben pauHo. ris or Inthc property whicb chanjed ownerslilp r« property was acquired from a corporailoa duriac tbe taxable penoi, propertf to tbe n>rporat.on laakuic tbe return, and also a balance t this retoni thowUie tbe values at srblcb neb property rvcelved invested capital cacti aoet a I iwan^ible pfoparty) p«i^ f pfoperiy pa;d t (tel or by IMI«tieolrapiialstock for taaflMeoe other asset* (fi) By paynkpnt of wvscuMnt^ by itvclrhoMen or by ereaiua of pah. la iorplDs by r (f ) Hy 1i<)>itilallon of part of Ihe capitMl by retirement ol stork or by |wrcha>e of irvsmry r (tf) l)y painsrnl otcash dividends out oreantlsci ofprtuf yean. as an addiOoo or deOortioa. dcducirati bone ' corporatloD is reacquired but not paid Igr o< . appbeable only to the issi:* or rcacTuistilon S. The net chstDFes not r*[>oned in MhediiL « petlud (incliidlse tl . Adjusted ar«a$e SCHEDULE J.-INAOMISS1BLC ASSETS. iaadmisnb:« assess (i. a . sioc^^i. bonds, ortd Miier obtliailons. uoept oMlcatuca nsent showlot lor Ibe taxable period ibc facts called Icr in Itei&s [•) to Ola""* eseu consists lo part «( jaic or profit Trom tbe sale or other disrwtion tbvreof. or red [ram such asset s it tn ellKi locluded m the l>et li>eoDM because ot l^• limltaiiOQ e purpose ol this scbedul ,1 be raloed at e«st of •c<;aUition. eicept 11 «t as at Ibe end ol the period correspoo'lioctv ilchaseabas taien pUce in Ihe amount oi 5 o the Refutatioos issued under authority c 1696 KIND OP BUSINE3S. Item pivfn i-ilow, i.l.nllfv thn rnrpnn QUESTIONS. N. If till uf the product. D. — Consiructjon — exca\ , alw e^juipptng and inBtilUng same with lanuiacturc, Stalo niiture c , buildingf Idml and eperial ; or water); clcrtric telephone. (elevators, ■warehouses, atoclaarda. etc) tation or utilities. State kind of projuvt duced bv the tndincj ronrcni. State mac mis^nn, and product handled. Sak-3 with Scrnce — domestic, including hotels, personal. technical eervice. State leurance. I. — Concerna cf several of them with no predominant l> built, matcrialfl El.— Tr.-r.<-:Arr>M"i"rii1 water, local, etc. State the i.J. I'u'i lie iilititiea — gas (natural, coal, I hrnting (eteam or hot water); ,' ;': I.' trading or profit from ealea— ■r :, t ?ii.red. El.— Leasing transpor- t". — I rn'iint; in goods bought and not pro- of trade, whether wholesale, retail, or com- rade with profit primarilv from sales. O. — mffl. etc- amiipements; other professional, rrM'e. H.— Finance, including bankinK, .■ !■! -' '■ .■ I lr^-3 (ol because of combining ■ns Wh: 18, where the same prodnrt n ( of the abo\e general clasin i : 111 two or more of the above I ■■■ '■,!'! n-port bueineaa as identified u.,.!' , <.i.'ncerna in A or B -which also product exctugively ur mainly, should still be identified , C {manufacturing) whirh own or control their source of in A or B and which alao transport, ecll. or install their own jiroduct ainly, should be identified with manufacturing; ' " exclusively _- ,, _, __ „, control or own source of supply of materials used excluaivelv or mainly i tive work; concerns in El or E2 may own or control the eouroe of their materhil or power; toncems io F may transport or store their own merchandiee, but ita production would idoutify them v,-ith A, B, or G. 3. Answers: (rt) Central claBs (use kev letter designation) „ '■ Main income-producing business 'give specificallv the information cillcd for uuder each key lctt*?r, also whether acting as principal, n; state if inactive or in liquidation!..., OTHER CORPORATIONS IN SAME BUSINESS. 8 oi fwe representative corpora- INCORPORATION 5. Date of incorporation .... _ _ C, Under llic biTs of what State crtcjntr REORGANIZATION AND ACQUISITION OF MIXED AGGRrCATES OF ASSETS 7. Haa the corporation, or anycfila pre<}eecstors,hcon reorcani/t'd, or has it. or any of its pTcd'.ceisora . taken over a, going business or acquired a mixed agf regat* of tangible and intangible property, and paid for such property m whole orin part with stock or other If E eibcwiEc;: {a\ The name of the concern taken over for from which the property was acqu: ft) The nature of the aiiscts and li-ibililies en acquired; (c) The total par v.-ilue of the slock issued there/or; (d) The value at which each cla?a of assets was carried on the books of the i from which Required (submit a balauce ehect of the predecessor concern as at the date of ecquifition c id full details of any adjustments subsequently made pertaining thereto and thisretij . the bieiti on which such revaluation was made. 9. If patents, copyrights, secret processes or formula, good will, trade-marks, trade hrande, franchises, or other intangible property were acquired, state the baaia on which their value was determined and how they were paid for. I of anypurchaM or reorganization as contemplated in queption 7, any ;ni or any vendee preliu ol tba pro|>ertT a5S*w«l 1 i ' 1 [i) InUirfM on obl«^» ^ SUM. 1 crrilofiii, and piiiu^ nib-' ~ i "" 1 tDMret oo Finn Lain B l»ued ucdtr Fcduil Fum Uwi 1 1 (i) Dlrldend. dM.irt.bt. unkr 5^rii„n' ;iir«V8'il'VhV'iu;ro.i; j (I^ R»p1«Mti»DU *nd PM»»6ls „, 1 . .L... )~~ (O Dii-]t^K«T»rora)l>tlspRlClM,M■^4loMdMO•d): [ 1 1 !___ _l (fl) .„ I .3>... ' 1 ' " m 1 1 — (;> OtheriiiuIhnnbladcdtictloitiCiotediUiM): J ' 1 ' ' 1 ' ~ 1 m .„.„ „ 1 1 1 1 IS. DI*ldad3iniddiuju;tto'bknblVpenad7siMirirtMi^ Mock or IhU MfopMy. or other property): s .. I .. 1 ... 1.^...: e Sorpraj Md ondlvided proBu as Lbawa bj bttaan ibi»i at ctoM ol precedlo; Im»Mo perlwj ^ 1 1 1 r " (i)Dw«pud Cbvacter 1 - 1 1 """" H. Ottardob.uiosarp.a,(«b.d««IW,. 1 10 ToUl of Items * too IqcIosIts S 1 1 1 1 ~ 12. Soiplm and ondlvldVd'prii'u M'VbiWi'iy "wMM's'toirird^'if' t-Mbte period (Item l6 talnas It«a 11) 1 (0 - ._ ... 1 ... " i "~ »_J 1 1 !, SCHEDULES TO BE FURNISHED IN SUPPORT OF ITEMS IN SCHEDULE A. The followipg acbedulea mmt be fumiabed. and thoae prepared on separate eheets should be firmly atucbed to this return. Enter name and addres of corporation on ea#.h sheet (J)C Ti.'iio.TrtMSi'iE^nf' »n . tno minor itams bvlDg groopad Id on* nir fy-r «5inTn.tor7MMidofy«r [ OPERATIOIfS OTHKR THAR <: TAXABLE IHTERBST OR LIBBSTT BONDS. ETC inlwwl oo ihe obtl^Uiocu liiWd In cohimn I ot tbe (oltoiriBf! tabl* is wbri>TW«Dpt kM ibe oMlcBtkHU held exceed tbcsa exempiiocs, the prineipal unoun le uubie period, Bttach » stataoMat showing tb« boldinn ^7 periods. 3 ii » consoUdUM Tvtora, oeb carporstion composms the AfllLued erouj •CcnCM* pottdp*! kKHn 1. ObIi|Ktioas. ExempUou. (Affrepta Principal AmoimO. In excess or eirmp- tlons spodfl«l In oolumna2.3.aBd4. principal amt 3. $30,000 3.tl25^ 4.»S,000 i^pS^ w ^^^^t^^'^'^^- <» F.ratand^wnd* j,«id Flrt. 8««nd. Tblrd, and Fourth September 1, 1917 (except Vic- tory Md TTeasury Now*) (J>VWory Uberty Uma ♦!% .Now Koire t SOCBCBS (Bol iDdndtac i lums »eiDg gnniped !□ 000 DCOOUQt- Tboloul of tbescbelule should b«« SCSBDULE AI2: EXPENSES (except aommtt caned tor aeptntely In balsg eronped Id oos i i; COMPEKSATJON OP OFnCSRS. SCHEDULE AM: REPAIRS (bdndfaic labor, aappllea. onthead, an< repair* ). be taxable ptfiod, and (t> la properly charteabla le i.parsera^S.) SCHBDULEAl : TAXES. e^auSmmi SS SCHKDtlLEAl : BAD oral k«>*4SUtf„ S!.%:^s' Kit: EXdAtrSnOS. WEAR ARD TEAR (Isdndtsc I eorrespood whh the figorei reflecud In'tlM ), psracnfA 10, and Seclloi Z Kind of propmr (KboUdlfljs.sm. D.>. Al. K?i* Con. or If ABwaat 01 «tepT«(±Mtjo ctar^ oi •"='"">""-" "T^ «,oM r,.^,^. 1 . . _... , 1 1 1 T~...- 1 •• t._ ..1 tioDDacosuy tobrlaKFDurdcfiiattooscbedijIaupK abia period bu bees deCwmUwd. lacueofilmbeT thissfaoald be done b? Siilnf la Fc^T (Usbcr). : AMORTIZATION OP WAR PACILmES. ictioaLselaicMdoDofcouQtofaDiortUitkui. aschadoleshouldbe submitted eootaisini Ike prtsented. A Copy of this form mar be obtained rrom the Commtdcoer. (See Section ni ue Act or 1921). OPIT OS LOSS ON SALES OP CAPITAL ASSETS AND MI5CBLLA1ISOUS >f property, resaltlnc In a profit or loo. a sebadLilela the loflovtiM: tora man be to> i>_-. . . '"^sacaootaos, 23*(o) t3ndSt{a)l4af thaRereaueActoltSL) 1 Ul taxable period as stated, pursuaatto the Revenue Act of 1921 and the R^nlataons iwoed usdor authority thereof . Sworn to and subscribed befoie me this ,,. day of . , 1922. 1698 Pago r of Instructions* INSTRUCTIONS FOR CORPORATION RETURN. LIABILITY FOR RLING RETURNS. !. Corporations generally.— Every domeatic or rosidont corporation, joint-stock coinpanv, association, or insurance company not specifically exempted by Section 231 of the Revenue Act of 1921, whether or not having any net income, must file a return. 2. A corporation, huving a net income of less than $3,000 for the taxable period need not fill m the schedules pertaining to excess prufits tax, but if the net income is $3,000 or more, it is subject to the exci-ss profits tax and must file a complete return on this form. 3. Goveroment Contracts. — In addition thereto, if net income ui excess of $10,0tXJ was derived duruig the taxable period from a Govern- ment contract. Form 1 120S should be secured from the Collector of Inter- nal Revenue fur your district and filed as a part of this return. 4. Corporations in Possessions of the United States. — Domestic corporations withm the possessions of the United States (except the Virgin Islands) may report as gross income only gross income from sources within the Cnited States, provided, (a) 80 per cent or more of the total gross income for the three-year period immediately preceding liie close of the taxable year (or such part thereof as may bo applicable) wiis derived from sources witlun a possession of the United States; and (6) 50 per cent or more of the total cross income for such thrco-ycar period or applicable part thereof was derived from tho active conduct of a trade or business within a possession of the United States. However, a corporation entitled to tho above benefits is not entitled to the specific exemption of 53,000 in computing the excess profits tax. (See Sections 262 and 312, Revenue Act of 1921.) 5. Foreign Corporations. — A foreign corporation subject to tho law, regardless of the amount of its net income, is required to file a return with the Collector in whose district is located it? principal office or agency through which is transacted the business in the United States. If it has no otfice or agency in the United States, the return should be filed with the Collector of Internal Revenue, Baltimore, Maryland. The net income should be computed in accordance with Section 217 of the Revenue Act of 1921. 6. Personal Service Corporations. — Personal service cori)orations must fiJe a return on Form 1065. CONSOLIDATED RETURNS. 7. The parent or principal reporting compan}' of afiiliated corpora- tions as defined in Section 240 of the Act must file a consolidated return on this form with the collector of the district in which its principal office is located and attach thereto a schedule showing the names and addresses of all affiliated corporations in the group, and if tho tax is apportioned among these corporations, tho amount allocated to each. (See partigraph 9, below.) Each of the other aSiliated corporations shall file Form 1122 in the office of the Collector of its district. Consolidated invested capital p3ust be computrd as at the beginning of the taxable period of the parent or principal reporting company and consolidated income must be computed on the basis of its taxable period. AJl supplementary and supporting scbedulea should bo prepared in columnar form, one column being provided for each corj)oration mcluded in the consolidation, one column lor a total of like items before adjust- ments are made, one column for intercompany eliminations and adjust- ments, and one column for a total of like items after giving effect to the eliminations and adiustmenta. The items included in the column for eliminations and adjustments should be symbolized so ae to readily identify contra items affected, and if necessary, in order to aive a correct understanding of these entries, suitable explanations should oe appended. 8. If one domestic corporation owns 95 per CMit or more of the outstanding votuig stock of another, or if 95 per cent or more of the outstanding voting stock of two or more domestic corporations is owned by the same individual or individuals, partnership or partnerships, in substantially the same proportion, a consolidated return must be filed by such corporations, except that the purpose of the statute being to prevent tho avoidance or reduction of tax habUity, corporations engaged m entirely distinct and unrelated lines of business, there being no common dealings between them giving rise to opportunity to avoid or reduce tax habUity, shall not be required to file a consolidated return. If the ownership is loss than 95 per cent of the outstanding voting stock, but exceeds 70 per cent, the parent or principal corporation of any group of affiliated corporations must furnish the information called for in ques- tions II to 14, page 3. 9. The Department prefers that the entire tax shown on a consoli- dated return be paid by the parent or principal reporting corporation, instead of being apportioned among the corporations composing the affiliated group. If apportionment is made, each subsidiary should state on its Form 1122 the amount of to be assessed against it for the taxable period affifiated corporation and profits taxee PERIOD COVERED. ^ fiscal period ended 10. The taxable period is the calendar year or th in such calendar year, and the net income shall be basit: of the corporation's onnual accounting period (calendar year or fiscal period) in accordance with tho method or keeping the books, unless such method does not clearly reflect the income. The accounting period establbuhed for the taxaVde year immediately preceding miLst bo adhered 'to unless p,enni3aion has been received from tue C-ommissioner to make a change. In the case of a return for a period of less than one year, the not income shall be placed on an annual basis by multiplying the amount thereof by twelve and dividing by tho number of months includi'd i period; and tho tax shall bo such part of a tax computed on such i basis as the number of months in such period is of twelve niorillis. If th. fractions of months as many thirtieths of parts of months. period for which the first or final return is i ths, there shall bo added to tho numbe mpb-i. there are days in the fractional 11. If 1 changes it^ accounting period, it shall a: !oUector for transmission to tne Commis corporatic as possible give to the Collector for transmission to the Commissioner written notice of such change and of its reasons therefor. Upon approval by the Commissioner, the corporation shall thereafter make its returns upon the basis of tho new accounting peri ' " ^ •- - - n.n*-N 226, Revenue Act of 1921. See Sections 212ff) i the United States shall , trustees in bankruptcy, or usiness of the corporation, such ute the return for such corpora- • pay it in person except at I TIME AND PLACE FOR FILING. 12. The return must bo sent to the Collector of Iiilornal Revenue for the district in which the corporation's prijicipal office is located, so a:i to reach the Collector's office on or before tno fifteenth day of the third month following the close of the taxable period. In the case of a foreign cor- poration not having any office or place of business in the United States the return shall be filed on or before tho fifteenth day of tho sixth month following the close of the taxable period. 13. The Collector is authorized to grant an extension of not more than thirty days for filing returns in cases of absence or sickness. In meritorious cases the Commissioner is authorized to grant a further ex- tension. SIGNATURES AND VERIFICATION. 14. The return shall be sworn to by the president, vice president, or other principal officer and by the treasurer or assistant treasurer. The return of a foreign corporation having an agent be sworn to by such agent. If re assignees are operating the property receivers, trustees, or assignees shall tioQ, under oath. PAYMENT OF TAXES. 15. The tax should be paid by sending or a check or money order drawn to the order c Revenue at (insert name of city and State)." 16. Do not send cash through the mail t the office of the Collector. 17. The total tax may be paid at the tijnc of filing the return or in four equal installmf^nts, as follows: The first installment shall be paid at the time fixed by law for fifing the return, the second installment shall be paid on the fifteenth day of the thL-d month, the third installment on the fifteenth day of the sixth month, and the fourth installment on the fifteenth day of the ninth month after the tijue fixed by law for filing the return. PENALTIES. For Making False or Fraudulent Return. 18. Not exceeding $10,000 or not exceeding one year's imprisonment, or both, in the discretion of the court, and, in addition, 50 per centum of the total tax evaded. For Failing to Make Return on Time. 19. Not more than $1,000, and, in addition, 25 per centum of the total amount of the tax. For Falling to Pay Tax When Due or Underetatement of Tax, Through Negligence, Etc. 20. Five per centum of the tax due but unpaid plus interest at the rate of 1 per centum per month during the period m v.hich it remains unpaid. WORKING PAPERS. 21. Every corporation should preserve, available for inspection by a revenue officer, working papers- showing — (a) Tlie balance in each account on the corporation's books that was used in preparing Schedule A. (ft) The amount deducted from each such balance on account of each class of nontaxable income, unallowable deductions, and other adjustments indicated in Schedule L, with a reference to the number of the item in Schedule L in which each amount so deducted was included. (c) The remainder of each such balance, analyzed to show the amount included in each item of Schedule A, with a reference to the number of the item in Schedule A in which each such amount was included INFORMATION AT THE SOURCE. 22. Every corporation making paj-ments of salaries, wages, interest, rent, commissions, or other flexed or determinable income of $1,000 or more during the calendar year, to any individual or partnership, is re- quired to make a true and accurate return to the Comniisaioncr of Internal Revenue, showing tlie nature of such payments and the name and addieaa of the recipient. Forms 1096 and 1009, for reporting such information, will be furnished by any coficctor of internal revenue. Such' returns of information covering the calendar year 1921 must be forwarded to the Commissioner of Internal Revenue,' Sorting Section, Washington, D. C, in time to be received not later than March 15, 1922. s-iocri 1699 F&«r« 3 of ln9trucUoD9. INSTRUCTIONS REGARDING INCOME, CREDITS, COMPUTATION OF TAX, ETC. CROSS INCOME AND DEDUCTIONS. 1 Rulrotd corpiiratji.r'. bank'. in-njrancecoaipaDies, and other corponiliooo reqoifed to submit ftateiBAitd cf lOC'itnc and expeo»e9 to any DAtiooiI, Statjj, muaicipaJ, or other pubbc ofhc<^r ouy aubmit iostead o( Schedule A s at^ktement of Income aod ezpeoBW in tfa« (prro tb which aubirutud to such officer- In such cases the lAiable net income wUI h* rernncil^ by meuis of Schedule L ^itb tbe net profit shown by the income and expense statement submitted, uid should be entered as Item 27, Schedule A. p^e 1. 2 A life insurance company iiffuiog life iRsuraoce &od luiouity contracts (indudiog contrwrla ol combined life, beatlh, ftod accident intiuraDCel, aa defined by Section 242 of the Revenue Act of 1921. shall file its tax return on Form 1120L, instead of Form 1120. 3. A n insurance company (other than a company taxed under Section 2-13 of the Act) isniingpoliaea covering life, health, and accident insurance combined in one poLiCy issued on ihe weekly premium payment plan, continuing for life, and not subject tocaocellatioa, sball file Its return on this form, and report aa a deduction in Schedule A12 subject to the approval of the Commiaeioner. such portion of tbe net addition (not req'iiied by law) made ^rithin tbe taxable period to reaerve hinds as may be required for the protection of the holders ol such polidee only. 4. An inrurancc company (othe> than a life insurance company) should report as a deduction in Schedule A12 of this form, (a) the net addition required by law to be made Tnthin the taxable period to reserve funds (including in the caK of an assessment iosur- an'-e company the actual deposit of eame witli Slate or Territorial officers pursuant to law as additions to guarantee or rese^^'e funds), and lb) the sums other than dividends paid srithin the taxable penod on policy and annuity coi.lracte. b A mutual marine insiuance company should report as Item 3, Schedule A, of this torm. the groM premiums collected and received, lose amounts paid for reineuraoce, and report as a deduction jn Schedule A12 amounts repaid to poU'-yholders on account of premiums preWoualy paid by them and interest paid upon such amounts between aacer- tainment and the payment thereof. 6 Tbe receipts of a shipowners' mutual protection and indemnity association, not organized for profit, and no part of tbe net earnings of which inures to the benefit of any pnvate stockholder or member, are exempt from taxation, but such aasociation shall be subject as a corporation to the tax upon ils net income from interest, dividends, and renls- 7. A mutual insurance company (including interir.surance and reciprocal nnder- wriiers, but not including a mutual life or mutual marine insurance company) requiring its members to make premium depoeils to pTo\'idc for losses and expenses, should report in Schedule A12 of this form, the amount of premium deposits returned to its poUc>'bolderB and the amount of premium deposits retained for the payment of looses, expenses, and reinsurance reserves (unless otherwise allowed in Schcductibleon account of depreciation in Item 18, Schedule A. isan amount rhirije'i off which fairly measures the loss during tbe year in the value of physical property by reason of exhaustion, wear, tear, and obsolescence. Such an amount should be determined upon the basis of the cost of the property or, if acquired prior to March 1, 1913, the fair market value on that date and the probable number of yi'ars remaining of lis useful life. The capital sum to be replaced should be charged off over the probable life of tbe property either in equal annual inatallmonts or in accordance with any other recogniiMi trade practice, such as an apportionment ol the capital sum over units of production. VrTiaievor plan or method is adopted must be reasonable and should be described in the return. Stocks, bonds, and like securities arc not subject to exhaustion, wear and tear within the meaning of tbe taw. 11. If property is compulsoniy or involuntarily converted into cash or iu equivalent at> a result of (a) its dcstnictioa in whole or in part, (6) theft or seizure, or (c> an exercise cf the power of requisition or condemnation, or the threat or imminence thereof; and if the taxpayer proceeds forthwith in good faith, tinder regulations prescribed by the Commis- sioner with the approval of the Secretarj-, to expend the proceeds of such conversion in the acquisition of other property of a character amilor or related in service or use to the properly 80 converted, or in the acquisition of go per centum or more of the stock or ebares of a corporation owning such other property, or ia the establishment of a replacement fund. then there shall be allowed aa a deduction such portion of the gain derived as the poriion of the proceeds so expended bears to the entire proceeds. The gross r«ceipts and deduc- tions claimed should be included in Schedule A23, cS*-e Section 234(o) H of the Revenue Act of 1921 ) 12, If a iredit is claimed in Item 1-1, Schedule D, a copy of Form 1118, completely filled out and sworn l> or affirmed, must be submitted with tbis return. If credit is sought luT taxes already paid, thv i. •i.j m^^t h,ive attached to it tbe receipt for each such tax pa\TQcnl, If credit j? - ::^,icd, the form must have attached to it the return on which e^f 1- - - t ised. . 13. Wlica a cred/ 1 '-ixes. the Commissooer nuy. as a condition precedent to tbe allo^' . ■ r, quire the corporation to .give a bond (Form 1119J. with suretii-a sviL-ff,-.. : ry i.^ jr.d to be approved by him in such penal sum as he may require, conditioned for tbe paym-int by the taxpayer o( any amount of taxes found due if the tnxcs when faid differ from tbe amount claimed in respect tberool. PROVISIONS AFFECTING COMPUTATION OF TAX. V (a) Return for ■ fiscel yea/.— If return La for a fiscal year ended io 1921, the tAz ahcold be computed in accordance with S-ectioaa 205, 236rc). and 33&(a)Q( the Reveuue Act of 192L (b) LimiutioQ on iacoms tax.— If the net income reported as Item 5. Schedule D, is more than $25,000 the Ux of 10 per centum imposed by Section 230 of the Act on the amount of tbe net income sha:i not exceed the tax which would be payable if ibc 32,00iJ credit were allowed, plus the amount of the not income in exces of J2^.O00. (c) limjttbons oa excess praflts tax. — The maximuoa excess profits tax iiDpose of the Act ) (/) Tax on profits from sale of mineral deposits.— In tbe case of a bona Gde sale of mines, oil or gas wells, or any interest therein, where the principal value of the pr^iperty has been demonstrated by prospecting or exploration and discovery work done by the taxpayer, the portion of the excess profits tax attributable to such sale shall not exceed 20 per cent of the selling price, of such property or interest. (See Section 337 of the .\ci-) The fim step is to find the excess profits Ux computed without regard to this provision ; the ee<:ood is to find of the tax thus computed such portion as the net income from the sale bears to the total net income. If this portion equals or does not exceed 20 per cent of tbe selling price, then no adjustment is permitted. Should such portion exceed 20 per cent of the selling price, the tax will be that portion of the excess profits tax which the oet income not attributable to the sale bears to tbe total net income plus 20 per cent of the selling price of tbe mineral deposits. 15. Statement of basis of claims. — If a corporation claims the benefit of any of tbe provisions outlined in (d"), (f), or (/), it should attach to the retunj a complete statement of the basis for such claim and a computation of the tax payable in the event that such claim is allowed. The smouDt cf tax so computed should be entered in Schedule D. SPECIAL CASES. 16- DefinitiDO of special caaes.— Section 327 of the Act provides that in the following caaes tbe tax shall be determined as provided in Section 328: (a) Where the Commissioner is unable to determine tbe invested ca^^tal as provided io Section :;2fl. (b) In tbe case of a foreign corporation or a corporation entitled to the benefits of Section 262 of the Revenue Act of 1921. See paragraph 4, page 1 o( Instructions. (c) Where a mixed a^^ate of tangible property and intangible property has been paid in for stock or for stock and bonds and the Commissiooer is unable sctisfactonly to determine the respective values of tbe several classes of property at tbe time of piymeot, or to distinguish the claaes of property paid in for stock aod for bonds, respectively, {d) Where, upon application by the corporation, the Commissioner finds and declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions aflectiog the capital or income of the corpontioo. work upon tbe corporation an exceptional hardibip evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the represeotative corporations specified in Section 323, Thissubdi^-ision shall notapply toany case: (I) In which tbe tax (computed without benefit of this section) is high merely because the corpo- ration earned within the taxable period a high rate of profit upon a normal invested capital, nor (2) in which 50 per centum or more of the gross income of tbe corporation for tbe tjx.'vble period (computed under Section 233 of the .\ct) consisted of gains, profits, commiseior.s, or other income derived on a cost-plus bai^is from a Government contract or contracts Qude between April 6. 1917. aod November 11, 191S. both dates inclusive. 17. Trcatmeot of special cases.— In the cases specified in Section 327 the tax will be specially determined under tbe provisions of Section 328, A corporation which ct.mes within tbe pri.vi^ions of sub a statement showing tbe amount ct gains, profits, commissions, or other income derived oo a cost-plus basis from Govemmeot contracts made bt-tween April 5. 1917. and November 12, 1918, both dates inclusive, and showing the per cent which such income is of the total income of the corporation. IS Returns id special cases. — Corporations other than foreign corporatioos mabiiK claim for assessment under Section 3?S of the Act shovU answer alt questions and file all schedules as far os possible and attach a 0tateme.1t exp.ainu)g wby il is impracticable to 611 out tbL' eniijo return UNDISTRIBUTED PROFITS TAXABLE TO STOCKHOLDERS. 19 II any corporation, however created or organiied. is formed or a-ailed ol lor the purpose of preventing the imposition of the surtax upon itsslockhidders or members thfOUgh the medium ol permitung gains and profits to accumulate instead of being divided or distributed, liiere shall be levied, collected aod paid for each Uxable >ear upon the net income of ^uch corponlioD a tax equal totweoty-fi'. epcrceol(25'^ ) of the amount thereof. which shall be io addition to tbe Ux imposed by Section 230. Revenue Act of 1921, aod shall be computed, collected and paid upon the same basis and 10 the same manner and subject to the eame proviaons of law, including penalties, as that tax, (See Section 220, Revenue Act of 1921 f a-iam 1700 Form 1041 n, S. IKTEHXAI, Revinue FIDUCIARY RETURN OF FOR CALENDAR YEAR 1921 Or for period begun 1920, and ended. — INCOME „ , 1921 Do not write in thn space Eutoined b, BE FILED NOT LATER Dat« r*c«iv»d THAN THE ISTH DAY OF THE THIRD MONTH PRINT NAMES AND ADDRESSES PLAINLV FOLLOWING THE CLOSE N.maand address of OF THE ACCOUNTING Name of AFFIDAVIT r (or ftSrm) that this return, including the accompuyiDgBchedulea aod a and Bub»cribed before me tbia. 1. Was a 2. Ifflo. eturo oC income for 1920 filed on bcbajf of the cstalc or trust named above? ) whai coUector'a office wng it Boot (^vc diatrict or cily and State)? 3. Give dale of creation of I r decedent's death.. ™, INCOME * 1. Interest on Bank Oepoeits, Notes, Mortgages, and Corporation Bonds 2. Income from Partnershipe, Fiduciaries, rtc. (State name and addreas of partnerships, etc.) 3. Rents and Royaltie e from piirtnerships).. 4. Profit (or loes) from Business or Profession (not iucludiog ii 5. Profit (or loss) from Sale of Real Estate - G. Profit (orloas) from Sale of Stocks, Bonds, elc — ~ 7. Dividends on Stock of Domestic rorporations..- - - 8. Other Income (iocludiag dividends received on stock of foreign corporations). (State c («). 9. Total Incoue is Item 10. Interest Paid (not including i] U. Taxes Paid (not inclading tax 12. Loeoefl by Fire, Storm, etc^- 13. Contributions ^ — _. ( Do DoC Includa vij loWiwt oo UberT; Boads, i ? 8 0^^ losses shown therein,, if any) ... DEDUCTIONS . deducted above) — , 14. Bad Debts (not including bad debts deducted above) . 15. Other Deductions Autboriwd by Law....™ 16. Total or Items 10 to 15 — 17. Net Incoue qtem 9 minus Item 16) BENEFICIARIES* SHARES OF INCOME AND CREDITS 18. Eolct below the ihate ol Oct income (»hclher diatribuled or not) buia try ol the c other than J prof apcrc u taxcB paid by the erti ffOtaRO basis, attach an cs 1 obligations planatory Bta jt the UDi k foreign c uolry tcs): eacti benou 01 to a pomeuion oi the ■ '" (DalfUU ooi.raia.oi Ma. | ii^si. „;.r=,. (MeHlTMlirvslTtMT). o'/t: "k^ S rouuaioit or J * '"' -" "' ~ ■ 1 '" " "■■ <'" - . <'> - (/) - — (J) - * (») .. (J) ~ '•- -" rporatioQ on tax-free covenant boodd, and the locouie and profits taxee paid by the estate or trust B determiDed on a basis other than a percentage basis, attach a 1 N^».»m.^»D«u_OTjE.CB^Il.mi.c...r Ml .i,sr:i^.,. ,„V.7,-SJ?Sf.".S,. -'-'BS'-- Taxes Paid to a Foreign ^, ' 1 1 ../ 1 1 1 1 1 1 .1 1 «) TOIAU _ -....1 • $ ( 1703 SCHEDULE A.-EXPLANATION OF ITEM 3. ( RcntH and Royalt «..) 6 to Inauurtloo ■ K™.»r.o-«„. 'Fmi'vUtr" R^^u"'? i^'o'irS" EtrtKSt*. 7. Net nown (0> U>S9). J t— :::;:: _ ._ .' Sute fstimatPcl life of property ftod bow you figured depreciatio SCHEDULE B.— EXPLANATION OF ITEM 4. (BmineM or Profai 1. Total iucome Irom busineBe (state kind of biuioesa) .. Cost of Goods Sold 2. Labor [»™ 3- 1l]atenalandsuppU€ 4. Mprrhandise bought for sale - 5. Other costs (lisL principal items and bi'low or on separate ebeet) 6. PluB iDveot43ry at beginning of year . 7. Total 8. Lee« inventory at cod of year 9 Net Cost op Goods Sold Other Business Deductions: | 10. Salaries and wages not reported as "Labor" on liae2 - - '$.„ 11. Rent on buainesa property in which esUie or I trust hae do equity ..,. 12. Interest on business indebtedness to others ... ' . LI. Taxes on busioeas and business property 14 Repaint, wear and tear, obsolescense, deple- I tiori, and property losses (explain below) 1.-. 18- Total (Items 10 to 17. inclusive) - X- 19, Net Cost pll-s Total DEOticTiONa (Item 9 plus 20. Net Proht (or Loss) troh Bubiwess (Item 1 Item 18) ttiinus Item 19)- Explanation ol deductions .. SCHEDULE C.-EXPLA^ATION OF ITEM S. Sale of Real Estate.) B«» Iwtrwtion I. ,.k™.,P«„„,. ,.!>.„ a«™«. ,.*-o™,B«.n,.o 4. Cost. 1 * ""^ '• '"^' 1 f Swotoowt 1 . DcraKJ.tioir j ''(**"i^'" 1 , .. , J..;..... 1 1 1 1 f 1 1 "■■■ , 1 1 1 ::]::::i:: 1 1 1 1 ! Ill 1 ! 1 1 1 IlZITJIIZ If not acquired by purchase, state how acquired - SCHEDULE D.-EXPLANATION OF ITEM 6. (Sale of Stocks. Bond*, etc) 8m tartmcttoo is. 1. KiKD or moPSRTT. aU1.?». a. com. 1 *•■ M'oa' 1. «". 1 5.Aiioin«T (oaLos; 1. 1, 1 1 1 ! 1 I...... If not acquired by purchase, stale how acquired .. SCHEDULE E-EXPLANATION OF ITEM 12. (LoMe. by Fir., Slorm. etc.) S»li»ini«i«i3j. >, n™. o. >..o,..-r. ^ f°,s ";.?„■?" I r.'.>?o";Lf r;.°j» .S.L,..r.v.„. V ,:»nu„.. S. NETL038. . 1 1 1 1 1 1 1 i SCHEDULE P.— EXPLANATION OF DEDUCTIONS CLAIMED IN ITEMS 13, 14, AND 15. An amended return mu«t be plainly marked "Amended" acrou the face of the t 1704 INSTRUCTIONS FOR FIDUCIARY RETURN I. RETURNS BY FIDUCIARIES. Ruiinu on Form ;w/ /or uMu ,nd (nuu.-EvBiy liduci.ry. o, one in tu, ol iou>t »M «1 000 or ova or (6) .oy beneficry ol mch e««to or tnul i, . oonrmideot lOieo 61.1 »,"lZ,°n, ^rr,'""-^" ?T ""^ '^'' -I"""' "I (" ' «t.t« ot decedent, belor. ^r."',!!^ r,'T°' '°.''""'' " '"™"' "'■''• "' "■'"■ "■"'" 'bo term. 01 U,.^" Sr^l ,^. „^°' ^'T "'If^'""'''". >« "^ed to the fiducmry a. . .mgle pe,„n, except th.t&omtheinc»meol.de«e^of.o.t.tethe«m.yfi,«bededucted.nvunountp.T,periy ^ JorT . ? ' ^"'^"^"y- 1° -uch a*, the fiduciary .hould make . return loMh, «Uteorlru.tonFomm0orl040A. (Se.Se«ion.200.219, Md225olthe Revenue Aclol ^Jji'^ °,l ^T "^^" I^M-^.-t. return on Fora, 10« or IWOA ri,ould be r«,dc«d by the fiducu^ u, the c.., ol (o) income di.tnbut.ble te . nonreddent .Uen regudJee. ol .mount. (I,) u ordiimry guudijuahip ol . minor (unlem .uch minor hun»U r!" ".' j'.'"^*'.^ °'°™"'«<' •<>' " ii'«»ne person, if the net income for the t«t.blo ymr amounted to K.OOO or over, a m.rned .nd U>-in8 w.th hu.b.nd or wife on the l„t d/y of the l...bJe ye.r. er tl the net income lor the t.x.ble yew nmom>ted to Jl.OOO or over il not m.mi.d or not living with hujbuid or wile on the iMt d«y dl the t»x.ble ye»r or il in ^^''„,"°°^ ,!,fT"°T° "" •*•** "' ""'■ ■" "■ «""' "' ' »'»" l-^l «'ll<^ men . .nd (rf) il pm ol the income of . truat eet.te i, dwtnbuted to beneliciane. uid pm ," >, ,7. '° ^°'" °' "" '^ """^ "'"'" "■" «° decedent from the beginning of the Ux.ble yeiw to the d.te ol hi, de.lh w.. tl.OOO. il unmixed, or S2,000. if mmed nnd Uving Mh Imitond or wile, or U in either cue the groes income was $5,000 or over the executor or luimini.tr.tor ehaU m.ke . return on Form 1040 or IWOA lor »jch decedent R,lu™/„r ,„, n^^^.-If „o „ „„„ ,^„ ,t, i„^„„ ^, ^^^^^^ ^^ ^^^^^^ ^ benefia.ne«. were crested by the same person .nd »re in ch.rge ol the o.me tnulee the iruaee »h.ll m.ke . .ingle return on Form 1041 lor .11 ,uch tr™,., notwithst.nding'tli.1 hey m.y .„.e Irom different in«rumenl.. II, however, . tm«ee hold. tn«l. c«t«i by different pcraons for the benefit ol the.mme beneficiuy, he gh.U m.ke • return on Form iCMI lor Mch trujt wpar.tely 2. PERIOD TO BE COVERED BY RETURN. In general, the regulation, governing the prepwation ol return, by fiduciarie* .re the same a. those governing individuals. The return must be filed lor the calendar year ending December 31, 1921 or lor the liK.1 year ending on the lust day ol any month other than December. The d.l<. on which the penod covered by the return begir« and end., U other than a calendar year muM be plainly stated at the head ol the return. A fiduciary wa« required to file the 1918 return for an estate or Iru.l on the bam. ol It. annual accounting period. The period for which the return for 1918 wa. filed mutt be ^Zlt '"-h" ■"'"*''"''°' ***"' '"^"' P'™""""" "" 'eceived Irom the &)mmi»ioner 3. ACCRUED OR RECEIVED INCOME. 11 the boots of an estate oi trust Me kept on an accrual ba.,., report all mcome .ccmed even though it ha. not been .ctu.lly received or entered on the book., .nd expenM incurred instead ol expenses pud. II the books do not eho» income aiyruod and expense, incurred, report all income rwPived or constructively received, such a. bank interest credited to the account ol the eetatc or trust, and expeosefl pud. 4. ITEMS EXEMPT FROM TAX. The following item, tkje exempt from Federal inc< unlc« it is desired to establish . net loss, in which t Act «f 1921 l») The proceeds ol life insurance policies pai.l upon the death of the insund (H The amount received by the insured u a return ol premium or premium, paid by him under hie insurance, endowment, or annuity contract., either during the term or at ihc matunty of the ttrm mentioned in the contract or upon surrender of the contract (c| Gift, (not made u . consideration for service rendered), and money and property acquired under a will or by inheritance (but the income derived from money or property received by gift, will, or inheritance is Uxable and mu« be report<-dl; Id) Interest upon (H the obUg.tions ol . SUte, Territory , or any political subdivi,ion tbcreol or the Duitrict ol C«lumbi.: or (2) securitie. issued under the provisions ol the lederal Farm Loan Act ol July 17, 1916, or (31 the obhpation. ol the United Sutes or it. possession.; or (4) bond, uaued by the W,r Finance CorfKjration, In the cai«! ol obliga- tions ol the Vmled Stat«« issued alter Sentembcr 1. 1917 (other than postal eavinga cer. tific.tc. ol dopos.ll and in the ca« of bonds issued by the Wu Finance Corporation the interest is exempt only il and to the extent provided in the resi,ective uu .uthori'zlng the uwue thereol u amended and supplemented by Section 1328 ol the Revenue Act of 1921, and should be excluded Irom grow income only il and to the extent it is wholly exempt to the Uxpayer from income t.x (c) Amount, received thrt>ugh K-cident or health insurance or under workmen's com- peniiation act., a. compcmiatlon lor pereon.1 injurie. or sickneM, plus the amount ol any damages received, whether by suit or agreement, on account ol such injurii.-, or sirkDciw (/) Amount, received a. compensation, lamily allotments and allowances under the proviinon, ol the War Risk Insurance and the Vocational R».h.bilitation Act., or a. [len- sion. Irom the I'nited .«UI»« lor service ol the heneficiuy or .notber in the milit.r)' or naval lortee ol the fniled .'^t.te. in time ol war. 5. FARMER'S INCOME SCHEDULE. II the eetata or trust derive, income Irom EwTniig. and no book, ol w>»unt u« kept, or book, ue kept on ft cash bams, obtun from the ,Ccriod on the baBia of which this re) the auntta] accounting^wriod of the partnerBhip, personal then you should inchidc in tlua return the distributive share of the total net iocome for such acrouDling period, ending within your taxable period. IS. INCOME FROM RENTS AND ROYALTIES. If property or crops was received in lieu of cbbH rent, report the income aa thougii the rent had been reteived in cash. Crops received as rent on a crop-ahare basis should be reported as income for the year in which disposed of i" unless your return shows income accrued). Explain in Schedule A, p^e 2, repairs, depreciation, depletion, and other eicpenses. Other expenses include interopt. taxes, fire inauiance, fuel, light, labor, and other beceffliary expenses of this character". ' 16. INCOME FROM BUSINESS OR PROFESSION. Report in Item 4 the net profit (or loss) from— (a) Sale of roerchandise, or of products of caanufaeturing, conatruriion, mining, and agriculture. (6) Business service, such as transportation, storage, laundering, hotel and restaurant sen-ice. livery and garage service, etc. In general, report in Item 4 any income in the earning of which expenses for labor, rent, etc., were incurred. If tlie estate or trust derives income from farming, see Instruction 5. Describe the btisineas or services rendered, as "grocery," "reiail clothing," "dnig store," "jobber," "importer," "broker," "farmer." etc.. on lino 1, Schedule B, page 2 of the return. Enter also on line 1 , Schedule B, the total income from business or sales, less any dis- counts 'or allowances from the sale price. If engaged in a trade or business in which the production, purchase, or sale of mer- chandise of any kind is an income-producing factor, secure from the Collector of Internal E«venue and file as a part of this return a CertiJicaU of Imerttrjjy, Form.il?6. Solaria. — Enter on line 10 all salaries and wages not reported as "Labor" on line 2. Rent. — Enter on line 11 rent on business property in which the estate or trust has no equity. Do not Include rent for dwelling occupied by any beneficiary for residential purpoeea. Interest. — Enter pn line 12 interest on business indebtedness toothers. Do not include interest of the estate or truft on capital invested in or advanced to the husinesB. Tojcs. — Enter on line 13 taxes on business property or for carrying on business. Do not io'-'Iude taxes assessed against local benefits of a kind tending to increase the value of the property assessed, as for paving, sewers, etc, , nor Federal income taxee. Repavs, wear and tear, obsoUsceitce. depletion, ajid property loiscs (other than merehan- dige). — Enter on line 14. (a) ordinary repaire required to keep property in uRable condition, (t) reasonable allowance for exhaustion, wear and tear of property used in the trade or busi- ness, including a reasonable allowance for obsolescence, and (c) losses of business property by fire, etorm, or other casualty, or theft, not compensated for by insuranre or otherwise and not made good by repairs claimed as deductions. Explain these deductions in Schedule B. The amount claimed for wear and tear (depreciation), including obsolescence, should not exceed the original cost of the property (or if acquired prior to March 1, 1913, the fair market value on that date) divided by its estimated^ life in years. If obsplescence ia claimed, state why useful life ia leas than actual life. \Mien the amount of depreciation and obsolescence allowed equals tho cost of the property (or if acquired prior to March 1, 1913. the fair market value on that date), no further claim should be made. Do not claim any deduction for depreciation in the valye of a building occupied by any beneGciary as a dwelling, or of other property held for personal use, nor for land (exclu- sive of improvements thereon), nor on slocks, bonds, and other securities. Depredatvin of palenta, copyrights, etc., and depletion of mxnet, etc. — If you claim a deduction on account of depreciation in the value of patents, copjTights, franchises, and other legal privileges, or on account of depletion of mines or oil and gas wells, see Section 214 [a) 8 and 10, of the Revenue Act of 1921. Arjurrtiiation of varfacililia. — If amortization of war facilities is claimed, see Section 214 (a)9, of the Revenue Act of 1921, and the Regulations issued under authority thereof. Bad dcbtt. — Enter on line 16 debts, or portions thereof, arising from sales that have been reported as income, which have been definitely ascertained to be worthless and charged off ■within the year, or such reasonable amount as has been added to a reserve for bad debts within the year. A debt preWouely charged off as bad, if subsequently collected, must be returned as income for the year in which collected. Other expenaca. — Enter on line 17 all ordinary and neceasan.- bu^ness expenses not classified above, such as lire insurance,' heat, and light. Do not include cost of business equipment or furniture, expenditures for replacements, or for permanent improvements to property, or living and family expenses of any bene- ficiary - Dtfial —If line 20 shows a deficit, indicate by urang red ink or a minus sign. 17. PROFIT FROM SALE OF REAL ESTATE. Describe the property briefly, as "farm," "house," "lot " State the actual consideration or price received, or, in case of an exchange, the fair market value of the property received. Enter the original coet of the property if purchased by the fiduciary, and if it was acquired in any manner prior to March 1, 1913, the fair market valueon that date. Incase the property was owned by the decedent, the basis for computing pro6t (or loss) u the inventory value at the date of death. Attach statement explaining how value ai March 1, 1913, was determined. Expenses incidental to the purchase may be included in the cost if never claimed in income tax returns as deductions from income Enter as depreciation the amount of wear and tear and obsolescence, or depletion, sustained since March 1, 1913 (or si nee date of acquisirion, if subseqoent to March 1, 1913'. In case the property was acquired by gift, bequest, devise, or inheritance after March I, 1913, or in any manner prior to that date, see Section 202 of the Revenue Act of 1921. If the net result to be entered in Item 5 is a deductible Ices, indicate the deficit by using red ink or a minus sign 18. PROFIT FROM SALE OF STOCKS, BONDS. ETC. The method of computation and the information to be submitted in the case of sales of stocks, bonds, etc , is similar to that required for Item 5, except that subsequent improve- ments and depreciation are not involved. The profit (or loas) should be computed in accordance with Instruction 17 above. 19. OTHER INCOME. Report all other taxable income for which no place is provided elsewhere on page 1 of the return, including dividends received on stock of foreign corporations, and corpora- tions satisfying the conditions provided in Section 262 of the Revenue Act of 1921 20. INTEREST PAID. Enter as Item 10 interest paid on other indebtednees as distinguished from business indebtedness (which should be deducted under Schedules A, B. C, or D). Do not include interest on indebtedness incurred for the purchase of bonds and other obligations, the inter- est on which is wholly exempt from tax, except interest on indebtednees incurred to pur- chase or cany Victory Liberty Loan 3J% Notes, originally subscribed for by the taxpayer 21. TAXES PAID. Enter as Item 11 personal taxes paid and all taxes on property not used in business, not including those assessed against local benefits of a kind tending to increase the value of the property. Do not include Federal income taxes, taxes imposed ujxin the estate or trust on its interest as stockholder of a corporation, which are paid by the corporation with- out reimbursement from the taxpayer, nor income and profits taxes reported in column b. Item 18, page 1 of the return. 22. LOSSES BY FIRE, STORM, ETC. Enter as Item 12 losses of property not connected with the trade, or business, sustained during the year from fire, storm, shipwreck, or other casualty, or from theft, which were not* compensated for by insurance or otherwise. Loaies claimed should be explained in Schedule E, on page 2 of the return. (See Section 214(a) 6 of the Revenue Act of 1921 ) 23. CONTRIBUTIONS. Enter as Item 13 any part of the gross income which, pumiant to the terms of the will or deed creating the trust, was during the accounting period paid to or permanently set aside for the use of: (a) the United States, any State, Territory, or any political 8ubdi\-iaion thereof, or the District of Columbia, for exclusively public purposes; (6) any corporation. or community chest, fund, or foundation, organized and operated excluaisely foe religious, charitable, scientific, literary, or educational purposes, including posts of the American Legion or the Women's Auxiliary units thereof, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private etock- botder or individual; or (r) the special hind for vocational rehabilitation authorized by Section 7 of the \'ocatioQal Rehabilitation Act. List names of organizations and amounts contributed to each in Schedule F. 24. BAD DEBTS. Enter as Item 14 all bad debts other than those claimed as a deduction in items above State in Schedule P, (a) of what the debts consisted, (b) when they were created, (c^ when they became due, and (d) how they were actually determined to be worthless. 2S. OTHER AUTHORIZED DEDUCTIONS. Enter as Item 15 all other deductions a elsewhere on page 1 of the return. Do nc were neither connected with the trade o deduction claimed should be explained ithorized by law for which i t deduct losses incurred in ■ business nor entered ini .n Schedule F. ) place is provided for profit. Any 1706 IF RETURN IS FOR CALENDAR YEAR 1921 FILE IT WITH THE COLLECTOR OF INTERNAL REVENUE FOR YOUR DISTRICT ON OR BEFORE MARCH 15, 1922 IF FOR A PERIOD OTHER THAN A CALENDAR YEAR THE RETURN SHOULD BE PILED ON OR BEFORE THE ISTH DAY OP THE THIRD MONTH FOUjOWINC THE CLOSE OF SUCH PERIOD INDIVIDUAL INCOME TAX RETURN fOB NTT INCOMES OF HOK£ THAN JS.W. OR SEPARATE RETUHNS OF HUSBAND AND WIFE IF COMBINED NH INCOME UCEEDS iS,000 FOR CALENDAR YEAR 1921 Or for pertod E>cgun _, 1920, and ended . PRINT NAME AND ADDRESS PLAINLY BELOW OCCUPATION. PROFE SSION, OR KIND OF BUSINESS . Do not write in this &fkace FIRST PAYMENT Caihier's Stntnp CASH CHEa MO. CERT. OF If Sworn to and nibacribed before me thii . 1. Are vou a citizen or reeident ot the United States? 4. U not. is a Ecparatc return being If ao, etat«: (a) Namo end oddreea filed by your hueband or wile? „ entered at head of that return 5. Were you married and living with huoband 6. If not, were you oq tho laat day of vour taxabl'; period Bupporting one or more peraonB or wile on Wife lafll day of your tax*blo period? living in yowbouBehold whoare cloecly related to you by blood, marrioge, or adoption? . 7. How many dcpeodcut persons (other than huBband or wife) under 18 years of age or incapable of ecU-support becauso 3. la this a joint return of huaband and wife? (6) Exemptioa claimed, j_ •ntally t ly dcpeodcut persons (otner tfitn ousoano or wiiej under JS years ol age or lacapabio ol eclf -support becauj phyaically deicctive were receiving their chief gupport from ycu on the laat d&y o( your ta.table period?^ ffi: INCOME. 1 . SaUriea. Wages. CommimooB. c 2. lotereetonBank Depouta, Notea, Mortgagea^-^nd Corporation Bond? , _ 3. iDCome from Futnerabips, Pidudaries, etc. (State name and address ui puinerehipa, etc.) 4. Rents and Royalties - ^ , 5. Profit (or'loflB) from Businees or Profeaaion (not including income from parlnerehipe) C. Profit (or loaa) from Sale of Real Estate „ 7. Profit (or loao) from Sale of Stocks, Bonds, etc ^ 8. Dividends on Stock of Domcetic Corpoiationa 9. Taxable Interest on Liberty Bwiido, tfic.,„ .0. Other locomo (including dividends received on stock of fordgo co:porations). (State oature of inoDme.) Total Income im Iteus I to 10 (lees looee shown therein, if any)..„ DEDUCTIONS. . Interest Paid (not including intcroal deducted above) „ . . Taxea Paid (not including taxes deducted above) _ ^ „ i„... . Losses by Fire, Slorro, etc — — „ „„. . Coolribuliona „ «, „ . Bad Debte (not including bad dcbu deducted above) . Other Dcduclioni Authorized by Law _ _ Total or Items 12 to 17 .,_ _ Net Income (Hem 11 minua Item 18) COMPUTATION OF TAX. 20. Net Income (Item 19 above). __^ 21. Ltm: Dividrndn (Item 8 above)... 22. Taxable Intercnton Liberty BoiidH,otc.(IIcmOabovc). £3. Forsonal Exemption and Credit for Depcudonte 24. Total or Itkhs 21, 22 and 23 25. D4Jaoco(lt«m 20 minus Item 24) 26. Amount taxable at 4% (not over HOOO) 27. Balance taxable at 8% (Item 2^ minus Item 26} l> Chvcka and drafta will be accepted onljr If pareMe at par. 28. Normal tax (4% of Item 26} «. ._ 29. Normal ux (8J& of Item 27) _ 30, Surtax on Itom ZK^'^eo Io«lniclion 6) .„.„„. 31, Total Tax.. _, 32. I,«m; Tax paid ataoureo ... 33. Income and proBia Uxoa paid to foreifcn countries ur poaN,l EMite.) E toIl»U ,P.o™t,. :. !>.„ AC,™.. ..A«>™.Erm™,. 1. Cear. ^ Uakh I. 1S13. iMrKovuiem . Dmixixmr. '■(■jLojuf" I ■« 1 L 1 1 1 1 1 1 T "T "■ 1 1 1 If not acquired by purchaae, state how acquired - SCHEDULE P.— EXPLANATION OF ITEM 7. (Sale of Stocks. Bonds. L KXtta OP FXOFESTT. AC* Items 1 to 10 (Icsb losses shown ibcioin, ii any) . — DEDUCTIONS. latcrcet Paid (not including inlercel deducted above) - . Taxes Paid (not iocludiog laie« deducted above) _ . Losaes by Fi/e, Storm, etc _._ — . Bad Debu (not including bad debts deducted above) . »»._ Other Deductions Authorized by Law - __...„,. _._., Net Iscomk (Hem II minus Item IS) -.- _■■ COMPUTATION OF TAX. 20. Net Incomo (Item 19 above) 21 Lett: Dividcoda (It«m 8 abovo).^.. | Taxable Int«rcitoo Liberty Boiids, ('ic.(It«m9abpve) „.. .. Personal Exemption and Credit for Dependents | — |.. 24 Total of Iteus 21, 22 and 23 - :i. Balance (Item 20 minus Item 2A) __ C Auiouul taxable at 4 ;i (not over $4,000) 7 Balance laxabU at »f« (Kern 26 minus Iiom 2C)... Ch*cks and drafts will be acespttd only If payabi* at par. 28. Normal tax (4^ of Item 2C) 29. N'omaJ Ux (8jC of Item 27) 30. Surtax on Item 20 (see InstnicUoa e) ToTAi. Tax ._„-__«_ ,..._ 32. Lm; Tax paid at source |.„ 23. InDjino and (>roflU Uxes paid to (orrign countries or p^>w<.>noi(>aHo( tho U. 8. (atladi Fonn Itl6) -..|.- , Balance duo ^Iirui J1 minus Items 32 and 33) .„. 3S. Amount of u» paid wbcu Clinp rotuni 1709 SCHEDULE A.-C3a>tANATI0M OF ITEM 4. (R«rty Iran -Ij^ Nftt«, and TrpaFiiryNotfw .... *:«., w«« TZZZE SCHEDULE F.-EXPLANATION OF ITEM H. (Looea br Fir., Sto™.. «c) So Innuioo a L Ean> <» nonan. iCor.GsUjucB l.i»ii,vucx^ a. DxnscuTKur «. eu.**o< Tjattx. ■TSmcaAjrcx. A. »«L-. , . SCHEDinX C.-EXPLANATION OF DEDUCXIONS CLAIMED IN ITEMS J, J5, IS, AND 17. (» n « Tnmd» J»»tMBaMMtt».p)«lBl7jn«»JMJ "^i n « nil »i l "if» «lth»»«tB;n.) I7IO INSTRUCTIONS FOR INDIVIDUAL RETURN I. PERSONS REQUIRED TO MAKE A RETURN OF INCOME. An Incomo ta:^ return must be filed by every citlren- of the United States whether residing at homo or abroad, and every person residiDj; In the United «toto«, though not a citizen thereoP, whose gross Income for the taxable period 192lamoarrtcd to J5,000, or whosenetlncomeamoontcd to— (i) 81,000 IfsingleorifmnniedandnotHvine with husband or wife. ' (6) S2,000 Jf mnrried and hvinc with husbana or wife. If the combined net income of Qusband, wife, and dependent minor chil- dren equalled or exceeded $2,000. or If the combined gross income of husband, wife, and dependent minor children equalled or exceeded $5,000 all such Income must be reported on a joint return , or on separate returns of husband and wife. Ifslngloand the net income.tncluding that of dependent minors.ifany, equalled or exceeded $1,000, or if Ibe pross income equalled or e:tceeded $5,000, a return must be filed. A minor, however, having a net income of $1,000 or $2,000, ac- cording to the marital statu»,OT a eross Income of $5,000. must file a return. Under each of the above -conditions, a return must be filed even though no taxis due. Note especially Histructfon 8, "Credits for Personal E:cemp- tionand Dependents.'' The Income of a minor or. incompetent, if derived ^rom a separate estate under control df a guardian, trustee, or other fiduciary, must be reported by his guardian or otatr legal representative Income of ia> estates of decedents before final settlement; (6) trusts, whether cfMted by ^tll or>ie5d, for nnas«vrtalTied persons or persons with contingent Interests, or income held, or wbichyn'^der the terms of the wUI or trust may bft held, for future distribution, i3f-«i:v.»'I to the fiduriarv as a single person, except t^at from theincome olan estate there may first be deducted any amount prop- administrator ahaU file a return on Form 1040 or 1040A for eucb decedent. 2. WHEN TO USE FORM 1040 INSTEAD OF THIS FORM. lb) Ifyoornetlncome exceeds $5,000. (e) If the net income reported In this rettuno exceeds $4,000 and the entire lamilr cxemptlQQ has been claimed tn a e^arate return filed by husband 3. PERIOD TO BE COVERED BY RETURN. Your return must be filed for the calendar year ending December 31. 1921. or for the fiscal year ending on the last day of any month other than December. The dates on which the period covered by the return begins and ends, If otbw than a calendar year must be plainly stated at the head of the return You were required to fUe ymir return for 1918 on the basis of your annua! accountingperiod, HavingeatabUshed an accounting period for 1018 thteperiod must be adhered to for subsequen t years, unless permission was receivod from the CommiasioD^ to make a change. In the case of a return for a period of less than one year, the net income ahaJl bo placed on an annual baeisbv multiplying the amount thereof by twelve and dividing by the number of months included In such period: and the tax shaUbesuch part of a tax computed on such annual basis as the muaber of monthsinsuch period Is of twelve moDtbs. 4. ACCRUED OR RECEIVED INCOME. 'If your books of account are kept on an accrual basis, report all Income accrued, even though It has cot been actuallv received or entered on the boo^, and expenses incurred instead of expenses paid. If your books do not show income accrued and expenses Incarred. report 5. INSTALLMENT SALES. If you hava used the lastiinineDt method In computing Inoamfi- fmm la- stallment salts you most attach tu y^r rettmi a schedule showing separately for the years 191», 1919, 1920, anj 1921 the fo&owing Information: (a) Oross sales; (6) coat of goods sold; (c) gross pfofits; (i) percentage of profits to gross salw; {e) amount collected; (/) gross prt^t on amount collected. 6. ITEMS EXEMPT FROM TAX. The following Items are exempt from Federal income tax and sboald not be reported, unless It is desired to establish a net loss. In which case see Section 264 of the Revenue Art of 1921: (a) The proceeds of life Insurance polldos paid upon the death of the Insured; m The amount received by the Insured as a return of premium or premiums paid by him under life Insurance, endcjwment, or annuity contracts, either daring the term or at the maturity of thertenn mentioned in the contrart or upon surrender of the contract; (r) Gifts (not roade as a considaratlan for aervlce rendered), and money and property acquired under a will or by_ inheritance (but the Income derived from money or property received by gift, wfll, or Inheritance Ic taxable and must be reported); (d) Interest upon (I) the obligations of a State, Temtoiy. or any political subdiviKlon thereof, or the District of Columbia; or (2) securities Issued under the provisions of the Federal Farm Loan Act of July 17, 1916; or (3> the obliga- tions of the United States or Its poase-sslons; or (A) bond.s issued by the War Finance Corporation. In the case of obligations of the United States isntod aftf r September 1, 1917 (other than postal savings certificates of deposit), and in the case of bonds issued by the war Finance Corporation, the interest Is •xmpt only if and to the extent provided In the respertlv© acts authorizing thtt L-isue thereof as amended and supplemented by Section 1328 of the Revenue Act of 1921, and should be excluded from grosslncomeonlylfand to the extent It is wholly exempt to the taxpayer from Income, war profits, and excess profits Kiles; (e) Amounts received through acddent or health Insuranco or onder work- men's compensation acts, as compensation for personal Injuries or sickness, plus the amount of any damages received, whether by suit or agreement, on accoont of iuch in hiries or sickness; (/) Amoimts received as eompensatloo, family allotment? and allowances und^ thtf provisions of the War Risk Insurance and the Vocational Rehabilita- tion Acts, cr as penMons from the United States for ser\'Ico of the beneQclary or anotherin the military or naval forces of the United Slates In time of war: (g) The rental value of a dwelling house and appurtenances thereof famished to a minister of the gospel as part of his campensation; ' (A ) Compensation paid by a State or political subdivision thereof to Its ofllcftts or employees. 7. FARMER'S INCOME SCHEDULE. If you are a farmer or a farm owner renting your farm out on shares and keep no books of account, or keep books on a cash basis, obtain from the Collector, and attach to this return. Form 1040 F, Schedule of Farm Income and Expenses. Enter the net farm Income'as Tteni 6, page 1 of tlio return. If vour farm books of accoimt are kept on an accrual basis, the filing of Form 1040 F its optional. Report income from salaries, interest, rents', sales of property, etc., in Items 1 to 7 of the return. 8. CREDITS FOR PERSONAL EXEMPTION AND DEPENDENTS. If you were married and living with yoitr husband or wife or wore head of a family on the Last day of your taxable period^ you may subtract from your net income on Form IOWA, iktoTe calculating your uorniJil tax, an exemption of $2,500, plus WOO for each person (ojhertlian husband" or wife) under IS years of age or ini^pable of self-support because mentally or physically detectlye, who was receiving his chief support from yon oiL^t^t date. If husband and wifo make separate retnms, the exemption or$2,500 may be claimed by either (but not by both) or may be divided between them, but the f -teinptlon of HOO for each dependent may be clafmiid only by the person fumishJng tbe chlel support. If you were noLjnarried or did not five with husband or vrife and wer© not head of aftfnliJv on the last day of your taxable period, you are entitled to 4 personal esemption of $1,000 plus $-tOO for each dependent person under J8 years ofage orlncapable o/solf-sQpport because mentally or physically deleo- live, who was receinng hia chief support from you on that date. An exemption of $1,000 may be claimed In cases where Form I040A la filed forestates In process of adminiatraUon, or with respect to Income held lor futore distribution. If bv reason of a change in your accounting period a return Is filed far part of a year« the personal exemption and credit for dependents may be claimed In accordance with your statua-on the last day of such taxable peilod. (9e» olsoInstractlonS on this page.) A "bead of family" is a person who actuaUy supports one or more persons Uvlnx in his (or her) houaebold, who are closely related to liim (or her) by blood, mamage, or adoption .- 9, AFFIDAVIT. The afQdavit must be executed by the peraqn whoiSe Income Ls reported onless be is a minor or Incompetent, or onlesshelslU, absent from the country^ or otherwise incapacitated, In Miich case the legal representative or agent may execute the affidavit. A minor, however, making his own return, must execute the affidavit. The oath will be administered- without charge by any collector, deputy collector, or Inteoul revenue agent, or (If you are in the military or naval service of the United States) by any militaiy or naval officer who is autborlzed to admin- ister oatha for pwposea of military or naval justice and administration. If an 10. WHEN AND WHERE THE RETURW MUST BE FILED. on or before March \5, 1922. If tor a ptsriod other tiian the calendar year, the return should be filed on or before the 15th day 4>f .tbo third month following the close of such period. In caso the taxpayer had no legal residence or plac« of business in the United Otates, the rettim should be forwarded to the Collector of Internal Revet nue, Baltimore, Md. IT the address of tbe oolleotor ^ not prloted on the return and yoa do not know It, ask at the post ofSce aDd), il a joint rrnirn 13 Cilcd. aod (c) each dctK-odett nuaor child ba\in? a set inooD\ooi Ices thHo ;^l,00'J peranoum. Use ascpaxaie Uoc ior each eairy, giviog the iDfoTCiaiion requcetc^I. Auy ainoiiDt cliiinod as a doductioo (or tuxfssary cTpcnsra acainpt eaUries. etc., ihould be (illy r'vpI:uoed la S<'bedu!t^ O, pa^c ? of the return, or 10 an iira<.-bed eutemcot Travcli:>L' c^;t(,r.■c^ (inrludiup the eonre amount expended for oii nli and lodging) while away from liouic id the pursuit of a trade or bu^iocs arc dcduciiblc. 14. INCOME FROM PARTNERSHIPS, FIDUCIARIES, ETC Tlf port your (Icfc fwbetbcr rccencd or not) in the profits of a p-ilnc:i'iip or personal (cr\iro eon>oratioi). or io the icromc o( an csiaic or tnist, e^f cpl iHe part &( euib t-bare that con?iilc'I 01 dividccds 03 «locW o( doi"f5lic corpora tioD'^, anj taxable interest on obli?alion-*o( the Untied butcs. which fhoiild beicciiidcd id ItcmvSaody. rc*pccuvely, po~o 1 of the return r.oport iQ Item 1, ralar>- received from .t partnership or ptrronal service corporalion. \i ihc ta.vabic |>cnod or. the bi-is of "h» h \ou file -.o-.ir rc'.iUD f*.U to comnde «Tib ihc8Lnualarcciinlin7iviiwJof ibcpaiiucr-hip. peroDafscrvicccorporaiioD. or fiduciary'. IS. INCOME FROM REI^TS AND ROYALTIES. Le reported a3 iniome for the year to ubicb disposed of (ualess y occniedV Exptais in Schedule A. repairs, dcpreciatioD, depIetioD. and olh< ', hiel, light, labor, and other 16. INCOME FROM BUSINESS OR PROFESSION. Report iD Item 5 the net profit (or loas) from— (n) Sale oC mercbandiie. or of producia of maDufaclimng. construciioo. m ftgrifuHuro ilege= cr oil and (^ wells, see Secuon 214 (o) 9. of the Revenue Act of 1021. and the Rc^iUuons issued under authority iLcrecf. Bentancc after ilarr^i 3, 1913. or in any nunncr prinr to that date, sec Section 202 of the Jlevcnuc Act of l-i'Jl. If the net lesc'ii to he entered in Item G is a deductible los£, indicate the deficit by ueiog red ink or a nunus cign. 18. PROnT FROM SALE OF STOCKS, BONDS. ETC. The method of corupuUtion and t!ie infoTsiaiion to be submitted in the case 01 ral-^a of Elects, bonds, etc., iseii3ilart^tli.'lrca) ebould be computed in accordance wtth Instruction 17 above. 19. TAXABLE INTEREST ON LIBERTY BONDS, ETC The interest on Liberty Bonds and other oblisaiions of the United Slates issued since September 1,1917 (except Victory Lii»criy Loan O; % ^ot<.=, and postal saving cert i6cai"3 of deposit), is subject to eurCa:^ to the extent that the holding exceed the exemptions provided by the act authorizing the issue 3nd subsequent acts. The exemptions specified m columns 2,3, and -1. Schedule E. are applic.ble to the obligations lifted on liaca (1). (6), and (0. but the tout amcunt entered on these lino ia any one column mu=t not exceed the exemption specified. The exemptions specified at head of columns do not apply to the oblisations where the word ■■Noae"appes:3. _ Enter in column S on the proper lines the principal amounta of the varioi:5 obU^tions ownfd m cscess of the exemptions specified, during the taxable period, including your share of these obligaiicTis held by partnorihips. personal service corporation?, and fiduciaries. To determine the interest on any ciaas of obhgauons received during the Wxabb period, where tiic books .ire kept on a cish receipts and disijurscment basis, add to the amount of all coupons and registered bend interest falling due within the uxabl* ncrioJ the amount of accrued interest received on sales of obligations between interest lav-cieni dates, and deduct from this sum the accrued interest paid on purchases of obligatiL>ns Itct^con interest pa>TLent dates. This cieih<5d will be followed where. l>ool!s are kept on a c^^h. hz£i£. whether or not the coupons falling due within ibc taxable period are actually If the books are kept on the accrual basis, report the actual amount of interest accrued ot) the ohligaiiona owned dunng the tax^ible period. 20. OTHER INCOME. 21. INTEREST PAID. Enter aa Item 12 intereet paid on personal indebtcdneas as distingxiished from business indebtedness (which should be deducted under Schedules A, B. C, or Dl. Do not include interest on indebtedness incurred or continued for the purchase of bonds and other obUga- lions. the interest on which ia wholly exempt from tax, except interest en indcbtedneBs incurred to purchase or carry Victorj- Liberty Loan Z\% Notes, onsinaily subechbed for by the taxpayer. 22. TA.\ES PAID. Enter as Item 13 personal taxes paid and all taxes on property not used in business or profeaion, not including those as9e«sed aaaintt local benefits of a kind tt-nding to increase the value of the property. Do not include Federal income taxes, taxes imposed upon the taxpayer upon his interest as shareholder or mcmlx?r of a corporaUon which are paid by the conwraiioo without reimbursement from the taxpayer, nor inctKne and profus taxes claimed as a credit m Item 33, pa^ 1 of the return. 23. LOSSES BY FIRE, STORM. ETC Enter as Item 14 losses of property not connected wiili your trade, busine?;. or profes- sion. sustained during the year from liro,6tonn. shipwreck, or other casual ly, or from theft, which were not compensated for by insi "' ~" explained in Schedule F, on page 2 of ih otherwise. (Loascs dauned ahould ba ithcr connected with your I deduct losses incurred in transactions which n trade or busineea. nor entered into for pivtfit. 24. CONTRIBUTIONS. Enter as Item 15 contributions nr gifts made within tlic taxable period to or for tho use of- (a) the United States, any Sute. Territory, or any pcli'-icjl sulKli\-isico thereof, or the District of Columbia, tor exclusively puMic purposes; (fc) -iny corporation, 1 Diunity chest, fund, or loundatic „ ^ ^„ ., . _j i and operater OCCUPATION. PROFESSION, OR KIND OF BUSINESS ScMul" 20 21 22 E 23 F 24 F 2S F 1. Salaries, ^Tagea. Commisflions, etc. (State nacneana addiess of person from whom received.) — f.. 2. Interest on Bank Deposite, Notes. Mortgagee, and Corporation Bonds 3. Income from Partnershipe, Fiduciariea, etc. (Statonameandaddresacrpartnershlps.ctc.) 4. Rents and Royalties _ - — 5. Profit (or loss) from Business or Profession (not including income from partnerships). 6. Pro6t (or loss) from Sale of Real Estate _.. 7. Profit (or loss) from Sale of Stocks, Bonds, ctc« 8. Other Income (except dividends from domestic corporations and Interest on obllgatic U.S.) (:^'tato nature oflncome) 9. Total Income ik Items 1 to 8 (less losses shown above, j£ any). DEDUCTIONS. 10. Interest Paid (not including interest deducted above) 11. Taxes Paid (not including taxes deducted above) _ 12. Losses by Fire, Storm, etc _ _ 13. Contributions _ _ 14. Bad Debts (nofincluding bad debts deducted above) — 15. Other Deductions Authorized by I.4iw 16. Total op Items 10 to 15 _ 17^ Taxable Net Income (Item 9 minus Item It). COMPUTATION OF TAX. 18. Net Income (Item 17 above) ?.. 19. Less Personal Exemption and Credit for Dependents _ , 20. Balance (Item 15 minus Item 19) t '- a^ka will l>o Lccepled if payabb at par at CoDwIor's Office. 21. Tax Due (4^ of It«m 20) „ 22. Less: Tax Paid at Source $ 23. IllOOlIlO Vid oioBl. t.«M piil lo > UoJtodSuU, <.tUcb iotm UIO) 24. Balance Due (Item 21 minus 22 and 23).. 25. Ta» Paid when Filing Return I7I3 SCHEDULE A.-EXPLANATION OF ITEM 4. (Rents and RoyaUiflff ) 1. Kind o( property. 2. Cost, or March 1, 1913, value. 3. Amount received. 4. Repairs. 5. Depreciation and depletion. 6. Other cxpengc^. 7. Net profit for Io3s). _ Stat» Mtimat«d life of property and how yon figured deprgctattoD - SCHEDULE B.-EXPLANATION OF ITEM S. (Bu«bie«» or Profcttlon.^ Total Income from Business or Professioa ■. Total Business Expenses (stnte specifically, see Instruction IC) KcT Pmorrr (ob Loss) (If profit Is less than usu^l, explain) . Explanation of busmec expenses SCHEDULE C -EXPLANATION OF ITEM «. (Sal« of Real Eatate.) 1. Kind of property. Tf not acquirr d by purchase, state hov acquired . SCHEDULB D.-EXPLANATION OF ITEM 7. (Sala of Stocka. Bond*, etc.) I. EiDd of propertx. 2. Data acquired. 3. Cost. 4. Uarch 1,1913, 5. Amount value. received. 6. Net profit (or loss). 1 1 1 1 1 - n not acquired by purchase, state how acquired . SCHEDULE E.-EXPLANATION OF ITEM 12. (Lo».s by Fi re. Storm, •te.) 1 . Kind of property. 3. Cost, or March 1, ldl3, value. 3. Depreciation previously taken. 4. 'Salvage Taloa. &. Insurance. 6. Net loss. , SCHEDULE F.-CXPLANATION OF DEDUCTIONS CLAIMED IN ITEMS t. U, 14. and IS.) I. Are you a citizen or 2. If you filed a return for r(>3ident of the United 1920, to what &}lIector's States? ^ office was it sent? 4. WSfc a separate If so^ state: rstura filed by your 3. Is this a Joint return of husband — and wife? >■ ou, ovovc. i%\ Name and address ... (a) Exempticm ent«red at head of husband or wife? claimed, t that return _„ _ r.. Were you married and Uvlng with husband 8. If not, were you on the last day of your tiiable period supporting one or more persons or wifeon the last day of youj taxable period? ._. living in your household who are closely related to you by blwd, marriage, or adoption? 7. How many dependent persons (other than husband or wife) under 18 yoors of age or incapable of self-support because mentally or physically defective uere receiving their chief support from you on the last day of your taxable period? 8. State aroounl of dividends received 9. State amount of 10, State amount.of interest received om Irom domestic cor^rations (Including tnterest received on other obU^lions of the United Stales (except Liberty Bonds) on a principal 3 of $5,000. I swEA9(erafflrm) that this return. Including the acccmpanying schedules and statements (ifanv), has been examined by me, and, to the best of my Imon^-iedgn and belief, is a true ana complete return, made in good fattb, for the taxable period as suted, pursuant to the Revenue Act of 192] and the Regulations issued under authority thereof. <^ors to and subscribed before me this day of ..« (SicQAture of iodividiuU er ftccot > (An amemded rvtum mu«e b* ^aialF mArkad **Am*ad«d" acroat th« (ace of the return.) 1714 INSTRUCTIONS FOR INDIVIDUAL RETURN I. PERSONS REQUIRED TO MAKE A RETURN OF INCOME. An incoajc tax rphiro mufit be filed by every oitizon of (be Uoiu-d States whether roaidiog at home or abroad, antl every person refaJiog iq the I'liited Sialee. tbDU(>h not Q cilizeo thereof, nhoee grofs income lor the laxBblc period 1921 sunouutcd lo J'>.000. or wboee ocfciofoine amounted lo— (a) Sl.OCM) it ;ior.le or it married and nol li\-ini; with hLshsnd or wite. (b) $:.Ono it roamed and livin-! Tviih biisbasd or mfc. If thecoinbiocd net inromc of husband, Tnfe, and dcpcodcnt minor children equalled or exccpded $2,000. or il the combined croaa, income of bu?band, wite. and dependent minor rhildren cr|ualled or c^tcccded $5,000 all Eucb inromc must be reported ( return, or on eeparate reluma ol husband and wite. If einele an ' " chiding that of dependent n c'lUAlIed or exceeded $5,000, a return must be Bled. A t income of $1,000 or $?,000, acconfmg to the marital etatui miutfilea retiim. Under each of tho above c Nolcespecially Instruction 8. In the case of hu:Hand and wife who^e combined net income exceeds fo.OOO, Form 1040 (not Form 10^0 A) should bf> ueed for separate returoe, even though the income on one or both retunu is lees than $5,000. The income of a minor or incompetent, if denved from a separate estate under control of a R:uardian, trustee, or ofber fiduciary, muf t be reported by euch legal representative Income of (u) estates of decedents before fina] Bettlcment, (b) trueta, whether created liv will or deed, for unascertained persona or pcreons with contingent interests; or income held, or which under the termn of the will or trust may be held, for future dbtribution, i3 taxed to the fiduciary a3 a ^^ngle person, except that from the income of a decedent's hi3 death waa $1,000. if unmarried, or $2,000, if married and tivi Ic, or if the CToaa income was $j,000 or over, the esecutor or adminiplrator ehall file a urn on Form 1040 or 1040A for euch decedent. 2. PERIOD TO BE COVERED BY RETURN. Your return muft be filed for the calendar year ending December 31, 1'j21. or for the r.acal year ending on tho taat dayof any month other than December. Tho dates on which the period covered by the i plainly stated at tho head of the B required t betrina and ends, if other than a calendar yej 1 for 1318 on the basie of your an period. Having eelabliehed an accounting period for 191S iliia period t to for subsequent yeara, \m'^ea permiasion waa received from the Commit •"baoge. In the caae ot a return for a period o( le«8 than one yeJr. the n ' 3 annual baaia by multiplying tho t thereof by twelve and dividing by 3. ACCRUED OR RECEIVED INCOME. If your books of account are kept on an accrual basis, report all i ihiugh it baa not been actually received or entered i " insioTid of expea=o paid If your books do not ehow income accrued and expenses incuned, report all income r coDfitnictivcly received, such as bank interest credited to your account, and xpetL 4. INSTALLMENT SALES. 33 puling i If you ha\o used tho inalallment method . ^ . _ Salea j-ou must attach to your return a Bcbedulo ehowing separately for tho yc 1919. 1920. and 1921 tlw foUowing information: (a) Gross aalee; (J>) cost of goods eold". .uuu puoiui mi tificates of deposit), and f n the case of bonda iuucd bv the War Finance Corpora intirefit is exempt only if and to tho extoot pro\-iJea in the respective acts authorizing Ihp issue thereof aa amended and Eupplemcnted by oeclioa 1328 of tho Revenue Act of 1921, and should be excluded from gross incomo only if and to tho extent it is wholly cxcmpttothe taxpayer from income, warprofilB, and excess profits taxes; (c) Amounls received through accident or health insurance or under workmen's com- penaalion acl^. as compeoaation for personal injuries or eickneas, plus the amount of any damages received, whether by suit or agreement, on account of euch injuries or eickne^a; (J) Amounts received aa compenaation, family nUotmcnta and allowances under tho __- w , .^,_ ^„. t,:,,, , ^ ^^^ jj^^ Vocational RehabiliUiion Acta, or aa pen- ncc o{ the bcne^iaxy or anotbeE in the military or proviBJonaof the War Risk In; dions from the United Sutes for sc naval forces of the United States in (g) The rental voJue of a dwelling house and appuitcn; fol the gospel as part of bis _ , ih) Compensation paid by a Stato empluyces. thereof tunuabcd I political subdivision thereof to its ofiiccr ipcnsalioo 7. FARMER'S INCOME SCHEDULE. r i^r a farm oi^ner rcntin? your farm out on shares and li b^toio a notary public, justice of the peace, or Olbet person authorized lo administer oaths. 10. WHEN AND WHERE THE RETURN MUST BE FILED. ; the taxpayer had tek at the post office er bank. II. WHEN AND TO WHOM THE TAX MUST BE PAID. The tax ehould be paid, if purfible. by Bending or bringing with tho return a check or money order drawn to the order of "Collector of Internal Revenue at (in&ert name of ciiy and Slate)." Do not send cash through the mail, nor pa/ it in person, except at the ofGceotths 12. PENALTIES. For MaJcins False or Fraudulent Return. eeding $10,000 or not e.'tceediog om the court, and, in addition, 50 per c For Failing to Make Return on Time. z than $1,000, and, in addition, 25 per centum of the tout amount ot the v For Failing to Pay Tax When Duo. or Underitatcmcnt of Tax Through I the rate of 1 percenti C. TABLES OF SURTAX AND INSTRUCTIONS FOR CALCULATION. SURTAX RATES. (Item 19 Second Third I t ihc return). INSTRUCTIONS. which is Iocs than tho toul i . lending amount of total surtax. >ir(.ix touna 06 above add an antouot computed as follows: Subtract from ibo D :j I multiply tho remainder by tho rate ohown on the next lino below in column . f. . I J, iinls is ihu toUl BurUx due. Ixjna lido nalc of mines, oil Of gas wells, o uoIlhosclUng price as provided by Section 211 (6) of tbo Revenue Act of 1921, CALCULATION OF SURTAX. 1. Largest sum in column A which is lees tbaa tbo total amount of the net income _ „„.„...... _.......... 2. Total surtax thereon ahowo in cotumn C... 3. RcEoaindorof net income after lubtroctinf* ItMD 1, abov« 4. Surtax on this remainder at nteihoirn In column DooU&o below that from which Item 1 was takoa _ ._„...-„ &. 7olaI tujtax du« (mm of It«ma 2 ao eich (tfpondcnt miDor child havinc a ntt Income of Ies3 Ih&n SI.WV) por annum. USo a separatoline for each cnir/. eivlnc the Information request^-l. Anv aniouDt clntmed as a deductioa for necessary Mponsf3-HEftirt5t salartos. etc., should bo fully explained in Schedule F, page2 of tUo Mtnro, or in an attached statement." , . ^ ^ , , ■ i ^ T^ i„ Trav^lin? e\pen:^ (including the entire amount expended formcal3 and lodE- In^) while away from horaeinthopursuitof a Iradd or business are detluctible. 14. INCOME FROM PARTNERSHIPS, FIDUCIARIES, ETC Report vour share (whether received or not) in the profits of a partner- ship or personal service corporation, or in the-inoome of bd estat* or trust, oitc*rt tho part of such sharothatconsisted'bfdividettdsdn stock of domestic corporations, and taxable intercut on obligations of the United States, which should be included in Items 8, 0, and 10, at foot of page 2 of the return. Report in Item 1, salary received from a partnership or personal service corporation. If the taxable period on the basis of which yon file your return fails to coincide with the annual accounting period ofthe pc^ner^ip, pwsonalscrvico corporfttion, or fiduciary, then you should include in your return your dis- tributive share of the total net income Sot such acconntlng period, ending within your taxable period. 15. INCOME FROM RENTS ANI> ROYALTIES. If you received property or crops In ilci] of cash r«>it. r*»port the Income as though the rent had been rfcoivod in oash. Crops roc^ved a^ rent on acrop- sharo basis should be reported as Income for the year in v-hlch disposed of (■.mless your return showsincome accrued). Ivxplain In Schedule A , repairs, depreciation, depletion ttSd otbftf ezpensM. Other expenses include interest, taxes, fire InWrance, fuel, Ught, labor, wd Otner necessary expenses of this character. 16. INCOME FROM BUSINESS OR PROFESSION. Keport in Item 5 incorile from— (a) Sale of merchandise, or of products of raanufaettiriDp.cpnstnicUon. mln- inr.'and agriculture. (b) Kusiness servicffe, such as transportation, storage, lamidcririr, hotel and restaurant service, livery and garage service, etc., if you ou'ned tno business. if vouaroonlvanemploveeofa business, report your salary or wages in Item 1. (e) A profession, such "as medicine, law, or dentistry, i I you practiced it on vour own account. If you wore employed on a salary, report your salary in In general, report in Item 5, any income in the earning of which you in- curred expenses for labor, rent, etc. If you are a farmer (or a farm owner renting your farm to another person on shares), see Instruction 7. Describe the business or profession, as "grocery," '^fetaii clothing," "drug rloro," "laundry," "doctor," "lawyer," "fanner," etc. Report the total income derived from sales or from servicc^^ less any discounts or almwances from the sale price or service choice. (Tor instalhnent sales see Instructions.) I "Total Busing obtained by adding _ ^ „ -...-, cbandiso and supplies purchased during the year, and deductme from this iuaith6inventoryatthecnQoftheyear;(2) business cxptrflses, which includo -ill ordinary and necessary business expenses not classified above, such as TiiBce -wages, rent, heat, light, and traveUng expctoscs {sac IhslTUctlon 13); (%) repairs, -wear and tear, obsolcsoence, dcpletian, and propfrty losses (otlicr t.han merchandise), such as (a) ordinary repairs feqplr^d to keep property lii usable conditon, (6) reasonable allowance f6r e^diaustlon wear and tear oi property used In the trade or boainess, including a reasonable allowance for obsolescence, and (c) losses of business property by fire, storm, drother casualty, or theft, not compensatcdforby Insurance or otnfericise dndTiot made good by Topairs claimed as deductions; and H) bad debts, or portions fbercor, arising ■rom sales or professional services that have been rtfpirrted as fuCOCJe, Tvhicli Have been definitely asccrtjuncd to bs worthless aria'cVatjjed off witrilu tho y^ar, or such reasonable amount r.s has bee n added to a reserve for bad debts Cv-rthin the year. A debt pre^ioi-sly charged off as bad. if siibsequently col- 'Uctcd.mustberetumedasincomeforlheycarin which canetted. Explain these deductions under Schedule B, page 2 of the return. ' Do not Include cost of business equiphient or furtiTtnrc, expendltrifgs for Replacements or for permanent imptovenlertts'to'iirOpcrty, 6r pergonal livlrig or family expenses, nor any deduction fordepredfltiotlih th9^•ftIue of a bond- ing occupied by you as a dwelhng, or of otherpfoperty held for personal use. if Item 5 shows a deficit, indicate by using red ink or a minus sign. 17. PROFIT FROM SALE OF REAL ESTATE, DescribO'the property bricflv, as "farm," "house," "lot," Slate the actual consideration or price received, or, in Cfts« of an exchange, tho fair market value of the property received. ir: ir it was ftConirM prior to lent explain- ing how value at "March I, ISl.-J, was determined. Exp^nsesincidcntal lotho purchase may be included In the cost If never cbimed Id Inoorao tax returns as deduct'oiis from income. ^ . , Enter as dourcciaiion tb« emount of wes"- and teer and ct.solr-xcncc, or depletion, sustained since March I, 1913 (or since fjite of acquisition, if sub- sequent to March 1, 1913). . ,■ , ■!._.»._ In caso the property was acquired by gs/l, bequest, devise, or Inheritance after March 1 , 1913, or in any manner prior to that date, soe Section 202 of^tho If the net result to be entered In Item 6 Is o deductible loss. Indicate the deiiclt by using red inlc or a minus sign. 18. PROFIT FROM SALE OF ffTOCKS. BONDS, ETC. The method of comptitati<-.n and the Inronnatlon to be submitted In the ca.'^e of sales of stocta, bonds, etc.. is similar to that required for Item «. except that subsequent improvements and depreciation arenot Involved . The profit (or loss) should be computed In accordance witii Instruction 17 above. 19. OTHER INCOME- Rcport all other taxable locomo for which i on page I of the return, including dividends r- poratiODS. Dividends r" ''""""' '""*" -• ->- » place Is provided elsewhere ived on stock of foreign cor- .„^ J stock of domestic corporations and taxable interest on obligations of the United States should be reported in Items 8, 9, and 10 at the foot of page 2 oJ the return. 30. INTEREST PAID. Enter as Item 10 interest paid on personal Indebtednees as distinguished from business indebtedness (which should te deducted imder Schedules A, B, C.or D). Do not include interest on indebtedness Incurred for the purchase of bonds and other obligations, tho interest on which is exempt from tajt, except interest on indebtedness Inourred to purchase or carry obligations of the United States Issned alter September 24, J917, and origlDally subscribed for by the taxpayer. 21. TAXES PAID. Enter as It«m U personal brres paid and all taxes on property not used in business or profession, rot Including those assessed against local benefits of a kmd lending to increase the value of the property. Do not Include Federal income taxes, taxes imposed open the taxpayer upon his Interest as shareholder or member of a corporation, which are paid by the corporation without reimbursement from the taxpayer, nor income and profits taxes claimed as a credit in Item 23, page 1 of the return. 22> LOSSES BY FIRE, STORM, ETC. 23. CONTRIBUTIONS. or lOF IBB uso oi; ^i) vu» sioaioLi.iu o> P[iuo«.L Sco.ct roK.-.u.t.o... . 1 I>«rui» ,...„.„. .a,» .,.«.„.„.»,....„„„.„.. sham held! DCor- poratioD. (ITCM^^^CUS, CO% UiAXT BOMDO. TUES P.JD TO . TO A PoaausioK or _ ..., 1 1 L i ! 1 .„._L.._._... ,j) _ 1 ; ■ ! 1^^ ." 1 .___. ■ i (it. Totals » 1 -!s ...! !, L .-- J The undersigBed. being severally duly sworn, each for himself deposes and a d is to the best of his knowledge and belief a tru '' '"* ' ''" ' Us issued under the authority thereof. Sworn to and etibscribed before me this irked "Amended" 1718 I the fac* of th« rvtunie) ?>«uurff nf corpora ti»i%, SCHEDULE C— RECONCILIATION OF NET INCOME AND ANALYSIS OF CHANCES IN SURPLUS. 1 N.i ,■...,,.■1. ., ^ uemr. M, Unallowable deductions: 1 • '1' 1 1 t, -^ issiiedMiiceS«ptctn'. '»soUheUnlW^JSUll«issucdbero^cScpteIn■ "'^ ^"dliu'ons (''h^';^-'^"'"* «"*Uilcs.TSrtiorics.«n(J^"ti5risut ■" 1 (') Rephcemenls and reccirals Jf^«»i>n F-»nu LooiiBondjlisiiedundaFKle»lFennUftn ■■■"■■■"1 1 1 (^ *'• •» ""* •" "" '1 ■ 1 6. <. aarccs otiii.si reserve»?or conliDsendcs, elc. (to be d«UUed): 1 1 (2)- - ,„ "T" \"" (j) Other uoaiicwabio deduetiwia (io be' tleiMM): 1 r (J) t 1 1 "^~ (') 1 T.ToUHroDilUmlS 1. . .1.' 15 Total Of Item H « 1 . ...' 1 ""?eVfear.?a!5rf^rA' Character...'. ■■■■■■ i i (O Daio pold Clunctfr (tl ! n Tolil of lUDM 8 to 10 Inclusive «. 1 1 IT. Other dcblU Io surpiiu (10 be deified): la-ToUlIromlH 1 1 (M 13. Surplus ftDd undividod proQis as shown by balance sbool »l Closo Of ». 1 ' 1 in Tol.lomtmslS.ndir 1 SCHEDULE D— BALANCE SHEETS. Attach hereto balance sheets as at the WginDuig and eod of the accouotlug period (preferably ia parallel columDs). showing (Tb<9e balance sheets ebould be prepared from the booka and ahould be io agreetoeot therewith, i Delened charfes to QUESTIONS. tsbya OF BUSINESS. eotifyltwcorpofalK ildcscrlpliooolthol and related tcdustr'.es, Inclndlog Gshlnc. locclnc. Ice harvcslloi;, cLc , and also the leasing Btalo the product or products. H— Mming and quarrymc, locludlog gas aod oil '^■^1''' " ipUed' by Iho llama of tbo product. D— ConstniclioD-oxcavalloos. buildlncs, so equlppliig and Installing same nlih svslcms. devices, or madilnciT, without ). EZ— PubUcutUltiea— gas "I'-ronrems not falllnE In above bridees. railroads, ships, phooe: waterworks or power. E^^toragi nrda, etc.) State proi" ' ' ~' TrsdJac U> GooSs bought doaiestie, ladudUic boi ■J (hydro Kfc^l —Leasing transportation c oot produced by the trading eonacra, wboM business Involves activity (alUne la two or m , coue era ed, shonM report business as id e ntified witr example, coocenis In A or B whidi also tra 'n or control tbelr sourca of matertal exclusively or mainl/, should to ptodudiu business. ojtuUfvll OTHER .nswcrlorins, shipnTeck, or ether casu-olty, or from (heft, and not cnmpcn-^aled for by inAuraucc or olherwL>w, except that column 3 should show "IniuwDfcaiidpalvaKo" instead of "Sale price." CAPITAL EMPLOYED IN BUSINESS. If the balance ehcot (S( hedulo D) of a peraonal nervicc corporalion indiinlw that a substanliol amount of capiul (invoHtod or borrowed) is employed in the busine^. submit a statement explaining why the employment of such capital ii incidental and aotnece^ary. WORKING PAPERS. Everj' partnership or c'TiHir: ofCciT, wnrkinR papers ^hov/int;- 1. The balftiirf> in -- 1- 1 wa-U'cdiii I ■' 2. Theann.'.ii.i a ! u Iftxalile ii I inSvlie.!..!- «. 3. The remainder of e: m Mb.'iild preserve, avaibble U-r innjwttion by a revenue ■f "-tnt ..fi tli.> partnerfhip'ri or corporation's Ivook.-. that n. . I !i HI Ii balance on account of each rloM* of non- 11 .v>: ir .l.ductton-<, and otiior adjustments indicated i» It l.-i> i« (• (•• tire numlier o( tho item in Schedule (' in oUiHlu. ted waa included. Kucit balance, analyzed tn show the amount included 1721 This form will not be accepted unless all information called for is furnished. STATEMENT OF INCOME RECEIVED BY NONRESIDENT ALIEN FROM SOURCES WITHIN UNITED STATES PERSONAL EXEMPTION CLAIMED. FOR CALENDAR YEAR 1921 lo be iiled with withholding agent by nonresident alien individual owning bonds of a domestic corporation which contain a tax-free covenant clause. The execution of this certificate does not relieve the bond owner from fiUng oivncrship certificates required by the regulations. NAMES rHUST BE PRINTED OR WRITTEN PLAINLY DEBTOR ORGANIZATION. City State . OWNER OF BONDS. Street . City Subject of . This is to certify that the owner of the above-described bonda is a nonresident alien as to the United States and is a subject of the country as stated above, and is entitled to the personal exemption of $1,000 as provided by Section 216 of the Revenue Act of 1921. Bond interest received during calendar year with respect to tax-tree covenant bond.s issued by above-named corporation $.. All other income from sources in United States... $ . Total ; Personal exemption $1 ,000.00 Note. — For the taxable year 1921 and subsequent years, only $1,000 personal exemption is allowed a nonresident alien indiWduol, whether he is single, married, or the head of a family, and regardless of his nationality. No credit is allowed for dependents. TO BE FILLED IN BY WITHHOLDING AGENT. District in which return Form 1013 is filed Amount of tax required to be withheld at source as shown by Form 1013, for 1921, $ _ To be reduced on accoimt of personal exemption claimed as indicated by this certificate, the items ap|icaring on the following monthly returns, Form 1012:' Month..-. Page Amount of tax... $.. Montli Page Amount of tax Month Page Amount of tajc Month Page Amount of tax... ._. Total... $.. Kamc of withholding agent. 1722 APPENDIX C REVENUE ACT OF 1921 APPENDIX C REVENUE ACT OF 1921 [Public — No. 98 — 67TH Congress.] [H. R. 8245.] An Act To reduce and equalize taxation, to provide revenue, and for other purposes. Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled, TITLE I.— GENERAL DEFINITIONS. Section i. That this Act may be cited as the "Revenue Act of 1931." Sec. 2. That when used in this Act — (i) The term "person" includes partnerships and corporations, as well as individuals ; (2) The term "corporation" includes associations, joint-stock com- panies, and insurance companies ; (3) The term "domestic" when applied to a corporation or partner- ship means created or organized in the United States ; (4) The term "foreign" when applied to a corporation or partnership means created or organized outside the United States; (5) The term "United States" when used in a geographical sense includes only the States, the Territories of Alaska and Hawaii, and the District of Columbia ; (6) The term "Secretary" means the Secretary of the Treasury ; (7) The term "Commissioner" means the Commissioner of Internal Revenue ; (8) The term "collector" means collector of internal revenue ; (9) The term "taxpayer" includes any person, trust or estate sub- ject to a tax imposed by this Act; (10) The term "military or naval forces of the United States" in- cludes the Marine Corps, the Coast Guard, the Army Nurse Corps, Female, and the Navy Nurse Corps, Female, but this shall not be deemed to ex- clude other units otherwise included within such terms; and (11) The term "Government contract" means (a) a contract made with the United Sfates, or with any department, bureau, officer, com- mission, board, or agency, under the United States and acting in its behalf, or with any agency controlled by any of the above if the contract is for the benefit of the United States, or (b) a subcontract made with a con- 1725 17^6 REVENUE ACT OF 1921 tractor performing such a contract if the products or services to be furnished under the subcontract are for the benefit of the United States. The term "Government contract or contracts made between April 6, 1917, and November 11, 1918, both d&tes inclusive" when applied to a contract of the kind referred to in clause (a) of this subdivision, includes all such contracts which, although entered into during such period, were originally not enforceable, but which have been or may become enforceable by reason of subsequent validation in pursuance of law. TITLE II.— INCOME TAX. Part I. — General Provisions. Definitions Sec. 200. That when used in this title — (i) The term "taxable year" means the calendar year, or the fiscal year ending during such calendar year, upon the basis of which the net income is computed imder section 212 or section 232. The term "fiscal year" means an accounting period of twelve months ending on the last day of any month other than December. The first taxable year, to be called the taxable year 1921, shall be the calendar year 1921 [1918] or any fiscal year ending during the calendar year 1921 ; (2) The term "fiduciary" means a guardian, trustee, executor, ad- ministrator, receiver, conservator, or any person acting in any fiduciary capacity for any person, trust or estate ; (3) The term "withholding agent'"' means any person required to de- duct and withhold any tax under the provisions of section 221 or section 237 ; (4) The term "paid" for the purposes of the deductions and credits under this title means "paid or accrued" or "paid or incurred," and the terms "paid or incurred" and "paid or accrued" shall be construed accord- ing to the method of accounting upon the basis of which the net income is computed under section 212; and (5) The term "personal service corporation" means a corporation whose income is to be ascribed primarily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the afifairs of the corporation and in which capital (whether invested or borrowed) is not a material income-producing factor; but does not include any foreign corporation, nor any corporation 50 per centum or more of whose gross income consists either (i) of gains, profits, or income derived from trading as a principal, or (2) of gains, profits, commissions, or other income, derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. REVENUE ACT OF 1921 1 727 Dividends Sec. 201 (a) That tlic term "dividend" when used in this title (ex- cept in paragraph (10) of subdivision (a) of section 234 and paragraph (4) of subdivision (a) of section 245) means any distribution made by a corporation to its shareholders or members, whether in cash or in other property, out of its earnings or profits accumulated since February 28, 1913, except a distribution made by a personal service corporation out of earnings or profits accumulated since December 31, 1917, and prior to January i, 1922. (b) For the purposes of this Act every distribution is made out of earnings or profits, and from the most recently accumulated earnings or profits, to the extent of such earnings or profits accumulated since February 28, 1913 ; but any earnings or profits accumulated or increase in value of property accrued prior to March i, 1913, may be distributed exempt from the tax, after the earnings and profits accumulated since February 28, 1913, have been distributed. If any such tax-free distribution has been made the distributee shall not be allowed as a deduction from gross income any loss sustained from the sale or other disposition of his stock or shares unless, and then only to t'he extent that, the basis provided in section 202 exceeds the sum of (i) the amount realized from the sale or other disposition of such stock or shares, and (2) the aggregate amount of such distributions received by him thereon. (c) Any distribution (whether in cash or other property) made by a corporation to its shareholders or members otherwise than out of (i) earnings or profits accumulated since February 28, 1913, or (2) earnings or profits accumulated or increase in value of property accrued prior to March i, 1913, shall be applied against and reduce the basis provided in section 202 for the purpose of ascertaining the gain derived or the loss sustained from the sale or other disposition of the stock or shares by the distributee. (d) A stock dividend shall not be subject to tax but if after the dis- tribution of any such dividend the corporation proceeds to cancel or redeem its stock at such time and in such manner as to make the distribution and cancellation or redemption essentially equivalent to the distribution of a taxable dividend, the amount received in redemption or cancellation of the stock shall be treated as a taxable dividend to the extent of the earnings or profits accumulated by such corporation after February 28, 1913. (e) For the purposes of this Act, a taxable distribution made by a cor- poration to its shareholders or members shall be included in the gross in- come of t'he distributees as of the date when the cash or other property is unqualifiedly made sul)ject to their demands. (f) Any distribution made during the first sixty days of any taxable year shall be deemed to have been made from earnings or profits accum- ulated during preceding taxable years ; but any distribution made during the remainder of the taxable year shall be deemed to have been made from earnings or profit's accumulated between the close of the preceding 1-28 REVENUE ACT OF 1921 taxable year and the date of distribution, to the extent of such earnings or profits, and if the books of the corporation do not show the amount of such earnings or profits, the earnings or profits for the accounting period within which the distribution was made shall l)e deemed to have been accumulated ratably during such period. This subdivision shall not be in effect after December 31. 1921. Basis for Determining Gain or Loss Sec. 202. (a) That the basis for ascertaining the gain derived or loss sustained from a sale or other disposition of property, real, personal, or mixed, acquired after February 28, 1913, shall be the cost of such property: except that — (i) In the case of such property, which should be included in the in- ventory, the basis shall be the last inventory value thereof ; (2) In the case of such property, acquired by gift after December 31, 1920, the basis shall be the same as that which it would have in the hands of the donor or the last preceding owner by whom it was not acquired by gift. If the facts necessary to determine such basis are unknown to the donee, the Commissioner shall, if possible, obtain such facts from such donor or last preceding owner, or any other person cognizant thereof. If the Commissioner finds it impossible to obtain such facts, the basis shall be^ the value of such property as found by the Commissioner as of the date or approximate date at which, according to the best information the Commissioner is able to obtain, such property was acquired by such donor or last preceding owner. In the case of such property acquired by gift on or before December 31, 1920, the basis for ascertaining gain or loss from a sale or other disposition thereof shall be the fair market price or value of such property at the time of such acquisition; (3) In the case of such property, acquired by bequest, devise, or in- heritance, the basis shall be the fair market price or value of such property at the time of such acquisition. The provisions of this paragraph shall apply to the acquisition of such property interests as are specified in sub- division (c) or (e) of section 402. (b) The basis for ascertaining the gain derived or loss sustained from the sale or other disposition of property, real, personal, or mixed, acquired before March i, 1913, shall be the same as that provided by subdivision (a) ; but— (i) If its fair market price or value as of March i, 1913, is in excess of such basis, the gain to be included in the gross income shall be the excess of the amount realized therefor over such fair market price or value ; (2) If its fair market price or value as of March i, 1913, is lower than such basis, the deductible loss is the excess of the fair market price or value as of March i, 1913, over the amount realized therefor; and (3) If the amount realized therefor is more than such basis but not more than its fair market price or value as of March i, 1913, or less REVENUE ACT OF 1921 1 729 than such basis but not less than such fair market price or value, no gain shall be included in and no loss deducted from the gross income. (c) For the purposes of this title, on an exchange of property, real, personal or mixed, for any other such property, no gain or loss shall be recognized unless the property received in exchange has a readily realizable market value; but even if the property received in exchange has a readily realizable market value, no gain or loss shall be recognized — • (i) When any such property held for investment, or for productive use in trade or business (not including stock-in-trade or other property held primarily for sale), is exchanged for property of a like kind or use; (2) When in the reorganization of one or more corporations a person receives in place of any stock or securities owned by him, stock or secur- ities in a corporation a party to or resulting from such reorganization. The word "reorganization," as used in this paragraph, includes a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or of sub- stantially all the properties of another corporation), recapitalization, or mere change in identity, form, or place of organization of a corporation, (however effected) ; or (3) When (A) a person transfers any property, real, personal or mixed, to a corporation, and immediately after the transfer is in control of such corporation, or (B) two or more persons transfer any such property to a corporation, and immediately after the transfer are in control of such corporation, and the amounts of stock, securities, or both, received by such persons are in substantially the same proportion as their interests in the property before such transfer. For the purposes of this paragraph, a person is, or two or more persons are, "in control" of a corporation when owning at least 80 per centum of the voting stock and at least 80 per centum, of the total number of shares of all other classes of stock of the corporation. (d) (i) Where property is exchanged for other property and no gain or loss is recognized under the provisions of subdivision (c), the property received shall, for the purposes of this section, be treated as taking the place of the property exchanged therefor, except as provided in subdivision (e) ; (2) Where property is compulsorily or involuntarily converted into cash or its equivalent in the manner described in paragraph (12) of sub- division (a) of section 214 and paragraph (14) of subdivision (a) of section 234, and the taxpayer proceeds in good faith to expend or set aside the proceeds of such conversion in the form and in the manner therein provided, the property acquired shall, for the purpose of this section, be treated as taking the place of a like proportion of the property converted. (3) Where no deduction is allowed for a loss or a part thereof under the provisions of paragraph (5) of subdivision (a) of section 214 and I730 REVENUE ACT OF 1921 paragraph (4) of subdivision (a) of section 234, that part of the property acquired with relation to which such loss is disallowed shall for the purposes of this section be treated as taking the place of the property sold or disposed of. (e) Where property is exchanged for other property which has no readily realizable market value, together with money or other property which has a readily realizable market value, then the money or the fair market value of the property having such readily realizable market value received in exchange shall be applied against and reduce the basis, provided in this section, of the property exchanged, and if in excess of such basis, shall be taxable to the extent of the excess ; but when property is exchanged for property specified in paragraphs (i), (2), and (3) of subdivision (c) as received in exchange, together with money or other property of a readily realizable market value other than that specified in such paragraphs, the money or the fair market value of such other property received in exchange shall be applied against and reduce the basis, pro- vided in this section, of the property exchanged, and if in excess of such basis shall be taxable to the extent of the excess. (f) Nothing in this section shall be construed to prevent (in the case of property sold under contract providing for payment in install- ments) the taxation of that portion of any installment payment repre- senting gain or profit in the year in which such payment is received. Inventories Sec. 203. That whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may pre- scribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income. Net Losses Sec. 204. (a) That as used in this section the term "net loss" means only net losses resulting from the operation of any trade or business regularly carried on by the taxpayer (including losses sustained from the sale or other disposition of real estate, machinery, and other capital assets, used in the conduct of such trade or business) ; and when so resulting means the excess of the deductions allowed by section 214 or 234, as the case may be, over the sum of the following: (i) the gross income of the taxpayer for the taxable year, (2) the amount by which the interest received free from taxation under this title exceeds so much of the interest paid or accrued within the taxable year on indebtedness as is not permitted to be deducted by paragraph (2) of subdivision (a) of section 214 or by paragraph (2) of subdivision (a) of section 234, (3) the amount by which the deductible losses not sustained in such trade or business exceed the taxable gains or profits not derived from such trade or business, (4) REVENUE ACT OF 1921 1 731 amounts received as dividends and allowed as a deduction under paragraph (6) of subdivision (a) of section 234, and (5) so much of the depletion deduction allov^red with respect to any mine, oil or gas well as is based upon discovery value in lieu of cost. (b) If for any taxable year beginning after December 31, 1920, it appears upon the production of evidence satisfactory to the Commissioner that any taxpayer has sustained a net loss, the amount thereof shall be deducted from the net income of the taxpayer for the succeeding taxable year; and if such net loss is in excess of the net income for such succeeding taxable year, the amount of such excess shall be allowed as a deduction in computing the net income for the next succeeding taxable year; the deduction in all cases to be made under regulations prescribed by the Commissioner with the approval of the Secretary. (c) The benefit of this section shall be allowed to the members of a partnership and the beneficiaries of an estate or trust, and to insurance companies subject to the tax imposed by section 243 or 246, under reg- ulations prescribed by the Commissioner with the approval of the Secretary. (d) If it appears, upon the production of evidence satisfactory to the Commissioner, that a taxpayer having a fiscal year beginning in 1920 and ending in 1921 has sustained a net loss during such fiscal year, such taxpayer shall be entitled to the benefits of this section in respect to the same proportion of such net loss which the portion of such fiscal year falling within the calendar year 1921 is of the entire fiscal year. FISCAL YEARS I92O-I92I AND I92I-I922. Sec. 205. (a) That if a taxpayer makes return for a fiscal year be- ginning in 1920 and ending in 1921, his tax under this title for the taxable year 1921 shall be the sum of: (i) the same proportion of a tax for the entire period computed under Title II of the Revenue Act of 1918 at the rates for the calendar year 1920 which the portion of such period fall- ing within the calendar year 1920 is of the entire period, and (2) the same proportion of a tax for the entire period computed under this title at' the rates for the calendar year 1921, which the portion of such period falling within the calendar year 1921 is of the entire period. Any amount paid before or after the passage of this Act on account of the tax imposed for such fiscal year by Title II of the Revenue Act of 1918 shall be credited toward the payment of the tax imposed for such fiscal year by this Act, and if the amount so paid exceeds the amount of such tax imposed by this Act, the excess shall be credited or refunded in accordance with the provisions of section 252. (b) If a taxpayer makes return for a fiscal year beginning in 1921 and ending in 1922, his tax under this title for the taxable year 1922 shall be the sum of: (i) the same proportion of a tax for the entire period com- puted under this title (as in force on December 31, 1921) at the rates 1732 REVENUE ACT OF 1921 for the calendar year 1921 which the portion of such period falling within the calendar year 1921 is of the entire period, and (2) the same pro- portion of a tax for the entire period computed under this title (as in force on January i, 1922) at the rates for the calendar year 1922 which the portion of such period falling within the calendar year 1922, is of the entire period : Provided, That in the case of a personal service corporation the amount to be paid shall be only that specified in clause (2). (c) If a fiscal year of a partnership begins in 1920 and ends in 1921, or begins in 1921 and ends in 1922, then (i) the rates for the calendar year during which such fiscal year begins shall apply to an amount of each partner's share of such partnership net income (determined under the law applicable to such year) equal to the proportion which the part of such fiscal year falling within such calendar year bears to the full fiscal year, and (2) the rates for the calendar year during which such fiscal year ends shall apply to an amount of each partner's share of such partner- ship net income (determined under the law applicable to such calendar year) equal to the proportion which the part of such fiscal year falling within such calendar year bears to the full fiscal year. Capital Gain Sec. 206. (a) That for the purpose of this title: (i) The term "capital gain" means taxable gain from the sale or exchange of capital assets consummated after December 31, 1921 ; (2) The term "capital loss" means deductible loss resulting from the sale or exchange of capital assets consummated after December 31, 1921 ; (3) The term "capital deductions" means such deductions as are al- lowed under this title for the purpose of computing net income and are properly allocable to or chargeable against items of capital gain as defined in this section ; (4) The term "capital net gain" means the excess of the total amount of capital gain over the sum of the capital deductions and capital losses ; (5) The term "ordinary net income" means the net income, computed in accordance with the provisions of this title, after excluding all items of capital gain, capital loss, and capital deductions ; and (6) The term "capital assets" as used in this section means property acquired and held by the taxpa5^er for profit or investment for more than two years (whether or not connected with his trade or business), but does not include property held for the personal use or consumption of the tax- payer or his family, or stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the tax- payer if on hand at the close of the taxable year. (b) In the case of any taxpayer (other than a corporation) who for any taxable year derives a capital net gain, there shall (at the election of the taxpayer) be levied, collected and paid, in lieu of the taxes imposed by sections 210 and 211 of this title, a tax determined as follows: A partial tax shall first be computed upon the basis of the ordinary REVENUE ACT OF 1921 1 733 net income at the rates and in the manner provided in sections 210 and 211, and the total tax shall be this amount plus 121/2 per centum of the capital net gain; but if the taxpayer elects to be taxed under this section the total tax shall in no such case be less than 12^ per centum of the total net income. The total tax thus determined shall be computed, collected and paid in the same manner, at the same time and subject to the same provisions of law, including penalties, as other taxes under this title. (c) In the case of a partnership or of an estate or trust, the proper part of each share of the net income which consists, respectively, of ordinary net income and capital net gain, shall be determined under rules and regulations to be prescribed by the Commissioner with the approval of the Secretary, and shall be separately shown in the return of the partnership or estate or trust, and shall be taxed fo the member or beneficiary or to the estate or trust as provided in sections 218 and 219, but at the rates and in the manner provided in subdivision (b) of this section. Part II. — Individuals. Normal Tax Sec. 210. That in lieu of the tax imposed by section 210 of the Revenue Act of 1918, there shall be levied, collected, and paid for each taxable year upon the net income of every individual a normal tax of 8 per centum of the amount of the net income in excess of the credits provided in section 216 : Provided, That in the case of a citizen or resident of the Unitfed States the rate upon the first $4,000 of such excess amount shall be 4 per centum. Surtax Sec. 211. (a) That, in lieu of the tax imposed by section 211 of the Revenue Act of 1918, but in addition to the normal tax imposed by section 210 of this Act, there shall be levied, collected, and paid for each taxable year upon the net income of every individual — (i) For the calendar year 1921, a surta.x equal to the sum of the following : 1 per centum of the amount by wliich the net income exceeds $5,000 and does not exceed $6,000. 2 per centum of the amount by which the not income exceeds $6,000 and does not exceed $8,000; 3 per centum of the amount by which the net income exceeds $8,000 and does not exceed $10,000; 4 per centum of the amount by which tlie net income exceeds $10,000 and does not exceed $12,000; 5 per centum of the amount by wliich the net income exceeds $12,000 and does not exceed $14,000; 1734 REVENUE ACT OF 1921 6 per centum of the amount by which tlie net income exceeds $14,000 and does not exceed $16,000; 7 per centum of the amount by which tlie net income exceeds $16,000 and does not exceed $18,000; 8 per centum of the amount by which the net income exceeds $18,000 and does not exceed $20,000; 9 per centum of the amount by which the net income exceeds $20,000 and does not exceed $22,000 ; 10 per centum of the amount by which the net income exceeds $22,000 and does not exceed $24,000 ; 11 per centum of the amount by which the net income exceeds $24,000 and does not exceed $26,000; 12 per centum of the amount by which the net income exceeds $26,000 and does not exceed $28,000; 13 per centum of the amount by which the net income exceeds $28,000 and does not exceed $30,000; 14 per centum of the amount by which the net income exceeds $30,000 but does not exceed $32,000; 15 per centum of the amount by which the net income exceeds $32,000 and does not exceed $34,000; 16 per centum of the amount by which the net income exceeds $34,000 and does not exceed $36,000; 17 per centum of the amount by which the net income exceeds $36,000 and does not exceed $38,000; 18 per centum of the amount by which the net income exceeds $38,000 and does not exceed $40,000; 19 per centum of the amount by which the net income exceeds $40,000 and does not exceed $42,000; 20 per centum of the amount by which the net income exceeds $42,000 and does not exceed $44,000; 21 per centum of the amount by which the net income exceeds $44,000 and does not exceed $46,000; 22 per centum of the amount by which the net income exceeds $46,000 and does not exceed $48,000 ; 2;i per centum of the amount 1)y which the net income exceeds $48,000 and does not exceed $50,000; 24 per centum of the amount by which the net income exceeds $50,000 and does not exceed $52,000; 25 per centum of the amount by which the net income exceeds $52,000 and does not exceed $54,000; 26 per centum of the amount by which the net income exceeds $54,000 and does not exceed $56,000; 27 per centum of the amount by which the net income exceeds $56,000 and does not exceed $58,000; 28 per centum of the amount by which the net income exceeds $58,000 and does not exceed $60,000; REVENUE ACT OF 1921 1 735 29 per centum of the amount by which the net income exceeds $60,000 and does not exceed $62,000; 30 per centum of the amount by which the net income exceeds $62,000 and does not exceed $64,000; 31 per centum of the amount by which the net income exceeds $64,000 and does not exceed $66,000; 32 per centum of the amount by which the net income exceeds $66,000 and does not exceed $68,000; S3 per centum of the amount by which the net income exceeds $68,000 and does not exceed $70,000; 34 per centum of the amount by which the net income exceeds $70,000 and does not exceed $72,000; 35 per centum of the amount by which the net income exceeds $72,000 and does not exceed $74,000; 36 per centum of the amount by wliich the net income exceeds $74,000 and does not exceed $76,000; 27 per centum of the amount by which the net income exceeds $76,000 and does not exceed $78,000 ; 38 per centum of the amount by which the net income exceeds $78,000 and does not exceed $80,000; 39 per centum of the amount by which the net income exceeds $8o,oeo and does not exceed $82,000; 40 per centum of the amount by which the net income exceeds $82,000 and does not exceed $84,000; 41 per centum of the amount by which the net income exceeds $84,000 and does not exceed $86,000; 42 per centum of the amount by which the net income exceeds $86,000 and does not exceed $88,000; 43 per centum of the amount by which the net income exceeds $88,000 and does not exceed $90,000; 44 per centum of the amount by which the net income exceeds $90,000 and does not exceed $92,000; 45 per centum of the amount by which the net income exceeds $92,000 and does not exceed $94,000; 46 per centum of the amount by which the net income exceeds $94,000 and does not exceed $96,000; 47 per centum of the amount by which the net income exceeds $96,000 and does not exceed $98,000; 48 per centum of the amount by which the net income exceeds $98,000 and does not exceed $100,000; 52 per centum of the amount by which the net income exceeds $100,000 and does not exceed $150,000; 56 per centum of the amount by which the net income exceeds $150,000 and does not exceed $200,000; 60 per centum of the amount by which the net income exceeds $200,000 and does not exceed $300,000; 1736 REVENUE ACT OF 1921 63 per centum of the amount by which the net income exceeds $300,000 and does not exceed $500,000; 64 per centum of the amount by which the net income exceeds $500,000 and does not exceed $1,000,000; 65 per centum of the amount by which the net income exceeds $1,000,000; (2) For the calendar .year 1922 and each calendar year thereafter, a surtax equal to the sum of the following : 1 per centum of the amount by which the net income exceeds $6,000 and does not exceed $10,000; 2 per centum of the amount by which the net income exceeds $10,000 and does not exceed $12,000; 3 per centum of the amount by which the net income exceeds $12,000 and does not exceed $14,000; 4 per centum of the amount by which the net' income exceeds $14,000 and does not exceed $16,000; 5 per centum of the amount by which the net income exceeds $16,000 and does not exceed $18,000; 6 per centum of the amount by wiiich the net income exceeds $18,000 and does not exceed $20,000; 8 per centum of the amount by which the net income exceeds $20,000 and does not exceed $22,000; 9 per centum of the amount by which the net income exceeds $22,000 and does not exceed $24,000; 10 per centum of the amount by which the net income exceeds $24,000 and does not exceed $26,000; 11 per centum of the amount by which the net income exceeds $26,000 and does not exceed $28,000 ; 12 per centum of the amount Ijy which the net income exceeds $28,000 and does not exceed $30,000; 13 per centum of the amount by which the net income exceeds $30,000 and does not exceed $32,000; 15 per centum of the amount by which the net income exceeds $32,000 and does not exceed $36,000; 16 per centum of the amount by which the net income exceeds $36,000 and does not exceed $38,000 ; 17 per centum of the amount by which the net income exceeds $38,000 and does not exceed $40,000; 18 per centum of the amount by which the net income exceeds $40,000 and does not exceed $42,000; 19 per centum of the amount by which the net income exceeds $42,000 and does not exceed $44,000; 20 per centum of the amount by which the net income exceeds $44,000 and does not exceed $46,000; 21 per centum of the amount by ^vhich the net income exceeds $46,000 and does not exceed $48,000; REVENUE ACT OF 1921 1 737 22 per centum of the amount by which the net income exceeds $48,000 and does not exceed $50,000; 23 per centum of the amount by which the net income exceeds $50,000 and does not exceed $52,000; 24 per centum of the amount by which the net' income exceeds $52,000 and does not exceed $54,000; 25 per centum of the amount by wliich the net income exceeds $S4,ooo and does not exceed $56,ooo; 26 per centum of the amount by which the net income exceeds $56,000 and does not exceed $58,000; 2,y per centum of the amount by which the net income exceeds $58,000 and does not exceed $60,000; 28 per centum of the amount by which the net income exceeds $60,000 and does not exceed $62,000; 29 per centum of the amount by which the net income exceeds $62,000 and does not exceed $64,000; 30 per centum of the amount by which the net' income exceeds $64,000 and does not exceed $66,000 ; 31 per centum of the amount by which the net income exceeds $66,000 and does not exceed $68,000; 32 per centum of the amount by which the net income exceeds $68,000 and does not exceed $70,000; 2,2, per centum of the amount by which the net income exceeds $70,000 and does not exceed $72,000; 34 per centum of the amount by which the net income exceeds $72,000 and does not exceed $74,000; 35 per centum of the amount l)y whicli tiie net income exceeds $74,000 and docs not exceed $76,000; 36 per centum of the amount by whicli the net' income exceeds $76,000 and does not exceed $78,000; 2,^ per centum of the amount by which the net income exceeds $78,000 and does not exceed $80,000; 38 per centum of the amount by wliich the net income exceeds $80,000 and does not exceed $82,000; 39 per centum of the amount by which the net income exceeds $82,000 and does not exceed $84,000; 40 per centum of the amount by which the net income exceeds $84,000 and does not exceed $86,000; 41 per centum of the amount by which the net income exceeds $86,000 and does not exceed $88,000; 42 per centum of the amount by wliich the net income exceeds $88,000 and does not exceed $90,000; 43 per centum of the amount by which the net income exceeds $90,000 and does not exceed $92,000; 44 per centum of the amount by which the net income exceeds $92,000 and docs not exceed $94,000; 1^38 REVENUE ACT OF 1921 45 per centum of the amount by which the net income exceeds $94,000 and does not exceed $96,000; 46 per centum of the amount by which the net income exceeds $96,000 and does not exceed $98,000; 47 per centum of the amount by which the net income exceeds $98,000 and does not exceed $100,000; 48 per centum of the amount liy which the net income exceeds $100,000 and does not exceed $150,000; 49 per centum of the amount by which the net income exceeds $150,000 and does not exceed $200,000; 50 per centum of the amount by which the net income exceeds $200,000. (b) In the case of a bona fide sale of mines, oil or gas wells, or any interest therein, where the principal value of the property has been dem- onstrated by prospecting or exploration and discovery work done by the taxpayer, the portion of the tax imposed by this section attributable to such sale shall not exceed, for the calendar year 1921, 20 per centum, and for each calendar 3'ear thereafter 16 per centum of the selling price of such property or interest. Net Income of Individuals Defined Sec. 212. (a) That in the case of an individual the term "net in- come" means the gross income as defined in section 213, less the deductions allowed by section 214. (b) The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keep- ing the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. If the taxpayer's annual accounting period is other than a fiscal year as defined in section 200 or if the taxpayer has no annual accounting period or does not keep books, the net income shall be computed on the basis of the calendar year. (c) If a taxpayer changes his accounting period from fiscal year to calendar year, from calendar year to fiscal year, or from one fiscal year to another, the net income shall, with the approval of the Commis- sioner, be computed on the basis of such new accounting period, subject t'o the provisions of section 226. Gross Income Defined Sec. 213. That for the purposes of this title (except as otherwise pro- vided in section 233) the term "gross income" — (a) Includes gains, profits, and income derived from salaries, wages, or compensation for personal service (including in the case of the Presi- dent of the United States, the judges of the Supreme and inferior courts REVENUE ACT OF 1921 I73() of the United States, and all other officers and employees, whether elected or appointed, of the United States, Alaska, Hawaii, or any political sub- division thereof, or the District of Columbia, the compensation received as such), of whatever kind and in whatever form paid, or from pro- fessions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property ; also from interest, rent, dividends, secur- ities, or the transaction of any business carried on for gain or profit, or gains or profit's, and income derived from any source whatever. The amount of all such items (except as provided in subdivision (e) of section 201) shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting per- mitted under subdivision (b) of section 212, any such amounts are to be properly accounted for as of a different period; but (b) Does not include the following items, which shall be exempt from taxation under this title : (i) The proceeds of life insurance policies paid upon the death of tile insured; (2) The amount received by the insured as a return of premium or premiums paid by him under life insurance, endowment, or annuity con- tracts, either during the term, or at the maturity of the term mentioned in the contract or upon surrender of the contract ; (3) The value of property acquired by gift, bequest, devise, or descent (but the income from such property shall be included in gross income) ; (4) Interest upon (a) the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia; or (b) secur- ities issued under the provisions of the Federal Farm Loan Act of July 17, 1916; or (c) the obligations of the United States or its possessions; or (d) bonds issued by the War Finance Corporation. In the case of obligations of the United States issued after September i, 1917 (other than postal saving certificates of deposit) and in the case of bonds issued by the War Finance Corporation, the interest shall be exempt only if and to the extent provided in the respective Acts authorizing the issue thereof as amended and supplemented and shall be excluded from gross income only if and to the extent it is wholly exempt to the taxpayer from income, war-profits and excess-profits taxes ; (5) The income of foreign governments received from investments in the United States in stocks, bonds, or other domestic securities, owned by such foreign governments, or from interest on deposits in banks in the United States of moneys belonging to such foreign governments, or from any other source within the United States ; (6) Amounts received, through accident or heallli insurance or under workmen's compensation acts, as compensation for personal injuries or sickness, plus the amount of any damages received whether by suit or agreement on account of such injuries or sickness; (7) Income derived from any public utility or the exercise of any I740 REVENUE ACT OF 1921 essential governmental function and accruing to any State, Territory, or the District of Columbia, or any political subdivision of a State or Ter- ritory, or income accruing to the Government of any possession of the United States, or any political subdivision thereof. Whenever any State, Territory, or the District of Columbia, or any political subdivision of a State or Territory, prior to September 8, 1916, entered in good faith into a contract with any person, the object and pur- pose of which is to acquire, construct, operate, or maintain a public utility, no tax shall be levied under the provisions of this title upon the income derived from the operation of such public utility, so far as the payment thereof will impose a loss or burden upon such State, Territory, District of Columbia, or political subdivision; but this provision is not intended and shall not be construed to confer upon such person any financial gain or exemption or to relieve such person from the payment of a tax as provided for in this title upon the part or portion of such income fo which such person is entitled under such contract ; (8) The income of a nonresident alien or a foreign corporation which consists exclusively of earnings derived from the operation of a ship or ships documented under the laws of a foreign country which grants an equivalent exemption to citizens of the United States and to corporations organized in the United States ; (9) Amounts received as compensation, family allotments and allow- ances under the provisions of the War Risk Insurance and the Vocational Rehabilitation Acts, or as pensions from the United States for service of fhe beneficiary or another in the military or naval forces of the United States in time of war; (10) So much of the amount received by an individual after December 31, 1921, and before January i, 1927, as dividends or interest from domestic building and loan associations, operated exclusively for the purpose of making loans to members, as does not exceed $300; (11) The rental value of a dwelling house and appurtenances thereof furnished to a minister of the gospel as part of his compensation ; (12) The receipts of shipowners' mutual protection and indemnity associations, not organized for profit, and no part of that net earnings of which inures to the benefit of any private stockholder or member but such corporations shall be subject as other persons to the tax upon their net income from interest, dividends, and rents. (c) In the case of a nonresident alien individual, gross income means only the gross income from sources within the United States, determined under the provisions of section 217. Deductions Allowed Individuals Sec. 214. (a) That in computing net income there shall be allowed as deductions : (i) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable REVENUE ACT OF 1921 1 741 allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity; (2) All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obliga- tions or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title ; (3) Taxes paid or accrued within the taxable year except (a) income, war-profits, and excess-profits taxes imposed by the authority of the United States, (b) so much of the income, war-profits and excess-profits taxes, imposed by the authority of any foreign country or possession of the United States, as is allowed as a credit under section 222 (c) taxes assessed against local benefits of a kind tending to increase the value of the prop- erty assessed, and (d) taxes imposed upon the taxpayer upon his interest as shareholder or member of a corporation, which are paid by the cor- poration without reimbursement from the taxpayer. For the purpose of this paragraph estate, inheritance," legacy, and succession taxes acrue on the due date thereof except as otherwise provided by the law of the jurisdiction imposing such taxes; (4) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in trade or business; (5) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in any transaction entered into for profit, though not connected with the trade or business ; but in the case of a nonresident alien individual only if and to the extent that the profit, if such transaction had resulted in a profit, would be taxable under this title. No deduction shall be allowed under this paragraph for any loss claimed to have been sustained in any sale or other disposition of shares of stock or securities made after the passage of this Act where it appears that within thirty days before or after the date of such sale or other dis- position the taxpayer has acquired (otherwise than by bequest or in- heritance) substantially identical property, and the property so acquired is held by the taxpayer for any period after such sale or other disposition. If such acquisition is to the extent of part only of substantially identical property, then only a proportionate part of the loss shall be disallowed ; (6) Losses sustained during the taxable year of property not con- nected with the trade or business (but in the case of a nonresident alein individual only property within the United States) if arising from fires, storms, shipwreck, or other casualty, or from theft, and if not com- pensated for by insurance or otherwise. Losses allowed under paragraphs (4), (5), and (6) of this subdivision shall be deducted as of the taxable 1742 REVENUE ACT OF 1921 year in which sustained unless, in order to clearly reflect the income, the loss should, in the opinion of the Commissioner, be accounted for as of a different period. In case of losses arising from destruction of or damage to property, where the property so destroyed or damaged was acquired before March i, 1913, the deductions shall be computed upon the basis of its fair market price or value as of March i, 1913; (7) Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addi- tion to a reserve for bad debts) ; and when satisfied that a debt is recover- able only in part, the Commissioner may allow such debt to be charged ofif in part; (8) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. In the case of such property acquired before Alarch i, 1913, this deduction shall be computed upon the basis of its fair market price or value as of March i, 1913; (9) In the case of buildings, machinery, equipment, or other facilities, constructed, erected, installed, or acquired, on or after April 6, 1917, for the production of articles contributing to the prosecution of the war against the German Government, and in the case of vessels constructed or acquired on or after such date for the transportation of articles or men contributing to the prosecution of such' war, there shall be allowed, for any taxable year ending before March 3, 1924 (if claim therefor was made at the time of filing return for the taxable year 1918, 1919, 1920, or 1921) a reasonable deduction for the amortization of such part of the cost of such facilities or vessels as has been borne by the taxpayer, but not again including any amount otherwise allowed under this title or previous Act of Congress as a deduction in computing net income. At any time before March 3, 1924, the Commissioner may, and at the request of the taxpayer shall, reexamine the return, and if he then finds as a result of an appraisal or from other evidence that the deduction originally allowed was incorrect, the income, war-profits, and excess-profits taxes for the year or years affected shall be redetermined; and the amount of tax due upon such redetermination, if any, shall be paid upon notice and demand by the collector, or the amount of tax overpaid, if any, shall be credited or refunded to the taxpayer in accordance with the provisions of section 252 ; (10) In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case, based upon cost including cost of development not otherwise deducted : Provided, That in the case of such properties acquired prior to March i, 1913, the fair market value of the property (or the taxpayer's interest therein) on that date shall be taken in lieu of cost up to that date : Provided further. That in the case of mines, oil and gas wells, discovered by the taxpayer, on or after March i, 1913, and not acquired as the result of REVENUE ACT OF 1921 1 743 purchase of a proven tract or lease, where the fair market value of the property is materially disproportionate to the cost, the depletion allow- ance shall be based upon the fair market value of the property at the date of the discovery, or within thirty days thereafter : And provided further, That such depletion allowance based on discovery value shall not exceed the net income, computed without allowance for depletion, from the property upon which the discovery is made, except where such net income so computed is less than the depletion allowance based on cost' or fair market value as of March i, 1913; such reasonable allowance in all the above cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary. In the case of leases the deductions allowed by this paragraph Shall be equitably ap- portioned between the lessor and lessee; (11) Contributions or gifts made within the taxable year to or for the use of : (A) The United States, any State, Territory, or any political sub- division thereof, or the District of Columbia, for exclusively public pur- poses; (B) any corporation, or community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, including posts of the American Legion or the women's auxiliary units thereof, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual; or (C) the special fund for vocational rehabilitation authorized by section 7 of the Vocational Rehabilitation Act; to an amount which in all the above cases combined does not exceed 15 per centum of the taxpayer's net income as computed without the benefit of this paragraph. In case of a nonresident alien individual this deduction shall be allowed only as to contributions or gifts made to domestic corporations, or to community chest's, funds or found- ations, created in the United States, or to such vocational rehabilitation fund. Such contributions or gifts shall be allowable as deductions only if verified under rules and regulations prescribed by the Commissioner, with the approval of the Secretary; (12) If property is compulsorily or involuntarily converted into cash or its equivalent as a result of (A) its destruction in whole or in part, (B) theft or seizure, or (C) an exercise of the power of requisition or condemnation, or the threat or imminence thereof; and if the taxpayer proceeds forthwith in good faith, under regulations prescribed by the Commissioner with the approval of the Secretary, to expend the proceeds of such conversion in the acquisition of other property of a character similar or related in service or use to the property so converted, or in the acquisition of 80 per centum or more of the stock or shares of a cor- poration owning such other property, or in the establishment of a re- placement fund, then there shall be allowed as a deduction such portion of a gain derived as the portion of the proceeds so expended bears to th« entire proceeds. The provisions of this paragraph prescribing the con- ditions under which a deduction may be taken in respect of the proceeds 1744 REVENUE ACT OF 1921 or gains derived from the compulsory or involuntary conversion of property into cash or its equivalent, shall apply so far as may be practicable to the exemption or exclusion of such proceeds or gains from gross income under prior income, war-profits and excess-profits fax acts. (b) In the case of a nonresident alien individual, the deductions al- lowed in subdivision (a), except those allowed in paragraphs (5), (6), and (11), shall be allowed only if and to the extent that they are con- nected with income from sources within the United States ; and the proper apportionment and allocation of the deductions with respect to sources of income within and without the United States shall be deter- mined as provided in section 217 under rules and regulations prescribed by the Commissioner with the approval of the Secretary. In the case of a citizen entitled to the benefits of section 262 the deductions shall be the same and shall be determined in the same manner as in the case of a non- resident alien individual. Items Not Deductible Sec. 215. (a) That in computing net income no deduction shall in any case be allowed in respect of — (i) Personal, living, or family expenses; (2) Any amount paid out for new buildings or for permanent im- provements or betterment's made to increase the value of any property or estate; (3) Any amount expended in restoring property or in making good the exhaustion thereof for w^hich an allowance is or has been made; or (4) Premiums paid on any life insurance policy covering the life of any officer or employee, or of any person financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or indirectly a beneficiary under such policy. (b) Amounts paid under the laws of any State, Territory, District' of Columbia, possession of the United States, or foreign country as income to the holder of a life or terminable interest acquired by gift, bequest, or inheritance shall not be reduced or diminished by any deduction for shrinkage (by whatever name called) in the value of such interest due to the lapse of time, nor by any deduction allowed by this Act for the purpose of computing the net income of an estate or trust but not allowed under the laws of such State, Territory, District of Columbia, possession of the United States, or foreign country for the purpose of compufiner the income to which such holder is entitled. Credits Allowed Individuals Sec. 216. That for the purpose of the normal tax onlv there shall be allowed the following credits : (a) The amount received as dividends (i) from a domestic corpora- tion other than a corporation entitled to the benefits of section 262. or (2) from a foreign corporation when it is shown to the satisfaction of the REVENUE ACT OF 1921 1 745 Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends for for such part of such ceriod as the corporation has been in existence") was derived from sources within the United States as determined under the orovisions of section 217; (b) The amount received as interest upon obligations of the United States and bonds issued by the War Finance Corporation, which is in- cluded in gross income under section 213 ; (c) In the case of a single person, a personal exemption of $1,000 ; or in the case of the head of a family or a married person living with husband or wife, a personal exemption of $2,500, unless the net income is in excess of $5,000, in which case the personal exemption shall be $2,000. A hus- band and wife living together shall receive but one personal exemption. The amount of such personal exemption shall be $2,500, unless the aggregate net income of such husband and wife is in excess of $S,ooo, in which case the amount of such personal exemption shall be $2,000. If such husband and wife make separate returns, the personal exemption may be taken by either or divided between them. In no case shall the reduction of the personal exemption from $2,500 to $2,000 operate to increase the tax, which would be payable if the exemption were $2,500, by more than the amount of the net income in excess of $5,000; (d) $400 for each person (other than husband or wife) dependent upon and receiving his chief support from the taxpayer if such dependent person is under eighteen years of age or is incapable of self-support be- cause mentally or physically defective. (e) In the case of a nonresident alien individual or of a citizen entitled to the benefits of section 262, the personal exemption shall be only $1,000, and he shall not be entitled to the credit provided in subdivision (d). (f) The credits allowed by subdivisions (c), (d), and (e) of this section shall be determined by the status of the taxpayer on the last day of the period for which the return of income is made; but in the case of an individual who dies during the taxable year, such credits shall be determined by his status at the time of his death, and in such case full credits shall be allowed to the surviving spouse, if any, according to his or her status at the close of the period for which such survivor makes return of income. Net Income of Nonresident Alien Individuals Sec. 217. (a) That' in the case of a nonresident alien individual or of a citizen entitled to the benefits of section 262, the following items of gross income shall be treated as income from sources within the United States : (i) Interest on bonds, notes, or otlicr interest-bearing obligations of residents, corporate or otherwise, not including (A) interest on deposits with persons carrying on the banking business paid to persons not engaged 1746 REVENUE ACT OF 1921 in business with the United States and not having an office or place of business therein, or (B) interest received from a resident alien individual or a resident foreign corporation when it is shown to the satisfaction of the Commissioner that less than 20 per centum of the gross income of such resident payor has been derived from sources within the United States, as determined under the provisions of this section, for the three-year period ending with the close of the taxable year of such payor, or for such part of such period immediately preceding the close of such taxable year as may be applicable ; (2) The amount received as dividends (A) from a domestic corpora- tion other than a corporation entitled to the benefits of section 262, or (B) from a foreign corporation unless less than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such part of such period as the corporation has been in existence) was derived from sources within the United States as de- termined under the provisions of this section; (3) Compensation for labor or personal services performed in the United States; (4) Rentals or royalties from property located in the United States or from any interest in such property, including rentals or royalties for the use of or for the privilege of using in the United States, patents, copyrights, secret processes and formulas, good will, trade-marks, trade brands, fran- chises, and other like property; and (5) Gains, profits and income from the sale of real property located in the United States. (b) From the items of gross income specified in subdivision (a) there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full at net income from sources within the United States. (c) The following items of gross income shall be treated as income from sources without the United States : (i) Interest other than that derived from sources within the United States as provided in paragraph (i) of subdivision (a) ; (2) Dividends other than those derived from sources within the United States as provided in paragraph (2) of subdivision (a) ; (3) Compensation for labor or personal service performed without the United States ; (4) Rentals or royalties from property located without the United States or from any interest in such property, including rentals or royalties for the use of or for the privilege of using without the United States, patents, copyrights, secret processes and formulas, good will, trade-marks, trade brands, franchises, and other like property; and REVENUE ACT OF 1921 1747 (S) Gains, profits, and income from the sale of real property located without the United States ; (d) From th-e items of gross income specified in subdivision (c) there shall be deducted the expenses, losses, and other deductions properly ap- portioned or allocated thereto, and a ratable part of any expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income. The remainder, if any, shall be treated in full as net income from sources without the United States. (e) Items of gross income, expenses, losses and deductions, other than those specified in subdivisions (a) and (c), shall be allocated or apportioned to sources within or without the United States under rules and regulations prescribed bj' the Commissioner with the approval of the Secretary. Where items of gross income are separately allocated to sources within the United States, there shall be deducted (for the purpose of computing the net income therefrom) the expenses, losses and other deductions properly apportioned or allocated thereto and a ratable part of other expenses, losses or other deductions which can not definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as net income from sources within the United States. In the case of gross income derived from sources partly within and partly without the United States, the net income may first be computed by deducting the expenses, losses or other deductions apportioned or allocated thereto and a ratable part of any expenses, losses or other deductions which can not definitely be allocated to some item or class of gross in- come; and the portion of such net income attributable to sources within the United States may be determined by processes or formulas of general apportionment prescribed by the Commissioner with the approval of the Secretary. Gains, profits and income from (i) transportation or other services rendered partly within and partly without the United States, or (2) from the sale of personal property produced (in whole or in part) by the taxpayer within and sold without the United States, or produced (in whole or in part) by the taxpayer without and sold within the United States, shall be treated as derived partly from sources within and partly from sources without the United States. Gains, profits and income derived from the purchase of personal property within and its sale without the United States or from the purchase of personal property without and its sale within the United States, shall be treated as derived entirely from the country in which sold. (f) As used in this section the words "sale" or "sold" include "ex- change" or "exchanged" ; and the word "produced" includes "created," "fab- ricated," "manufactured," "extracted," "processed," "cured," or "aged." (g) A nonresident alien individual or a citizen entitled to the benefits of section 262 shall receive the benefit of the deductions and credits allowed in this title only by filing or causing to be filed with the collector a true and accurate return of his total income received from all sources corporate or otherwise in the United States in the manner prescribed in this title; f748 REVENUE ACT OF 1921 including therein all the information which the Commissioner may deem, necessary for the calculation of such deductions and credits: Provided, That the benefit of the credit allowed in subdivision (e)' of section 216 may, in the discretion of the Commissioner, be received by filing a claim therefor with the withholding agent. In case of failure to file a return, the collector shall collect the tax on such income, and all property belonging to such nonresident alien individual or foreign trader shall be liable to distraint for the tax. Partnerships and Personal Service Corporations Sec. 218. (a) That individuals carrying on business in partnership shall be liable for income tax only in their individual capacity. There shall be included in computing the net income of each partner his dis- tributive share, whether distributed or not, of the net income of the part- nership for the taxable year, or, if his net income for such taxable year is computed upon the basis of a period different from that upon the basis of which the net income of the partnership is computed, then his distributive share of the net income of the partnership for any account- ing period of the partnership ending within the fiscal or calendar year uppn the basis of which the partner's net income is computed. (b) The partner shall, for the purpose of the normal tax, be allowed as credits, in addition to the credit's allowed to him under section 216, his proportionate share of such amounts specified in subdivisions (a) and (b) of section 216 as are received by the partnership. (c) The net income of the partnership shall be computed in the same manner and on the same basis as provided in section 212 except that the deduction provided in paragraph (11) of subdivision (a) of section 214 shall not be allowed. (d) Personal service corporations shall not be subject to taxation under this title, but the individual stockholders thereof shall be taxed in the same manner as the members of partnerships. All the provisions of this title relating to partnerships and the members thereof shall so far as practicable apply to personal service corporations ^nd the stockholders thereof : Provided, That for the purpose of this subdivision amounts distri- buted by a personal service corporation during its taxable year shall be accounted for by the distributees; and any portion of the net income remaining undistributed at the close of its taxable year shall be accounted for by the stockholders of such corporation at the close of its taxable year in proportion to their respective shares. This subdivision shall not be in effect after December 31, 1921. In the case of a personal service corporation having a fiscal year beginning in 1921 and ending in 1922, amounts distributed prior to January I, 1922, to its stockholders out of earnings or profits accumulated after December 31, 1920, shall be taxed to the distributees ; and the stockholders of record on December 31, 1921, shall be taxed upon their distributive shares of the difference (if any) between such distributive profits and the portion REVENUE ACT OF 1921 1 749 of the corporation's net income assignable to the calendar year 1921, de- termined in the manner provided in clause (i) of subdivision (c) of section 205 of this Act. Estates and Trusts Sec. 219. (a) That the tax imposed by sections 210 and 211 shall apply fo the income of estates or of any kind of property held in trust, in- cluding — (i) Income received by estates of deceased persons during the period of administration or settlement of the estate; (2) Income accumulated in trust for the benefit of unborn or un- ascertained persons or persons with contingent int'erests ; (3) Income held for future distribution under the terms of the will or trust; and (4) Income which is to be distributed to the beneficiaries periodically, whether or not at regular intervals, and the income collected by a guardian of an infant to be held or distributed as the court may direct. (b) The fiduciary shall be responsible for making the return of income for the estate or trust for which he acts. The net income of the estate or trust shall be computed in the same manner and on the same basis as provided in section 212, except that (in lieu of the deduction authorized by paragraph (11) of subdivision (a) of section 214) there shall also be allowed as a deduction, without limitation, any part of the gross income which, pursuant to the terms of the will or deed creating the trust, is during the taxable year paid or permanently set aside for the purposes and in the manner specified in paragraph (11) of subdivision (a) of section 214. In cases in which there is any income of the class described in paragraph (4) of subdivision (a) of this section the fiduciary sliall include in the return a statement of the income of the estate or trust which, pursuant to the instrument or order governing the distribution, is distributable to each beneficiary, whether or not distributed before the close of the taxable year for which the return is made. (c) In cases under paragraphs (i), (2), or (3) of subdivision (a) or in any other case within subdivision (a) of this section except para- graph (4) thereof the tax shall be imposed upon the net income of the estate or trust and shall be paid l)y the fiduciary, except that in determin- ing the net income of the estate of any deceased person during the period of administration or settlement there may be deducted the amount of any income properly paid or credited to any legatee, heir or other beneficiary. In such cases the estate or trust shall, for the purpose of the normal tax, be allowed the same credits as are allowed to single persons under section 216. (d) In cases under paragraph (4) of subdivision (a), and in the case of any income of an estate during the period of administration or settle- ment permitted by subdivision (c) to be deducted from the net income upon which tax is to be paid by the fiduciary, the tax shall not be paid I750 REVENUE ACT OF 1921 by the fiduciary, but there shall be included in computing the net income of each beneficiary that part of the income of the estate or trust for its taxable year which, pursuant to the instrument or order governing the distribution, is distributable to such beneficiary, whether distributed or not, or, if his taxable year is different from that of the estate or trust, then there shall be included in computing his net income his distributive share of the income of the estate or trust for its taxable year ending within the taxable year of the beneficiary. In such cases the beneficiar>' shall, for the purpose of the normal tax, be allowed as credits, in addition to the credits allowed to him under section 216, his proportionate share of such amounts specified in subdivisions (a) and (b) of section 216 as are received by the estate or trust. (e) In the case of an estate or trust the income of which consists both of income of the class described in paragraph (4) of subdivision (a) of this section and other income, the net income of the estate or trust shall be computed and a return thereof made by the fiduciary in accordance with subdivision (b) and the tax shall be imposed, and shall be paid by the fiduciary in accordance with subdivision (c), except that there shall be allowed as an additional deduction in computing the net income of the estate or trust that part of its income of the class described in para- graph (4) of subdivision (a) which, pursuant to the instrument or order governing the distribution, is distributable during its taxable year to the beneficiaries. In cases under this subdivision there shall be included, as provided in subdivision (d) of this section, in computing the net income of each beneficiary, that part of the income of the estate or trust which, pursuant to the instrument or order governing the distribution, is distribut- able during the taxable j^ear to such beneficiary. (f) A trust created by an employer as a part of a stock bonus or profit-sharing plan for the exclusive benefit of some or all of his em- ployees, to which contributions are made by such employer, or employees, or both, for the purpose of distributing to such employees the earnings and principal of the fund accumulated by the trust in accordance with such plan, shall not be taxable under this section, but the amount 'actually dis- tributed or made available to any distributee shall be taxable to him in the year in which so distributed or made available to the extent that it exceeds the amounts paid in by him. Such distributees shall for the purpose of the normal tax be allowed as credits that part of the amount so distributed or made available as represents the items specified in subdivisions (a) and (b) of section 216. Evasion of Surtaxes by Incorporation Sec. 220. That if any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its stockholders or members through the medium of per- mitting its gains and profits to accumulate instead of being divided or dis- tributed, there shall be levied, collected, and paid for each taxable year REVENUE ACT OF 1921 - 1751 upon the net income of such corporation a tax equal to 25 per centum of the amount thereof, which shall be in addition to the tax imposed by section 230 of this title and shall be computed, collected, and paid upon the same basis and in the same manner and subject to the same pro- visions of law, including penalties, as that tax : Provided, That if all the stockholders or members of such corporation agree thereto, the Com- missioner may, in lieu of all income, war-profits and excess-profit's taxes imposed upon the corporation for the taxable year, tax the stockholders or members of such corporation upon their distributive shares in the net income of the corporation for the taxable year in the same manner as provided in subdivision (a) of section 218 in the case of members of a partnership. The fact that any corporation is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a pur- pose to escape the surtax; but the fact that the gains and profits are in any case permitted to accumulate and become surplus shall not be con- strued as evidence of a purpose to escape the tax in such case unless the Commissioner certifies that in his opinion such accumulation is unreason- able for the purposes of the business. When requested by the Com- missioner, or any collector, every corporation shall forward to him a correct statement of such gains and profits and the names and addresses of the individuals or shareholders who would be entitled to the same if divided or distributed, and of the amounts that would be payable to each. Payment of Individual's Tax at Source Sec. 221. (a) That all individuals, corporations, and partnerships, in whatever capacity acting, including lessees or mortgagors of real or per- sonal property, fiduciaries, employers, and all officers and employees of the United States having the control, receipt, custody, disposal, or pay- ment of interest (except interest on deposits with persons carrying on the banking business paid to persons not engaged in business in the United States and not having an office or place of business therein), rent, salaries, wages, premiums, annuities, compensations, remunerations, emol- uments, or other fixed or determinable annual or periodical gains, profits, and income, of any nonresident alien individual or partnership composed in whole or in part of nonresident aliens (other than income received as dividends of the class allowed as a credit by subdivision (a) of section 216) shall (except in the cases provided for in subdivision (b) and except as otherwise provided in regulations prescribed by the Commissioner under section 217) deduct and withhold from such annual or periodical gains, profits and income a tax equal to 8 per centum thereof : Provided, That the Commissioner may authorize such tax to be deducted and with- held from the interest upon any securities the owners of which are not known to the withholding agent. (b) In any case where bonds, mortgages, or deeds of trust, or other 1752 REVENUE ACT OF 1921 similar obligations of a corporation contain a contract or provision by which the obligor agrees to pay any portion of the tax imposed by this title upon the obligee, or to reimburse the obligee for any portion of the tax, or to pay the interest without deduction for any tax which the obligor may be required or permitted to pay thereon, or to retain there- from under any law of the United States, the obligor shall deduct and withhold a tax equal to 2 per centum of the interest upon such bonds, mortgages, deeds of trust, or other obligations, whether such. interest is payable annually or at shorter or longer periods and whether payable to a nonresident alien individual or to an individual citizen or resident of the United States or to a partnership : Provided, That the Commissioner may authorize such tax to be deducted and withheld in the case of interest upon any such bonds, mortgages, deeds of trust, or other obligations, the owners of which are not known to the withholding agent. Such de- duction and withholding shall not be required in the case of a citizen or resident entitled to receive such interest, if he files with the with- holding agent on or before February i a signed notice in writing claiming the benefit of the credits provided in subdivisions (c) and (d) of section 216; nor in the case of a nonresident alien individual if so provided for in regulations prescribed by the Commissioner under subdivision (g) of section 217. (c) Every individual, corporation, or partnership required to deduct and withhold any tax under this section shall make return thereof on or before March i of each year and shall on or before June 15 pay the tax to the official of the United States Government authorized to receive it. Every such individual, corporation, or partnership is hereby made liable for such tax and is hereby indemnified against the claims and demands of any individual, corporation, or partnership for the amount of any pay- ment made in accordance with the provisions of this section. (d) Income upon which any tax is required to be withheld at the source under this section shall be included in the return of the recipient of such income, but any amount of tax so withheld shall be credited against the amount of income tax as computed in such return. (e) If any tax required under this section to be deducted and with- held is paid by the recipient of the income, it shall not be re-collected from the withholding agent ; nor in cases in which the tax is so paid shall any penalty is imposed upon or collected from the recipient of the income or the withholding agent for failure to return or pay the same, unless such failure was fraudulent and for the purpose of evading payment. Credit for Taxes in Case of Individuals Sec. 222. (a) That the tax computed under Part II of this title shall be credited with : (i) In the case of a citizen of the United States the amount of any income, war-profits and excess-profits taxes paid during the taxable year to any foreign country or to any possession of the United States; and REVENUE ACT OF 1921 1 753 (2) In the case of a resident of the United States, the amount of any such taxes paid during the taxable year to any possession of the United States ; and (3) In the case of an alien resident of the United States, the amount of any such taxes paid during the taxable year to any foreign country, if the foreign country of which such alien resident is a citizen or subject, in imposing such taxes, allows a similar credit to citizens of the United States residing in such country ; and (4) In the case of any such individual who is a member of a partner- ship or a beneficiary of an estate or trust, his proportionate share of such taxes of the partnership or the estate or trust paid during the taxable year to a foreign country or to any possession of the United States, as the case may be. (5) The above credit's shall not be allowed in the case of a citizen entitled to the benefits of section 262 ; and in no other case shall the amount of credit, taken under this subdivision exceed the same proportion of the tax, against which such credit is taken, which the taxpayer's net income (computed without deduction for any income, war-profits and excess- profits taxes imposed by any foreign country or possession of the United States) from sources without the United States bears to his entire net income (computed without such deduction) for the same taxable year. (b) If accrued taxes when paid differ from the amounts claimed as credits by the taxpaj-er, or if any tax paid is refunded in whole or in part, the taxpayer shall notify the Commissioner, who shall redetermine the amount of the tax due under Part II of this title for the year or years affected, and the amount of tax due upon such redetermination, if any, shall be paid by the taxpayer upon notice and demand by the col- lector, or the amount of tax overpaid, if any, shall be credited or refunded to the taxpayer in accordance with the provisions of section 252. In the case of such a tax accrued but not paid, the Commissioner as a condi- tion precedent to the allowance of this credit may require the taxpayer to give a bond with sureties satisfactory to and to be approved by the Commissioner in such penal sum as the Commissioner may require, condi- tioned for the payment by the taxpayer of any amount of tax found due upon any such redetermination ; and the bond herein prescribed shall con- fain such further conditions as the Commissioner may require. (c) These credits shall be allowed only if the taxpayer furnishes evidence satisfactory to the Commissioner showing the amount of income derived from sources without the United States, and all other information necessary for the verification and computation of such credits. (d) If the taxpayer makes a return for a fiscal year beginning in 1920 and ending in 1921, the credit for the entire fiscal year shall, not- withstanding any provision of this Act, be determined under the provisions of this section ; and the Commissioner is authorized to disallow, in whole or part, any such credit which he finds has already been taken by the taxpayer. 1754 REVENUE ACT OF 1921 Individual Returns Sec. 223. (a) That the following individuals shall each make under oath a return stating specifically the items of his gross income and the deductions and credits allowed under this title — (i) Every individual having a net income for the taxable year of $1,000 or over, if single, or if married and not living with husband or wife; (2) Every individual having a net income for the taxable year of $2,000 or over, if married and living with husband or wife; and (3) Every individual having a gross income for the taxable year of $5,000 or over, regardless of the amount of his net income. (b) If a husband and wife living together have an aggregate net income for the taxable year of $2,000 or over, or an aggregate gross income for such year of $5,000 or over — (i) Each shall make such a return, or (2) The income of each shall be included in a single joint return, in which case the tax shall be computed on the aggregate income. (c) If the taxpayer is unable to make his own return, the return shall be made by a duly authorized agent or by the guardian or other person charged with the care of the person or property of such taxpayer. Partnership Returns Sec. 224. That every partnership shall make a return for each tax- able year, stating specifically the items of its gross income and the de- ductions allowed by this title, and shall include in the return the names and addresses of the individuals who would be entitled to share in the net income if distributed and the amount of the distributive share of each individual. The return shall be sworn to by any one of the partners. Fiduciary Returns Sec. 225. (a) That every fiduciary (except a receiver appointed by authority of law in possession of part only of the property of an individual) shall make under oath a return for any of the following individuals, estates, or trusts for which he acts, stating specifically the items of gross income thereof and the deductions and credits allowed under' this title — (i) Every individual having a net income for the taxable year of $1,000 or over, if single, or if married and not living with husband or wife; (2) Every individual having a net income for the taxable year of $2,000 or over, if married and living with husband or wife; (3) Every individual having a gross income for the taxable year of $5,000 or over, regardless of the amount of his net income; (4) Every estate or trust the net income of which for the taxable year is $1,000 or over; and (5) Every estate or trust of which any beneficiary is a nonresident alien. (b) Under such regulations as the Commissioner with the approval REVENUE ACT OF 1921 1 75 5 of the Secretary may prescribe a return made by one of two or more joint fiduciaries and filed in the office of the collector of the district where such fiduciary resides shall be sufficient compliance with the above requirement. Such fiduciary shall make oath (i) that he has sufficient knowledge of the affairs of the individual, estate or trust for which the return is made, to enable him to make the return, and (2) that the return is to the best of his knowledge and belief, true and correct. Any fiduciary required to make a return under this Act shall be subject to all the provisions of this Act which apply to individuals. Returns for a Period of Less Than Twelve Months Sec. 226. (a) That if a taxpayer, with the approval of the Com- missioner, changes the basis of computing net income from fiscal year to calendar year a separate return shall be made for the period between the close of the last fiscal year for which return was made and the following December 31. If the change is from calendar year to fiscal year, a separate return shall be made for the period between the close of the last" calendar year for which return was made and the date designated as the close of the fiscal year. If the change is from one fiscal year to another fiscal year a separate return shall be made for the period between the close of the former fiscal year and the date designated as the close of the new fiscal year. (b) In all cases where a separate return is made for a part of a taxable year the net income shall be computed on the basis of such period for which separate return is made, and the tax shall be paid thereon at the rate for the calendar year in which such period is included- (c) In the case of a return for a period of less than one year the net income shall be placed on an annual basis by multiplying the amount thereof by twelve and dividing by the number of months included in such period; and the tax shall be such part of a tax computed on such annual basis as the number of months in such period is of twelve months. Time and Place for Filing Individual, Partnership, and Fiduciary Returns Sec. 227. (a) That returns (except in the case of nonresident aliens) shall be made on or before the fifteenth day of the third month following the close of the fiscal year, or, if the return is made on the basis of the calendar year, then the return shall be made on or before the 15th day of March. In the case of a nonresident alien individual returns shall be made on or before the fifteenth day of the sixth month following the close of the fiscal year, or, if the return is made on the basis of the calendar year, then the return shall be made on or before the isth day of June. The Commissioner may grant a reasonable extension of time for filing returns whenever in his judgment good cause exists and shall keep a record of every such extenr.ion and the reason therefor. Except in the case of taxpayers who are abroad, no such extension shall be for more than six months. 1756 REVENUE ACT OF 1921 (b) Returns shall be made to the collector for the district in which is located the legal residence or principal place of business of the person making the return, or, if he has no legal residence or principal place of business in the United States, then to the collector at Baltimore, Mary- land. Understatement in Returns Sec. 228. That if the collector or deputy collector has reason to believe that the amount of any income returned is understated, he shall give due notice to the taxpayer making the return to show cause why the amount of the return should not be increased, and upon proof of the amount understated, may increase the same accordingly. Such taxpayer may furnish sworn testimony to prove any relevant fact's and if dissatisfied with the decision of the collector may appeal to the Commissioner for his decision, under such rules of procedure as may be prescribed by the Commissioner with the approval of the Secretary. Incorporation of Individual or Partnership Business Sec. 22g. That in the case of the organization as a corporation within four months after the passage of this act of any trade or business in which capital is a material income-producing factor, and which was pre- viously owned by a partnership or individual, the net income of such trade or business from January i, 1921, to the date of such organization may at the option of the individual or partnership be taxed as the net income of a corporation is taxed under Titles II and III ; in which event the net income and .invested capital of such trade or business shall be com- puted as if such corporation had been in existence on and after January I, 1921, and the undistributed profits or earnings of such trade or business shall not be subject to the surtaxes imposed in section 211, but amounts distributed on and after January i, 1921, from the earnings or profits of such trade or business accumulated after December 31, 1920, shall be taxed to the recipients as dividends ; and all the provisions of Titles II and III relating to corporations shall so far as practicable apply to such trade or business : Provided, That this section shall not apply to any trade or business, the net income of which for the taxable year 1921 was less than 20 per centum of its invested capital for such year: Provided further. That any taxpayer who fakes advantage of this section shall pay the tax imposed by section 1000 of the Revenue Act of 1918 as if such taxpayer had been a corporation on and after January i, 1921. Part III. — Corporations. Tax on Corporations Sf.c. 230. That, in lieu of the tax imposed by section 230 of the Revenue Act of 1 918, there shall be levied, collected, and paid for each taxable year upon the net income of every corporation a tax at the following rates : REVENUE ACT OF 1921 1757 (a) For the calendar year 1921, 10 per centum of the amount of the net income in excess of the credits provided in section 236; and (b) For each calendar year thereafter, 12I/2 per centum of such excess amount. Conditional and Other Exemptions of Corporations Sec. 231. That the following organizations shall be exempt' from tax- ation under this title — (1) Labor, agricultural, or horticultural organizations; (2) Mutual savings banks not having a capital stock represented by shares ; (3) Fraternal beneficiary societies, orders or associations, (a) operating under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system; and (b) providing for the payment of life, sick, accident, or other benefits to the members of such society, order, or association or their dependents; (4) Domestic building and loan associations substantially all the busi- ness of which is confined to making loans to members; and cooperative banks without capital stock organized and operated for mutual purposes and without profit ; (5) Cemetery companies owned and operated exclusively for the benefit of their members or which are not operated for profit; and any corporation chartered solely for burial purposes as a cemetery corporation and not permitted by it's charter to engage in any business not necessarily incident to that purpose, no part of the net earnings of which inures to the benefit of any private stockholder or individual ; (6) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual ; (7) Business leagues, chambers of commerce, or boards of trade, not organized for profit and no part' of the net earnings of which inures to the benefit of any private stockholder or individual; (8) Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare; (9) Clubs organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, no part of the net earnings of which inures to the benefit of any private stockholder or member; (10) Farmers' or other mutual hail, cyclone, or fire insurance com- panies, mutual ditch or irrigation companies, mutual or cooperative telephone companies, or like organizations of a purely local character, the income of which consists solely of assessments, dues, and fees collected from members for the sole purpose of meeting expenses ; (11) Farmers', fruit growers', or like associations, organized and op- crated as sales agents for the purpose of marketing the products of members 17^8 REVENUE ACT OF 1921 and turning back to them the proceeds of sales, less the necessary selling expenses, on the basis of the quantity of produce furnished by them; or organized and operated as purchasing agents for the purpose of purchas- ing supplies and equipment for the use of members and turning over such supplies and equipment to such members at actual cost, plus necessary ex- penses ; (12) Corporations organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses, fo an organization which itself is exempt from the tax imposed by this title; (13) Federal land banks and national farm-loan associations as pro- vided in section 26 of the Act approved July 17, 1916, entitled "An Act to proyide capital for agricultural development, to create standard forms of investment based upon farm mortgage, to equalize rates of interest upon farm loans, to furnish a market for United States bonds, to create Gov- ernment depositaries and financial agents for the United States, and for other purposes" ; (14) Personal service corporations. This subdivision shall not be in effect after December 31, 1921. Net Income of Corporations Defined Sec. 232. That in the case of a corporation subject to the tax imposed by section 230 the term "net income" means the gross income as defined in section 233 less the deductions allowed by section 234, and the net income shall be computed on the same basis as is provided in subdivision (b) of section 212 or in section 226. In the case of a foreign corporation or of a corporation entitled to the benefits of section 262 the computation shall also be made in the manner provided in section 217. Gross Income of Corporations Defined Sec. 233. (a) That in the case of a corporation subject to the tax imposed by section 230 the term "gross income" means the gross income as defined in sections 213 and 217, except that mutual marine insurance companies shall include in gross income the gross premiums collected and received by them less amounts paid for reinsurance. (b) In the case of a foreign corporation, gross income means only gross income from sources within the United States, determined (except in the case of insurance companies subject to the tax imposed by sections 243 or 246) in the manner provided in section 217. Deductions Allowed Corporations Sec. 234. (a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as de- ductions : (i) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reason- REVENUE ACT OF 1921 I759 able allowance for salaries or other compensation for personal services actually rendered, and including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity ; (2) All interest paid or accrued within the taxable year on its in- debtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the tax- payer) the interest upon which is wholly exempt from taxation under this title; (3) Taxes paid or accrued within the taxable year except (a) income, war-profits and excess-profits taxes imposed by the authority of the United States, (b) so much of the income, war-profits and excess-profits taxes imposed by the authority of any foreign country or possession of the United States as is allowed as a credit under section 238, and (c) taxes assessed against local benefits of a kind tending to increase the value of the property assessed. In the case of obligors specified in subdivision (b) of section 221 no deduction for the payment of the tax imposed by this title, or any other tax paid pursuant to the contract or provision referred to in that subdivision, shall be allowed nor shall such tax be included in the gross income of the obligee. The deduction allowed by this para- graph shall be allowed in the case of taxes imposed upon a shareholder or member of a corporation upon his interest as shareholder or member which are paid by the corporation without reimbursement from the shareholder or member, but in such cases no deduction shall be al- lowed the shareholder or member for the amount of such taxes. For the purpose of this paragraph, estate, inheritance, legacy, and succession taxes accrue on the due date thereof except as otherwise provided by the law of the jurisdiction imposing such taxes; (4) Losses sustained during the taxable year and not compensated for by insurance or otherwise; unless, in order to clearly reflect the income, the loss should in the opinion of the Commissioner be accounted for as of a different period. No deduction shall be allowed for any loss claimed to have been sustained in any sale or other disposition of shares of stock or securities made after the passage of this Act where it appears that within thirty days before or after the date of such sale or other disposition the taxpayer has acquired (otherwise than by bequest or inheritance) sub- stantially identical property, and the property so acquired is held by the tax- payer for any period after such sale or other disposition, unless such claim is made by a dealer in stock or securities and with respect to a transaction made in the ordinary course of its business. If such acquisition is to the extent of part only of substantially identical property, then only a pro- portionate part of the loss shall be disallowed. In case of losses arising from destruction of or damage to property, where the property so des- troyed or damaged was acquired before March i, 1913, the deduction shall 1760 REVENUE ACT OF 1921 be computed upon the basis of its fair market price or value as of March I, 1913; (5) Debts ascertained to be worthless and charged off within the taxable year (or in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts) ; and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged oflF in part ; (6) The amount received as dividends (A) from a domestic corpora- tion other than a corporation entitled to the benefits of section 262, or (B) from any foreign corporation when it is shown to the satisfaction of the Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such part of such period as the foreign corporation has been in existence) was derived from sources within the United States as determined under section 217; (7) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. In the case of such property acquired before March i, 1913, this deduction shall be computed upon the basis of its fair market price or value as of March i, 1913; (8) In the case of buildings, machinery, equipment, or other facilities, constructed, erected, installed, or acquired, on or after April 6, 1917, for the production of articles contributing to the prosecution of the war against the German Government, and in the case of vessels constructed or acquired on or after such date for the transportation of articles or men contributing to the prosecution of such war, there shall be allowed, for any taxable year ending before March 3, 1924 (if claim therefor was made at the time of filing return for the taxable year 1918, 1919, 1920, or 1921) a reasonable deduction for the amortization of such part of the cost of such facilities or vessels as has been borne by the taxpayer, but not again including any amount otherwise allowed under this title or previous Acts of Congress as a deduction in computing net income. At any time before March 3, 1924, the Commissioner may, and at the request of the tax- payer shall, reexamine the return, and if he then finds as a result of an appraisal or from other evidence that the deduction originally allowed was incorrect, the income, war-profits, and excess-profit's taxes for the year or years afifected shall be redetermined and the amount of tax due upon such redetermination, if any, shall be paid upon notice and demand by the collector, or the amount of tax overpaid, if any, shall be credited or refunded to the taxpayer in accordance with the provisions of section 252; (9) In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of im- provements, according to the peculiar conditions in each case, based upon cost including cost of development not otherwise deducted : Provided, That in the case of such properties acquired prior to March i, 1913, the REVENUE ACT OF 1921 1761 fair market value of the property (or the taxpayer's interest therein) on that date shall be taken in lieu of cost up to that date: Provided further, That in the case of mines, oil and gas wells, discovered by the taxpayer, on or after March i, 1913, and not acquired as the result of purchase of a proven tract or lease, where the fair market value of the property is materially disproportionate to the cost, the depletion allowance shall be based upon the fair market value of the property at the date of the dis- covery, or within thirty days thereafter: And provided further. That such depletion allowance based on discovery value shall not exceed the net income, computed without allowance for depletion, from the property upon which the discovery is made, except where such net income so com- puted is less than the depletion allowance based on cost or fair market value as of March i, 1913; such reasonable allowance in all the above cases to be made under rules and regulations to be prescribed by the Commisioner with the approval of the 'Secretary. In the case of leases the deductions allowed by this paragraph shall be equitably apportioned between the lessor and lessee; (10) In the case of insurance companies (other than life insurance companies), in addition to the above (unless otherwise allowed) : (A) The net addition required by law to be made within the taxable year to reserve funds (including in the case of assessment insurance companies the actual deposit of sums with State or Territorial officers pursuant to law as additions to guarantee or reserve funds) ; and (B) the sums other than dividends paid within the taxable year on policy and annuity con- tracts. After December 31, 1921, this subdivision shall apply only to mutual insurance companies other than life insurance companies; (11) In the case of corporations (except those taxed under section 243) issuing policies covering life, health, and accident insurance combined in one policy issued on the weekly premium payment plan continuing for life and not subject to cancellation, in addition to the above," such portion of the net addition (not required by law) made within the taxable year to reserve funds as the Commissioner finds to be required for the pro- tection of the holders of such policies only. This subdivision shall not be in effect after December 31, 1921 ; (12) In the case of mutual marine insurance companies, there shall be allowed, in addition to the deductions allowed in paragraphs (i) to (10), inclusive, and paragraph (14), unless otherwise allowed, amounts repaid to policyholders on account of premiums previously paid by them, and interest paid upon such amounts between the ascertainment and the payment thereof ; (j3) In the case of mutual insurance companies (including interinsurers and reciprocal underwriters, but not including mutual life or mutual marine insurance companies) requiring their members to make premium deposits to provide for losses and expenses, there shall be allowed, in addition to the deductions allowed in paragraphs (i) to (10), inclusive, and paragraph (14), unless otherwise allowed, the amount of premium 1762 REVENUE ACT OF 1921 deposits returned to their policyholders and the amount of premium de- posits retained for the payment' of losses, expenses, and reinsurance re- serves ; (14) If property is compulsorily or involuntarily converted into cash or its equivalent as a result of (A) its destruction in whole or in part, (B) theft or seizure, or (C) an exercise of the power of requisition or condemnation, or the threat or imminence thereof ; and if the taxpayer proceeds forthwith in good faith under regulations prescribed by the Commissioner with the approval of the Secretary, to expend the proceeds of such conversion in the acquisition of other property of a character similar or related in service or use to the property so converted, or in the acquisition of 80 per centum or more of the stock or shares of a cor- poration owning such other property, or in the establishment of a re- placement fund, then there shall be allowed as a deduction such portion of the gain derived as the portion* of the proceeds so expended bears to the entire proceeds. The provision of this paragraph prescribing the con- ditions under which a deduction may be taken in respect of the proceeds or gains derived from the compulsory or involuntary conversion of property into cash or its equivalent, shall apply so far as may be practicable to the exemption or exclusion of such proceeds or gains from gross income under prior income, war-profits and excess-profits tax Acts. (b) In the case of a foreign corporation or of a corporation entitled to the benefit's of section 262 the deductions allowed in subdivision (a) shall be allowed only if and to the extent that they are connected ■with income from sources within the United States; and the proper apportion- ment and allocation of the deductions with respect to sources within and without the United States shall be determined as provided in section 217 under rules and regulations prescribed by the Commissioner with the approval of the Secretary. Items Not Deductible by Corporations Sec. 235. That in computing net income no deduction shall in any case be allowed in respect of any of the items specified in section 215. Credits Allowed Corporations Sec. 236. That for the purpose only of the tax imposed by section 230 there shall be allowed the following credits : (a) The amount received as interest upon obligations of the United States and bonds issued by the War Finance Corporation, which is included in gross income under section 233 ; (b) In the case of a domestic corporation the net income of which is $25,000 or less, a specific credit of $2,000; but if the net income is more than $25,000 the tax imposed by section 230 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000; and (c) The amount of any war-profits and excess-profits taxes imposed REVENUE ACT OF 1921 1 763 by Act of Congress for the same taxable year. The credit allowed by this subdivision shall be determined as follows : (1) In the case of a corporation which makes return for a fiscal year beginning in 1920 and ending in 1921, in computing the income tax as provided in subdivision (a) of section 205, the portion of the war- profits and excess-profits tax computed for the entire period under clause (i) of subdivision (a) of section 335 shall be credited against the net income computed for the entire period as provided in clause (i) of sub- division (a) of section 205, and the portion of the war-profits and excess- profits tax computed for the entire period under clause (2) of subdivision (a) of section 335 shall be credited against the net income computed for the entire period as provided in clause (2) of subdivision (a) of section 205. (2) In the case of a corporation which makes return for a fiscal year beginning in 1921 and ending in 1922, in computing the income tax as provided in subdivision (b) of section 205, the war-profits and excess- profits tax computed under subdivision (b) of section 335 shall be credited against the net income computed for the entire period as provided in clause (i) of subdivision (b) of section 205. Payment of Corporation Income Tax at Source Sec. 237. That in the case of foreign corporations subject to taxation under this title not engaged in trade or business within the United States and not having any office or place of business therein, there shall be de- ducted and withheld at the source in the same manner and upon the same items of income as is provided in section 221 a tax equal to I2j/^ per centum thereof (but during the calendar year 1921 only 10 per centum), and such tax shall be returned and paid in the same manner and subject to the same conditions as provided in that section : Provided, That in the case of interest described in subdivision (b) of that section the deduction and withholding shall be at the rate of 2 per centum. Credit for Taxes in Case of Corporations Sec. 238. (a) That in the case of a domestic corporation the tax imposed by this title, plus the war-profits and excess-profits taxes, if any, shall be credited with the amount of any income, war-profits, and excess-profits taxes paid during the same taxable year to any foreign country, or to any possession of the United States: Provided, That the amount of credit taken under this subdivision shall in no case exceed the same proportion of the taxes, against which such credit is taken, which the taxpayer's net income (computed without deduction for any income, war-profits, and excess-profits taxes imposed by any foreign country or possession of the United States) from sources without the United States bears to its entire net income (computed without such deduction) for the same taxable year. In the case of domestic insurance companies subject to the tax imposed by section 243 or 246, the term "net income", as used 1764 REVENUE ACT OF 1921 in this subdivision means net income as defined in sections 245 and 246, respectively. (b) If accrued taxes when paid differ from the amounts claimed as credits by the corporation, or if any tax paid is refunded in whole or in part, the corporation shall at once notify the Commissioner, who shall redetermine the amount of the income, war-profits and excess-profits taxes for the year or years affected, and the amount of taxes due upon such redetermination, if any, shall be paid by the corporation upon notice and demand by the collector, or the amount of taxes overpaid, if any, shall be credited or refunded to the corporation in accordance with the provisions of section 252. In the case of such a tax accrued but not paid, the Commissioner as a condition precedent to the allowance of this credit may require the corporation to give a bond with sureties satisfactory to and to be approved by him in such penal sum as he may require, con- ditioned for the payment by the taxpayer of any amount of taxes found due upon any such redetermination ; and the bond herein prescribed shall contain such further conditions as the Commissioner may require. (c) These credits shall be allowed only if the taxpayer furnishes evi- dence satisfactory to the Commissioner showing the amount of income derived from sources without the United States, and all ofher information necessary for the verification and computation of such credit. (d) If a domestic corporation makes a return for a fiscal year begin- ning in 1920 and ending in 1921, the credit for the entire fiscal year shall, notwithstanding any provision of this Act, be determined under the pro- visions of this section ; and the Commissioner is authorized to disallow, in whole or in part, any such credit which he finds has already been taken by the taxpayer. (e) For the purposes of this section a domestic corporation which owns a majority of the voting stock of a foreign corporation from which it receives dividends (not deductible under section 234) in any taxable year shall be deemed to have paid the same proportion of any income, war-profits, or excess-profits taxes paid by such foreign corporation to any foreign country or to any possession of the United States, upon or with respect to the accumulated profits of such foreign corporation from which such dividends were paid, which the amount of such dividends bears to the amount of such accumulated profits : Provided, That the credit allowed to any domestic corporation under this subdivision shall in no case exceed the same proportion of the taxes against which it is credited, which the amount of such dividends bears to the amount of the entire net income of the domestic corporation in which such dividends are included. The term "accumulated profits" when used in this subdivision in reference to a foreign corporation, means the amount of its gains, profits, or income in excess of the income, war-profits, and excess-profit's taxes imposed upon or with respect to such profits or income; and the Commissioner with the approval of the Secretary shall have full power to determine from the accumulated profits of what year or years such REVENUE ACT OF 1921 1765 dividends were paid; treating dividends paid in the first sixty days of any year as having been paid from the accumulated profits of the preceding year or years (unless to his satisfaction shown otherwise), and in other respects treating dividends as having been paid from the most recently accumulated gains, profits, or earnings. In the acse of a foreign corpora- ation, the income, war-profits, and excess-profits taxes of which are determined on the basis of an accounting period of less than one year, the word "year" as used in this subdivision shall be construed to mean such accounting period. (f) For the purposes of this section a corporation entitled to the benefits of section 262 shall be treated as a foreign corporation. Corporation Returns Sec. 239. (a) That every corporation subject to taxation under this title and every personal service corporation shall make a return, stating specifically the items of its gross income and the deductions and credits allowed by this title. The return shall be sworn to by the president, vice president, or other principal officer and by the treasurer or assistant treasurer. If any foreign corporation has no office or place of business in the United States but has an agent in the United States, the return shall be made by the agent. In cases where receivers, trustees in bank- ruptcy, or assignees are operating the property or business of corporations, such receivers, trustees or assignees shall make returns for such corpora- tions in the same manner and form as corporations are required to make returns. Any tax due on the basis of such returns made by receivers, trustees, or assignees shall be collected in the same manner as if collected from the corporations of whose business or property they have custody and control. (b) Returns made under this section shall be subject to the pro- visions of sections 226 and 228. When return is made under section 226 the credit provided in subdivision (b) of section 236 shall be reduced to an amount which bears the same ratio to the full credit therein provided as the number of months in the period for which such return is made bears to twelve months. (c) There shall be included in the return or appended thereto a state- ment of such facts as will enable the Commissioner to determine the portion of the earnings or profits of the corporation (including gains, profits and income not taxed) accumulated during the taxable year for which the return is made, which have been distributed or ordered to be distributed, respectively, to its stockholders or members during such year. Consolidated Returns of Corporations Sec. 240. (a) That corporations which are affiliated within the meaning of this section may, for any taxable year beginning on or after January I, 1922, make separate returns or, under regulations prescribed by the Commissioner with the approval of the Secretary, make a consolidated 1766 REVENUE ACT OF 1921 return of net income for the purpose of this title, in which case the taxes thereunder shall be computed and determined upon the basis of such return. If return is made on either of such bases, all returns thereafter made shall be upon the same basis unless permission to change the basis is granted by the Commissioner. (b) In any case in which a tax is assessed upon the basis of a consol- idated return, the total tax shall be computed in the first instance as a unit and shall then be assessed upon the respective affiliated corporations in such proportion as may be agreed upon among them, or, in the absence of any such agreement, then on the basis of the net income properly assign- able to each. There shall be allowed in computing the income tax only one specific credit computed as provided in subdivision (b) of section 236. (c) For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (i) if one corporation owns directly or controls through closely affiliated interests or by a nominee or nominees substantially all the stock of the other or others, or (2) if sub- stantially all the stock of two or more corporations is owned or con- trolled by the same interests. (d) For the purposes of this section a corporation entitled to the benefits of section 262 shall be treated as a foreign corporation : Provided, That in any case of two or more related trades or businesses (whether un- incorporated or incorporated and whether organized in the United States or not) owned or controlled directly or indirectly by the same interests, the Commissioner may consolidate the accounts of such related trades and businesses, in any proper case, for the purpose of making an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such related trades or businesses. (e) Corporations which are affiliated within the meaning of this section shall make consolidated returns for any taxable year beginning prior to January i, 1922, in the same manner and subject to the same conditions as provided by the Revenue Act of 1918. Time and Place for Filing Corporate Returns Sec. 241. (a) That returns of corporations shall be made at the same time as is provided in subdivision (a) of section 227, except that in the case of foreign corporations not having any office or place of business in the United States returns shall be made at the same time as provided in section 227 in the case of a nonresident alien individual. (b) Returns shall be made to the collector of the district in which is located the principal place of business or principal office or agency of the corporation, or, if it has 110 principal place of business or principal office or agency in the United States, then to the collector at Baltimore, Maryland. Taxes on Insurance Companies Sec. 242. That when used in this title the term "life insurance com- REVENUE ACT OF 1921 1767 pany" means an insurance company engaged in the business of issuing life insurance and annuity contracts (including contracts of combined life, health, and accident insurance), the reserve funds of which held for the fulfillment of such contracts comprise more than 50 per centum of its total reserve funds. Sec. 243. That in lieu of the taxes imposed by sections 230 and 1000 and by Title III, there shall be levied, collected, and paid for the calendar year 1921 and for each taxable year thereafter upon the net income of every life insurance company a tax as follows : (i) In the case of a domestic life insurance company, the same per- centage of its net income as is imposed upon other corporations by section 230 ; (2) In the case of a foreign life insurance company, the same per- centage of its net income from sources within the United States as is imposed upon the net income of other corporations by section 230. Sec. 244. (a) That in the case of a life insurance company, the term "gross income" means the gross amount of income received during the taxable year from interest, dividends, and rents. (b) The term "reserve funds required by law" includes, in the case of assessment insurance sums actually deposited by any company or associ- ation with State or Territorial officers pursuant to law as guaranty or reserve funds, and any funds maintained under the charter or articles of incorporation of the company or association exclusively for the payment of claims arising under certificates of membership or policies issued upon the assessment plan and not subject to any other use. Sec. 245. (a) That in the case of a life insurance company the term "net income" means the gross income less — (1) The amount of interest received during the taxable year which under paragraph (4) of subdivision (b) of section 213 is exempt from taxation under this title ; (2) An amount equal to the excess, if any, over the deduction specified in paragraph (i) of this subdivision, of 4 per centum of the mean of the reserve funds required by law and held at the beginning and end of the taxable year, plus (in case of life insurance companies issuing policies covering life, health, and accident insurance combined in one policy issued on the weekly premium payment plan, continuing for life and not subject to cancellation) 4 per centum of the mean of such reserve funds (not required by law) held at the beginning and end of the taxable year, as the Commissioner finds to be necessary for the protection of the holders of such policies only; (3) The amount received as dividends (A) from a domestic corpora- tion other than a corporation entitled to the benefits of section 262, or (B) from any foreign corporation when it is shown to the satisfaction of the Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such 1768 REVENUE ACT OF 1921 part of such period as the foreign corporation has been in existence) was derived from sources within the United States as determined under section 217 ; (4) An amount equal to 2 per centum of any sums held at the end of the taxable year as a reserve for dividends (other than dividends payable during the year following the taxable year) the payment of which is deferred for a period of not less than five years from the date of the policy contract ; (5) Investment expenses paid during the taxable year: Provided, That if any general expenses are in part assigned to or included in the investment expenses, the total deduction under this paragraph shall not exceed one-fourth of i per centum of the book value of the mean of the invested assets held at the beginning and end of the taxable year; (6) Taxes and other expenses paid during the taxable year exclusively upon or with respect to the real estate owned by the company, not in- cluding taxes assessed against local benefits of a kind tending to increase the value of the property assessed, and not including any amount paid out for new buildings, or for permanent improvements or betterments made to increase the value of any property. The deduction alowed by this paragraph shall be allowed in the cases of taxes imposed upon a share- holder or member of a company upon his interest as shareholder or member, which are paid by the company without reimbursement from the shareholder or member, but in such case no deduction shall be allowed the shareholder or member for the amount of such taxes ; (7) A reasonable allowance for the exhaustion, wear and tear of property, including a reasonable allowance for obsolescence. In the case of property acquired before March i, 1913, this deduction shall be com- puted upon the basis of its fair market price or value as of March i, 1913; (8) All interest paid or accrued within the taxable year on its indebted- ness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title ; (9) In the case of a domestic life insurance company, the net income of which (computed without the benefit of this paragraph) is $25,000 or less, the sum of $2,000; but if the net income is more than $25,000 the tax imposed . by section 243 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000. (b) No deduction shall be made under paragraphs (6) and (7) of subdivision (a) on account of any real estate owned and occupied in whole or in part by a life insurance company unless there is included in the return of gross income the rental value of the space so occupied. Such rental value shall be not less than a sum which in addition to any rents received from other tenants shall provide a net income (after de- REVENUE ACT OF 1921 1 769 ducting taxes, depreciation, and all other expenses) at the rate of 4 per centum per annum of the book value at the end of the taxable year of the real estate so owned or occupied. (c) In the case of a foreign life insurance company the amount of its net income for any taxable year from sources within the United States shall be the same proportion of its net income for the taxable year from sources within and without the United States, which the reserve funds re- quired by law and held by it at the end of the taxable year upon business transacted within the United States is of the reserve funds held by it at the end of the taxable year upon all business transacted. Sec. 246. (a) That, in lieu of the taxes imposed by sections 230 and 1000, there shall be levied, collected and paid for the calendar year 1922, and for each taxable year thereafter, upon the net income of every in- surance company (other than a life or mutual insurance company) a tax as follows : (i) In the case of such a domestic insurance company the same per- centage of its net income as is imposed upon other corporations by section 230; (2) In the case of such a foreign insurance company the same per- centage of its net income from sources within the United States as is imposed upon the net income of other corporations by section 230. (b) In the case of an insurance company subject to the tax imposed by this section — (i) The term "gross income" means the combined gross amount, earned during the taxable year, from investment income and from underwriting income as provided in this subdivision, computed on the basis of under- writing and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners ; (2) The term "net iricome" means the gross income as defined in paragraph (i) of this subdivision less the deductions allowed by section 247; (3) The term "investment income" means the gross amount of income earned during the taxable year from interest, dividends and rents, com- puted as follows : To all interest, dividends and rents received during the taxable year, add interest, dividends and rents due and accrued at the end of the taxable year, and deduct all interest, dividends and rents due and accrued at the end of the preceding taxable year ; (4) The term "underwriting income" means the premiums earned on insurance contracts during the taxable year less losses incurred and ex- penses incurred; (5) The term "premiums earned on insurance contracts during the taxable year" means an amount computed as follows : From the amount of gross premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance. To the result so obtained add unearned premiums on out- standing business at the end of the preceding taxable year and deduct I770 REVENUE ACT. OF 1921 unearned premiums on outstanding business at the end of the taxable year; (6) The term "losses incurred" means losses incurred during the tax- able year on insurance contracts, computed as follows : To losses paid during the taxable year, add salvage and reinsurance recoverable outstanding at the end of the preceding taxable year, and de- duct salvage and reinsurance recoverable outstanding at the end of the taxable year. To the result so obtained add all unpaid losses outstanding at the end of the taxable year and deduct unpaid losses outstanding at the end of the preceding taxable year; (7) The term "expenses incurred" means all expenses shown on the annual statement approved by the National Convention of Insurance Com- missioners, and shall be computed as follows : To all expenses paid during the taxable year add expenses unpaid at the end of the taxable j'ear and deduct expenses unpaid at the end of the preceding taxable year. For the purpose of computing the net income sub- ject to the tax imposed by this section there shall be deducted from expenses incurred as defined in this paragraph all expenses incurred which are not allowed as deductions by section 247. Sec. 247. (a) That in computing the net income of an insurance com- pany subject to the tax imposed by section 246 there shall be allowed as deductions : (i) All ordinary and necessary expenses incurred, as provided in para- graph (i) of subdivision (a) of section 234; (2) All interest as provided in paragraph (2) of subdivision (a) of section 234; (3) Taxes as provided in paragraph (3) of subdivision (a) of section 234; (4) Losses incurred ; , (5) Bad debts in the nature of agency balances and bills receivable ascertained to be worthless and charged off within the taxable year; (6) The amount received as dividends from corporations as provided in paragraph (6) of subdivision (a) of section 234; (7) The amount of interest earned during the taxable year which under paragraph (4) of subdivision (b) of section 213 is exempt from taxation under this title, and the amount of interest allowed as a credit under sub- division (a) of section 236 ; (8) A reasonable allowance, for the exhaustion, wear and tear of property, as provided in paragraph (7) of subdivision (a) of section 234; (9) In the case of such a domestic insurance company, the net income of which (computed without the benefit of this paragraph) is $25,000 or less, the sum of $2,000; but if the net income is more than $25,000 the tax imposed by section 246 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000. (b) In the case of a foreign corporation the deductions allowed in I REVENUE ACT OF 1921 1 771 this section shall be allowed to the extent provided in subidvision (b) of section 234. (c) Nothing in this section or in section 246 shall be construed to permit the same item to be twice deducted. Part IV. — Administrative Provisions. Payment of Taxes Sec. 250. (a) That except as otherwise provided in this section and sections 221 and 237 the tax shall be paid in four installments, each con- sisting of one-fourth of the total amount of the tax. The first installment shall be paid at the time fixed by law for filing the return, and the second installment shall be paid on the fifteenth day of the third month, the third installment on the fifteenth day of the sixth month, and the fourth install- ment on the fifteenth day of the ninth month, after the time fixed by law for filing the return. Where an extension of time for filing a return is granted the time for payment of the first installment shall be postponed until the date of the expiration of the period of the extension, but the time for payment of the other installments shall not be postponed unless the Commissioner so provides in granting the extension. In any case in which the time for the payment of any installment is at the request of the tax- payer thus postponed, there shall be added as a part of such installment in- terest thereon at the rate of one-half of i per centum per month from the time it would have been due if no extension had been granted, until paid. If any installment is not paid when due, the whole amount of the tax unpaid shall become due and payable upon notice and demand by the collector. The tax may at the option of the taxpayer be paid in a single payment instead of installments, in which case the total amount shall be paid on or before the time fixed by law for filing the return, or, where an extension of time for filing the return has been granted, on or before the expiration of the period of such extension. (b) As soon as practicable after the return is filed, the Commissioner shall examine it. If it then appears that the correct amount of the tax is greater or less than that shown in the return, the installments shall be recomputed. If the amount already paid exceeds that which should have been paid on the basis of the installments as recomputed, the excess so paid shall be credited against the subsequent installments; and if the amount already paid exceeds the correct amount of the tax, the excess shall be credited or refunded to the taxpayer in accordance with the provisions of section 252. If the amount already paid is less than that which should have been paid, the difference, to the extent not covered by any credits due to the tax- payer under section 252 (hereinafter called "deficiency"), together with interest thereon at the rate of one-half of i per centum per month from the time the tax was due (or, if paid on the installment basis, on the deficiency of each installment from the time the installment' was due), shall be paid 1772 REVENUE ACT OF 1921 upon notice and demand by the collector. If any part of the deficiency is due to negligence or intentional disregard of authorized rules and regulations with knowledge thereof, but without intent to defraud, there shall be added as part of the tax 5 per centum of the total amount of the deficiency in the tax, and interest in such a case shall be collected at the rate of i per centum per month on the amount of such deficiency in the tax from the time it was due (or, if paid on the installment basis, on the amount of the deficiency in each installment from the time the installment was due), which penalty and interest shall become due and payable upon notice and demand by the collector. If any part of the deficiency is due to fraud with intent to evade tax, then, in lieu of the penalty provided by section 3176 of the Revised Statutes, as amended, for false or fraudulent returns willfully made, but in addition to other penalties provided by law for false or fraudulent returns, there shall be added as part of the tax 50 per centum of the total amount of the deficiency in the tax. In such case the whole amount of the fax unpaid, including the penalty so added, shall become due and pay- able upon notice and demand by the collector. (c) If the return is made pursuant to section 3176 of the Revised Statutes as amended, the amount of tax determined to be due under such return shall be paid upon notice and demand by the collector. (d) The amount of income, excess-profits, or war-profits taxes due under any return made under this Act for the taxable year 1921 or suc- ceeding taxable years shall be determined and assessed by the Commissioner within four years after the return was filed, and the amount of any such faxes due under any return made under this Act for prior taxable years or under prior income, excess-profits, or war-profits tax Acts, or under section 38 of the Act entitled "An Act to provide revenue, equalize duties, and encourage the industries of the United States, and for other purposes," approved August 5, 1909, shall be determined and assessed within five years after the return was filed, unless both the Commissioner and the taxpaj-er consent in writing to a later determination, assessment, and collection of the tax; and no suit or proceeding for the collection of any such taxes due under this Act or under prior income, excess-profits, or war-profits tax Acts, or of any taxes due under section 38 of such Act of August 5, 1909, shall be begun, after the expiration of five years after the date when such return was filed, but this shall not affect suits or proceedings begun at the time of the passage of this Act : Provided, That in the case of income re- ceived during the lifetime of a decedent, all taxes due thereon shall be de- termined and assessed by the Commissioner within one year after written request therefor by the executor, administrator, or other fiduciary represent- ing the estate of such decedent : Proz'ided further, That in the case of a false or fraudulent return with intent to evade tax, or of a failure to file a required return, the amount of tax due may be determined, assessed, and collected, and a suit or proceeding for the coQection of such amount may be begtui, at any time after it becomes due : Provided further, That in cases coming within the scope of paragraph, ig) gf subdivision (a) of REVENUE ACT OF 1921 1773 section 214, or of paragraph (8) of subdivision (a) of section 234, or in cases of final settlement of losses and other deductions tentatively allowed by the Commissioner pending a determination of the exact amount de- ductible, the amount of tax or deficiency in tax due may be determined, assessed, and collected at any time ; but prior to the assessment thereof the taxpayer shall be notified and given a period of not less than thirty days in which to file an appeal and be heard as hereinafter provided in this sub- division. If upon examination of a return made under the Revenue Act of 1916, the Revenue Act of 191 7, the Revenue Act of 1918, or this Act, a tax or a deficiency in tax is discovered, the taxpayer shall be notified thereof and given a period of not less than thirty days after such notice is sent by registered mail in which to file an appeal and show cause or reason why the tax or deficiency should not be paid. Opportunity for hearing shall be granted and a final decision thereon shall be made as quickly as practicable. Any tax or deficiency in tax then determined to be due shall be assessed and paid, together with the penalty and interest, if any, ap- plicable thereto, within ten days after notice and demand by the collector as hereinafter provided, and in such cases no claim in abatement of the amount so assessed shall be entertained : Provided, That in cases where the Commissioner believes that the collection of the amount due will be jeopardized by such delay he may make the assessment without giving such notice or awaiting the conclusion of such hearing. (e) If any tax remains unpaid after the date when it is due, and for ten days after notice and demand by the collector, then, except in the case of estates of insane, deceased, or insolvent persons, there shall be added as part of the tax the sum of 5 per centum on the amount due but unpaid, plus interest at the rate of i per centum per month upon such amount from the time it became due : Provided, That as t'o any such amount which is the subject of a bona fide claim for abatement filed within ten days after notice and demand by the collector, where the taxpayer has not had the benefit of the provisions of subdivision (d), such sum of 5 per centum shall not be added and the interest from the time the amount was due until the claim is decided shall be at the rate of one-half of i per centum per month on that part of the claim rejected. In the case of the first installment provided for in subdivision (a) the instructions printed on the return shall be sufficient notice of the date when the tax is due and sufficient demand, and the taxpayer's compu- tation of the tax on the return shall be sufficient notice of the amount due. In the case of each subsequent installment the collector may, within thirty days and not later than ten days before the installment becomes due, mail to the taxpayer notice of the amount of the installment and the date on which it is due for payment. Such notice of the collector shall be sufficient notice and sufficient demand under this section. (f) In the case of any deficiency (except where the deficiency is due to negligence or to fraud with intent to evade tax) where it is shown to t774 REVENUE ACT OF 1921 the satisfaction of the Commissioner that the payment of such deficiency would result in undue hardship to the taxpayer, the Commissioner may, with the approval of the Secretary, extend the time for the payment of such deficiency or any part thereof for such period not in excess of eighteen months from the passage of this Act as the Commissioner may determine. In such case the Commissioner may require the taxpayer to furnish a bond with sufficient sureties conditioned upon the payment of the deficiency in accordance with the terms of the extension granted, there shall be added in lieu of other interest provided by law, as a part of such deficiency, in- terest thereon at the rate of two-thirds of i per centum per month from the time such extension is granted; except where such other interest pro- vided by law is in excess of interest at the rate of two-thirds of i per centum per month. If the deficiency or any part thereof is not paid in accordance with the terms of the extension granted, there shall be added as part of the deficiency, in lieu of other interest and penalties provided by law, the sum of 5 per centum of the deficiency and interest on the deficiency at the rate of i per centum per month from the time it becomes payable in accordance with the terms of such extension. (g) If the Commissioner finds that a taxpayer designs quickly to de- part from the United States or to remove his property therefrom, or to conceal himself or his property therein, or to do any other act tending to prejudice or to render wholly or partly ineffectual proceedings to collect the tax for the taxable year then last past or the taxable year then cur- rent unless such proceedings be brought without delay, the Commissioner shall declare the taxable period for such taxpayer immediately terminated and shall cause notice of such finding and declaration to be given the tax- payer, together with a demand for immediate payment of the tax for the taxable period so declared terminated and of the tax for the preceding taxable year or so much of said tax as is unpaid, whether or not the time otherwise allowed by law for filing return and paying the tax has ex- pired ; and such taxes shall thereupon become immediately due and pay- able. In any action or suit brought to enforce payment of taxes made due and payable by virtue of the provisions of this subdivision the finding of the Commissioner, made as herein provided, whether made after notice to the taxpayer or not, shall be for all purposes presumptive evidence of the taxpayer's design. A taxpayer who is not in default in making any return or paying income, war-profits, or excess-profits tax under any Act of Con- gress may furnish to the United States, under regulations to be prescribed by the Commissioner with the approval of the Secretary, security approved by the Commissioner that he will duly make the return next thereafter re- quired to be filed and pay the tax next thereafter required to be paid. The Commissioner may approve and accept in like manner security for return and payment of taxes made due and payable by virtue of the provisions of this subdivision, provided the taxpayer has paid in full all other income, war-profits, or excess-profits taxes due from him under any Act of Con- gress. If security is approved and accepted pursuant to the provisions of REVENUE ACT OF 1921 1 775 this subdivision and such further or other security with respect to the tax or taxes covered thereby is given as the Commissioner shall from time to time find necessary and require, payment of such taxes shall not be en- forced by any proceedings under the provisions of this subdivision prior to the expiration of the time otherwise allowed for paying such respective taxes. In the case, of a citizen of the United States about to depart from the United States the Commissioner may, at his discretion, waive any or all of the requirements placed on the taxpayer by this subdivision. No alien shall depart from the United States unless he first secures from the collector or agent in charge a certificate that he has complied with all the obligations imposed upon him by the income, war-profits, and excess- profits tax laws. If a taxpayer violates or attempts to violate this sub- division there shall, in addition to all other penalties, be added as part of the tax 25 per centum of the total amount of the tax or deficiency in the tax, together with interest at the rate of i per centum per month from the time and fax became due. (h) The provisions of subdivisions (e), (f) and (g) of this section shall apply to the assessment and collection of taxes which have accrued or may accrue under the Revenue Act of 1917, the Revenue Act of 1918 or this Act. Receipts for Taxes Sec. 251. That every collector to whom any payment of any tax is made under the provisions of this title shall upon request give to the person making such payment a full written or printed receipt, stating the amount paid and the particular account for which such payment was made; and whenever any debtor pays taxes on account of payments made or to be made by him to separate creditors the collector shall, if requested by such debtor, give a separate receipt for the tax paid on account of each creditor in such form that the debtor can conveniently produce such receipts separately to his several creditors in satisfaction of their respective de- mands up to the amounts stated in the receipts ; and such receipts shall be sufficient evidence in favor of such debtor to justify him in withholding from his next payment to his creditor the amount therein stated ; but the creditor may, upon giving to his debtor a full written receipt acknowledging the payment to him of any sum actually paid and accepting the amount of tax paid as aforesaid (specifying the same) as a further satisfaction of the debt to that amount, require the surrender to him of such col- lector's receipt. Refunds Sec. 252. That if, upon examination of any return of income made pursuant to this Act, the Act of August 5, 1909, entitled "An Act to pro- vide revenue, equalize duties, and encourage the industries of the United States, and for other jjurposes," the Act of October 3, 1913, entitled "An Act to reduce tariff duties and to provide revenue for the Government, 1776 REVENUE ACT OF 1921 and for other purposes," the Revenue Act of 1916, as amended, the Revenue Act of 1917, or the Revenue Act of 1918, it appears that an amount of income, war-profits or excess-profits tax has been paid in ex- cess of that properly due, then, notwithstanding the provisions of section 3228 of the Revised Statutes, the amount of the excess shall be credited against any income, war-profits or excess-profits taxes, or installment thereof, then due from the taxpayer under any other return, and any balance of such excess shall be immediately refunded to the taxpayer : Provided, That no such credit or refund shall be allowed or made after five years from the date when the return was due, unless before the ex- piration of such five years a claim therefor is filed by the taxpayer: Provided further, That if upon examination of any return of income made pursuant to the Revenue Act of 1917, the Revenue Act of 1918, or this Act, the invested capital of a taxpayer is decreased by the Commissioner, and such decrease is due to the fact that the taxpayer failed to take adequate deductions in previous years, with the result that an amount of income tax in excess of that properly due was paid in any previous year or years, then, notwithstanding any other provision of law and regardless of the expiration of such five-year period, the amount of such excess shall, without the filing of any claim therefor, be credited or refunded as pro- vided in this section: A7id provided further. That nothing in this section shall be construed to bar from allowance claims for refund filed prior to the passage of the Revenue Act of 1918 under subdivision (a) of section 14 of the Revenue Act of 1916, or filed prior to the passage of this Act under section 252 of the Revenue Act of 1918. Penalties Sec. 253. That any individual, corporation, or partnership required under this title to pay or collect any tax, to make a return or to supply in- formation, who fails to pay or collect such tax, to make such return, or to supply such information at the time or times required under this title, shall be liable to a penalty of not more than $1,000. Any individual, cor- poration, or partnership, or any officer or employee of any corporation or member or employee of a partnership, who willfully refuses to pay or collect such tax, to make such return, or to supply such in- formation at the time or times required under this title, or who willfully attempts in any manner to defeat or evade the tax imposed by this title, shall be guilty of a misdemeanor and shall be fined not more than $10,000 or imprisoned for not more than one year, or both, together with the costs of prosecution. Returns of Payments of Dividends Sec. 254. That every corporation subject to the tax imposed by this title and every personal service corporation shall, when required by the Commissioner, render a correct return, duly verified under oath, of its payments of dividends, stating the name and address of each stockholder. REVENUE ACT OF 1921 1 777 the number of shares owned by him, and the amount of dividends paid to him. Returns of Brokers Sec. 255. That every individual, corporation, or partnership doing business as a broker shall, when required by the Commissioner, render a correct return duly verified under oath, under such rules and regulations as^the Commissioner, with the approval of the Secretary, may prescribe, showing the names of customers for whom such individual, corporation, or partnership has transacted any business, for such details as to the profits, losses, or other information which the Commissioner may require, as to each of such customers, as will enable the Commissioner to determine whether all income tax due on profit's or gains of such customers has been paid. Information at Source Sec. 256. That all individuals, corporations and partnerships in whatever capacity acting, including lessees or mortgagors of real or per- sonal property, fiduciaries, and employers, making payment to another in- dividual, corporation, or partnership, of interest, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments or other fixed or determinable gains, profits, and income (other than payments described in sections 254 and 255), of $1,000 or more in any taxable year, or, in the case of such payments made by the United States, the officers or employees of the United States having information as to such payments and required to make returns in regard thereto by the regulations herein- after provided for, shall render a true and accurate return to the Com- missioner, under such regulations and in such form and manner and to such extent as may be prescribed by him with the approval of the Secretary, setting forth the amount of such gains, profits, and income, and the name and address of the recipient of such payment. Such returns may be required, regardless of amounts, (i) in the case of payments of interest upon bonds, mortgages, deeds of trust', or other similar obligations of corporations, and (2) in the case of collections of items (not payable in the United States) of interest upon the bonds of foreign countries and interest upon the bonds of and dividends from foreign corporations by individuals, corporations, or partnerships, under- taking as a matter of business or for profit the collection of foreign pay- ments of such interest or dividends by means of coupons, checks, or bills of exchange. When necessary to make effective the provisions of this section the name and address of the recipient of income shall be furnished upon de- mand of the individual, corporation, or partnership paying the income. The provisions of this section shall apply to the calendar year 1921 and each calendar year thereafter, but shall not apply to the payment of in- terest on obligations of the United States. 1778 REVENUE ACT OF 1921 Returns to Be Public Records Sec. 257. That returns upon which the fax has been determined by the Commissioner shall constitute public records ; but they shall be open to inspection only upon order of the President and under rules and regula- tions prescribed by the Secretary and approved by the President : Provided, That the proper officers of any State imposing an income tax may, upon request of the governor thereof, have access to the returns of any corpora- tion, or to an abstract thereof showing the name and income of the cor- poration, at such times and in such manner as the Secretary may pre- scribe : Provided further, That all bona fide stockholders of record owning I per centum or more of the outstanding stock of any corporation shall, upon making request of the Commissioner, be allowed to examine the an- nual income returns of such corporation and of its subsidiaries. Any stockholder who pursuant to the provisions of this section is allowed to examine the return of any corporation, and who makes known in any manner whatever not provided by law the amount or source of income, profits, losses, expenditures, or any particular thereof, set forth or dis- closed in any such return, shall be guilty of a misdemeanor and be pun- ished by a fine not exceeding $1,000, or by imprisonment not exceeding one year, or both. The Commissioner shall as soon as practicable in each year cause to be prepared and made available to public inspection in such manner as he may determine, in the office of the collector in each internal-revenue district and in such other places as he may determine, lists containing the names and the post-office addresses of all individuals making income- tax returns in such district. Publication of Statistics Sec. 258. That the Commissioner, with the approval of the Secretary, shall prepare and publish annually statistics reasonably available with re- spect to the operation of the income, war-profits and excess-profits tax laws, including classifications of taxpayers and of income, the amounts allowed as deductions, exemptions, and credits, and any other facts deemed pertinent and valuable. Collection of Foreign Items Sec. 259. That all individuals, corporations, or partnerships under- taking as a matter of business or for profit the collection of foreign pay- ments of interest or dividends by means of coupons, checks, or bills of ex- change shall obtain a license from the Commissioner and shall be subject to such regulations enabling the Government to obtain the information required under this title as the Commissioner, with the approval of the Secretary, shall prescribe ; and whoever knowingly undertakes to collect such payment's without having obtained a license therefor, or without complying with such regulations, shall be guilty of a misdemeanor and shall be fined not more than $5,000, or imprisoned for not more than one year, or both. REVENUE ACT OF 1921 1779 Citizens of Possessions of the United States Sec. 260. That any individual who is a citizen of any possession of the United States (but not otherwise a citizen of the United States) and who is not a resident of the United States, shall be subject to taxation under his title only as to income derived from sources within the United States, and in such case the tax shall be computed and paid in the same manner and subject to the same conditions as in the case of other persons who are taxable only as to income derived from such sources. Nothing in this section shall be construed to alter or amend the pro- visions of the Act entitled "An Act making appropriations for the naval service for the fiscal year ending June 30, 1922, and for other purposes," approved July 12, 1921, relating to the imposition of income taxes in the Virgin Islands of the United States. Porto Rico and Philippine Islands Sec. 261. That in Porto Rico and the Philippine Islands the income tax shall be levied, assessed, collected, and paid as provided by law prior to the passage of this Act. The Porto Rican or Philippine Legislature shall have power by due enactment to amend, alter, modify, or repeal the income tax laws in force in Porto Rico or the Philippine Islands, respectively. Income from Sources Within the Possessions of the United States Sec. 262. (a) That in the case of citizens of the United States or domestic corporations, satisfying the following conditions, gross income means only gross income from sources within the United States — (i) If 80 per centum or more of the gross income of such citizen or domestic corporation (computed without the benefit of this section) for the three-year period immediately preceding the close of the taxable year (or for such part of such period immediately preceding the close of such taxable year as may be applicable) was derived from sources within a possession of the United States ; and (2) If, in the case of such corporation, 50 per centum or more of its gross income (computed without the benefit of this section) for such period or such part thereof was derived from the active conduct of a trade or business within a possession of the United States ; or (3) If, in the case of such citizen, 50 per centum or more of his gross income (computed without the benefit of this, section) for such period or such part thereof was derived from the active conduct of a trade or business within a possession of the United States either on his own ac- count or as an employee or agent of another. (b) Notwithstanding the provisions of subdivision (a) there shall be included in gross income all amounts received by such citizens or cor- porations within the United States, whether derived from sources within or without the United States. 1780 REVENUE ACT OF 1921 (c) As used in this section the term "possession of the United States" does not include the Virgin Islands of the United States. Effective Date of Title Sec. 263. That this title shall take effect as of January i, 1921. TITLE III.— WAR-PROFITS AND EXCESS-PROFITS TAX FOR 1921. Part I. — General Definitions, Sec. 300. That when used in this title the terms "taxable year," "fiscal year," "personal service corporation," "paid or accrued," and "dividends" shall have the same meaning as provided for the purposes of income tax in sections 200 and 201. Part II. — Imposition of Tax Sec. 301. (a) That in lieu of the tax imposed by Title III of the Revenue Act of 1918, but in addition to the other taxes imposed by this Act, there shall be levied, collected and paid for the calendar year 1921 upon the net income of every corporation (except corporations taxable under subdivision (b) of this section) a tax equal to the sum of the following : First Bracket 20 per centum of the amount of the net income in excess of the excess- profits credit (determined under section 312) and not in excess of 20 per centum of the invested capital; Second Bracket 40 per centum of the amount of the net income in excess of 20 per per centum of the invested capital; (b) For the calendar year 1921 there shall be levied, collected, and paid upon the net income of every corporation which derives in such year a net income of more than $10,000 from any Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive, a tax equal to the sum of the following: (i) Such a portion of a tax computed at the rates specified in sub- division (a) of section 301 of the Revenue Act of 1918, as the part of the net income attributable to such Government contract or contracts bears to the entire net income. In computing such tax the excess-profits credit and the war-profits credit which would be applicable to such calendar year under the Revenue Act of 1918 if it had been continued in force, shall be used ; REVENUE ACT OF 1921 1781 (2) Such a portion of a tax computed at the rates specified in sub- division (a) of this section as the part of the net income not attributable to such Government contract' or contracts bears to the entire net income. For the purpose of determining the part of the net income attributable to such Government contract or contracts, the proper apportionment and allocation of the deductions with respect to gross income derived from such Government contract or contracts and from other sources, respec- tively, shall be determined under rules and regulations prescribed by the Commissioner with the approval of the Secretary. (c) In any case where the full amount of the excess-profits credit is not allowed under the first bracket of subdivision (a), by reason of the fact that such credit is in excess of 20 per centum of the invested capital, the part not so allowed shall be deducted from the amount in the second bracket. Sec. 302. That the tax imposed by subdivision (a) of section 301 shall in no case be more than 20 per centum of the amount of the net income in excess of $3,000 and not in excess of $20,000, plus 40 per centum of the amount of the net income in excess of $20,000; and the limitations im- posed by section 302 of the Revenue Act of 1918 (upon taxes computed un- der subdivision (c) of section 301 of that Act) are hereby made applicable to taxes computed under subdivision (b) of section 301 of this Act. Nothing in this section shall be construed in such manner as to increase the tax imposed by section 301 of this Act. Sec. 303. That if part of the net income of a corporation is derived (i) from a trade or business (or a branch of a trade or business) in which the employment of capital is necessary, and (2) a part (constituting not less than 30 per centum of its total net income) is derived from a separate trade or business (or a distinctly separate branch of the trade or business) which if constituting the sole trade or business would bring it within the class of "personal service corporations," then (under regulations prescribed by the Commissioner with the approval of the Secretary) the tax upon the first part of such net income shall be separately computed (allowing in such computation only the same proportionate part of the credits authorized in section 312), and the fax upon the second part shall be the same percentage thereof as the tax so computed upon the first part is of such first part : Provided, That the tax upon such second part shall in no case be less than 20 per centum thereof, unless the tax upon the entire net income, if computed without benefit of this section, would constitute less than 20 per centum of such entire net income, in which event the tax shall be determined upon the entire net income, without reference to this section, as other taxes are determined under this title. The total tax computed under this section shall be subject to the limitations provided in section 302. Sec. 304. (a) That the corporations enumerated in section 231 shall, to the extent that they are exempt from income tax under Title II, be exempt from taxation under this title. 1782 REVENUE ACT OF 1921 (b) Any corporation whose net income for the taxable year is less than $3,000 shall be exempt from taxation under this title. (c) In the case of any corporation engaged in the mining of gold, the portion of the net income derived from the mining of gold shall be exempt from the tax imposed by this title or any tax imposed by Title II of the Revenue Act of 1917, and the tax on the remaining portion of the net in- come shall be the same proportion of a tax computed without the benefit of this subdivision which such remaining portion of the net income bears to the entire net income. Sec. 305. That if a tax is computed under this title for a period of less than twelve months, the specific exemption of $3,000, wherever re- ferred to in this title, shall be reduced to an amount which is the same proportion of $3,000 as the number of months in the period is of twelve months. Part III. — Excess-Profits Credit. Sec. 312. That the excess-profits credit shall consist of a specific exemp- tion of $3,000 plus an amount equal to 8 per centum of the invested capital for the taxable year. A foreign corporation or a corporation entitled to the benefits of sec- tion 262 shall not be entitled to the specific exemption of $3,000. Part IV. — Net Income. Sec. 320. That for the purpose of this title the net income of a corpora- tion shall be ascertained and returned for the taxable year upon the same basis and in the same manner as provided for income tax purposes in Title II of this Act. Part V. — Invested Capital. Sec. 325. (a) That as used in this title — The term "intangible property" means patents, copyrights, secret processes and formulae, good will, trade-marks, trade-brands, franchises, and other like property; The term "tangible property" means stocks, bonds, notes, and other evidences of indebtedness, bills and accounts receivable, leaseholds, and other property other than intangible property; The term "borrowed capital" means money or other property borrowed, whether represented by bonds, notes, open accounts, or otherwise ; The term "inadmissible assets" means stocks, bonds, and other obliga- tions (other than obligations of the United States), the dividends or in- terest from which is not included in computing net income, but where the income derived from such assets consists in part of gain or profit derived from the sale or other disposition thereof, or where all or part of the REV'ENUE ACT OF 1921 1783 interest derived from such assets is in effect included in the net income because of the limitation on the deduction of interest under paragraph (2) of subdivision (a) of section 234, a corresponding part of the capital in- vested in such assets shall not be deemed to be inadmissible assets ; The term "admissible assets" means all assets other than inadmissible assets, valued in accordance vv-ith the provisions of subdivision (a) of section 326 and section 331. (b) For the purposes of this title the par value of stock or shares shall, in the case of stock or shares issued at a nominal value or having no par value, be deemed to be the fair market value as of the date or dates of issue of such stock or shares. Sec. 326. (a) That as used in this title the term "invested capital" for any year means (except as provided in subdivision (b) and (c) of this section) : (i) Actual cash bona fide paid in for stock or shares; (2) Actual cash value of tangible property, other than cash, bona fide paid in for stock or shares, at the time of such payment, but in no case to exceed the par value of the original stock or shares specifically issued therefor, unless the actual cash value of such tangible property at the time paid in is shovi^n to the satisfaction of the Commissioner to have been clearly and substantially in excess of such par value, in which case such excess shall be treated as paid-in surplus : Provided, That the Commis- sioner shall keep a record of all cases in which tangible property is in- cluded in invested capital at a value in excess of the stock or shares issued therefor, containing the name and address of each taxpayer, the business in which engaged, the amount of invested capital and net income shown by the return, the value of the tangible property at the time paid in, the par value of the stock or shares specifically issued therefor, and the amount included under this paragraph as paid-in surplus. The Commissioner shall furnish a copy of such record and other detailed information with re- spect to such cases when required by resolution of either House of Con- gress, without regard to the restrictions contained in section 257 ; (3) Paid-in or earned surplus and undivided profits; not including surplus and undivided profits earned during the year ; (4) Intangible property bona fide paid in for stock or shares prior to March 3, 1917, in an amount not exceeding (a) the actual cash value of such property at the time paid in, (b) the par vakic of the stock or shares issued therefor, or (c) in the aggregate 25 per centum of the par value of the total stock or shares of the corporation outstanding on March 3, 1917, whichever is lowest; (5) Intangible property bona fide paid in for stock or shares on or after March 3, 1917, in an amount not exceeding (a) the actual cash value of such property at the time paid in, (b) the par value of the stock or shares issued therefor, or (c) in the aggregate 25 per centum of the par value of the total stock or shares of the corporation outstanding at the beginning of the taxable year, whichever is lowest: Provided, That in no 1784 REVENUE ACT OF 1921 case shall the total amount included under paragraphs (4) and (5) exceed in the aggregate 25 per centum of the par value of the total stock or shares of the corporation outstanding at the beginning of the taxable year ; but (b) As used in this title the term "invested capital" does not include borrowed capital. (c) There shall be deducted from invested capital as above defined a percentage thereof equal to the percentage which the amount of inadmis- sible assets is of the amount of admissible and inadmissible assets held during the taxable year. (d) The invested capital for any period shall be the average invested capital for such period, but in the case of a corporation making a return for a fractional part of a year, it shall be the same fractional part of such average invested capital. Sec. 327. That in the following cases the tax shall be determined as provided in section 328: (a) Where the Commissioner is unable to determine the invested capi- tal as provided in section 326; (b) In the case of a foreign corporation or of a corporation entitled to the benefits of section 262 ; (c) Where a mixed aggregate of tangible ^property and intangible prop- erty has been paid in for stock or for stock and bonds and the Commis- sioner is unable satisfactorily to determine the respective values of the several classes of property at the time of payment, or to distinguish the classes of property paid in for stock and for bonds, respectively; (d) Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or in- come of the corporation, work upon the corporation an exceptional hard- ship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the repre- sentative corporations specified in section 328. This subdivision shall not apply to any case (i) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital, nor (2) in which 50 per centum or more of the gross income of the corporation for the taxable year (computed under section 233 of Title II) consists of gains, profit's, commissions, or other income, derived on a cost-plus basis from a Government contract or contracts made between April 6, 1917, and No- vember II, 1918, both dates inclusive. Sec. 328. (a) That in the cases specified in section 327 the tax shall be the amount which bears the same ratio to the net income of the tax- payer (in excess of the specific exemption of $3,000) for the taxable year, as the average tax of representative corporations engaged in a like or similar trade or business, bears to their average net income (in excess of the specific exemption of $3,000) for such year. In the case of a foreign corporation or of a corporation entitled to the benefits of section 262 REVENUE ACT OF 1921 1 785 the tax shall be computed without deducting the specific exemption of $3,000 either for the taxpayer or the representative corporations. In computing the tax under this section the Commissioner shall com- pare the taxpayer only with representative corporations whose invested capital can be satisfactorily determined under section 326 and which are, as nearly as may be, similarly circumstanced with respect to gross income, net income, profits per unit of business transacted and capital employed, the amounts and rate of war profits or excess profits, and all other relevant facts and circumstances. (b) For the purposes of subdivision (a) the ratios between the aver- age tax and the average net income of representative corporations shall be determined by the Commissioner in accordance with regulations pre- scribed by him with the approval of the Secretary. (c) The Commissioner shall keep a record of all cases in which the tax is determined in the manner prescribed in subdivision (a), containing the name and address of each taxpayer, the business in which engaged, the amount of invested capital and net income shown by the return, and the amount of invested capital as determined under such subdivision. The Commissioner shall furnish a copy of such record and other detailed in- formation with respect to such cases when required by resolution of either House of Congress, without regard to the restrictions contained in section 257. Part VI. — Reorganizations. Sec. 331. That in the case of the reorganization, consolidation, or change of ownership of a trade or business, or change of ownership of property, after March 3, 1917, if an interest or control in such trade or business or property of 50 per centum or more remains in the same persons, or any of them, then no asset transferred or received from the previous owner shall, for the purpose of determining invested capital, be allowed a greater value than would have been allowed under this title in computing the in- vested capital of such previous owner if such asset had not been so trans- ferred or received : Provided, That if such previous owner was not a cor- poration, then the value of any asset so transferred or received shall be taken at its cost of acquisition (at the date when acquired by such previous owner) with proper allowance for depreciation, impairment, betterment or development, but no addition to the original cost shall be made for any charge or expenditure deducted as expense or otherwise on or after March I, 1913, in computing the net income of such previous owner for purposes of taxation. Part VII. — Miscellaneous. Skc. 335. (a) That if a corporation (other than a personal service corporation) makes return for a fiscal year beginning in 1920 and ending 1786 REVENUE ACT OF 1921 in 1921, the war-profits and excess-profits tax for the taxable year 1921 shall be the sum of: (i) the same proportion of a tax for the entire period computed under the Revenue Act of 1918, which the portion of such period falling within the calendar year 1920 is of the entire period, and (2) the same proportion of a tax for the entire period computed under this title, which the portion of such period falling within the calendar year 1921 is of the entire period. Any amount heretofore or hereafter paid on account of the tax imposed for such taxable year by the Revenue Act of 1918 shall be credited towards the payment of the tax as above computed, and if the amount so paid exceeds the amount of such tax, the excess shall be credited or refunded to the corporation in accordance with the provisions of section 252 of this Act. (b) If a corporation (other than a personal service corporation) makes a return for a fiscal year beginning in 1921 and ending in 1922, the war- profits and excess-profits tax for the portion of the year falling within the calendar year 1921 shall be an amount equivalent to the same pro- portion of a tax for the entire period computed under this title, which the portion of such period falling within the calendar year 1921 is of the entire period. Sec. 336. That every corporation, not exempt under section 304, shall make a return for the purposes of this title. Such returns shall be made, and the taxes imposed by this title shall be paid, at the same times and places, in the same manner, and subject to the same conditions, as is pro- vided in the case of returns and payment of income tax by corporations for the purposes of Title II, and all the provisions of that title not in- applicable, including penalties, are hereby made applicable to the taxes imposed by this -title. Sec. 337. That in the case of a bona fide sale of mines, oil or gas wells, or any interest therein, where the prinicipal value of the property has been demonstrated by prospecting or exploration and discovery work done by the taxpayer, the portion of the tax imposed by this title at- tributable to such sale shall not exceed 20 per centum of the selling price of such property or interest. Effective Date of Title Sec. 338. That this title shall take effect as of January i, 1921. TITLE IV.— ESTATE TAX. Sec. 400. That when used in this title — The term "executor" means the executor or administrator of the decedent, or, if there is no executor or administrator, any person in actual or constructive possession of any property of the decedent; The term "net estate" means the net estate as determined under the provisions of section 403 ; The term "month" means calendar month ; and REVENUE ACT OF 1921 1787 The term "collector" means the collector of internal revenue of the district in which was the domicile of the decedent at the time of his death, or, if there was no such domicile in the United States, then the collector of the district in which is situated the part of the gross estate of the decedent in the United States, or, if such part of the gross estate is situated in more than one district, then the collector of internal revenue of such district as may be designated by the Commissioner. Sec. 401. That, in lieu of the tax imposed by Title IV of the Revenue Act of 1918, a tax equal to the sum of the following percentages of the value of the net estate (determined as provided in section 403) is hei^eby imposed upon the transfer of the net estate of every decedent dying after the passage of this Act, whether a resident or nonresident of the United States : 1 per centum of the amount of the net estate not in excess of $50,000; 2 per centum of the amount by which the net estate exceeds $50,000 and does not exceed $150,000; 3 per centum of the amount by whicli the net estate exceeds $150,000 and does not exceed $250,000; 4 per centum of the amount l)y whicli the net estate exceeds $250,000 and does not exceed $450,000; 6 per centum of the amount by which the net estate exceeds $450,000 and does not exceed $760,000 ; 8 per centum of the amount by which the net estate exceeds $750,000 and does not exceed $1,000,000; ro per centum of the amount by which the net estate exceeds $1,000,000 and does not exceed $1,500,000; 12 per centum of the amount by which the net estate exceeds $1,500,000 and does not exceed $2,000,000; 14 per centum of the amount by which the net estate exceeds $2,000,000 and does not exceed $3,000,000; 16 per centum of the amount by which the net estate exceeds $3,000,000 and does not exceed $4,000,000; 18 per centum of the amount by which the net estate exceeds $4,000,000 and does not exceed $5,000,000 ; 20 per centum of the amount by which the net estate exceeds $5,000,000 and does not exceed $8,000,000; 22 per centum of the amount liy wliicli the net estate exceeds $8,000,000 and does not exceed $10,000,000; and 25 per centum of the amount by which the net estate exceeds $10,000,000. The taxes imposed by this title or by Title II of the Revenue Act of 1916 (as amended by the Act entitled "An Act to provide increased revenue to defray the expenses of the increased appropriations for the Army and Navy and the extensions of fortifications, and for other purposes," ap- proved March 3, 1917) or by Title IX of the Revenue Act of 1917, or by Title IV of the Revenue Act of 1918, shall not apply to the transfer of the net estate of any decedent who has died or may die from injuries received 1788 REVENUE ACT OF 1921 or disease contracted in line of duty while serving in the military or naval forces of the United States in the war against the German Government, or to the transfer of the net estat'e of any citizen of the United States who has died or may die from injuries received or disease contracted in line of duty while serving in the military or naval forces of any country ^yhile associated with the United States in the prosecution of such war, or prior to the entrance therein of the United States, and any tax collected upon such transfer shall be refunded to the estate of such decedent. Sec. 402. That the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated — (a) To the extent of the interest therein of the decedent at the time of his death which after his death is subject to the payment of the charges against his estate and the expenses of its administration and is subject to distribution as part of his estate; (b) To the extent of any interest therein of the surviving spouse, ex- isting at the time of the decedent's death as dower, curtesy, or by virtue of a statute creating an estate in Heu of dower or curtesy; (c) To the extent of any interest therein of which the decedent has at any time made a transfer, or with respect to which he has at any time created a trust, in contemplation of or intended to take effect in possession or enjoyment at or after his death (whether such transfer or trust is made or created before or after the passage of this Act), except in case of a bona fide sale for a fair consideration in money or money's worth. Any transfer of a material part of his property in the nature of a final disposi- tion or distribution thereof, made by the decedent within two years prior to his death without such a consideration, shall, unless shown to the con- trary, be deemed to have been made in contemplation of death within the meaning of this title; (d) To the extent of the interest therein held jointly or as tenants in the entirety by the decedent and any other person, or deposited in banks or other institutions in their joint names and payable to either or the sur- vivor, except such part thereof as may be shown to have originally be- longed to such other person and never to have been received or acquired by the latter from the decedent for less than a fair consideration in money or money's worth : Provided, That where such property or any part there- of, or part of the consideration with which such property was acquired, is shown to have been at any time acquired by such other person from the decedent for less than a fair consideration in money or money's worth, there shall be excepted only such part of the value of such property as is proportionate to the consideration furnished by such other person : Provided further, That where any property has been acquired by gift, bequest, devise, or inheritance, as a tenancy in the entirety by the decedent and spouse, or where so acquired by the decedent and any other person as joint tenants and their interests are not otherwise specified or fixed by law, then to the extent of one-half of the value thereof; REVENUE ACT OF 1921 1 789 (e) To the extent of any property passing under a general power of appointment exercised by the decedent (i) by will, or (2) by deed executed in contemplation of, or intended to take effect in possession or enjoyment at or after, his death, except in case of a bona fide sale for a fair consideration in money or money's worth ; and (f) To the extent of the amount receivable by the executor as insur- ance under policies taken out by the decedent upon his own life; and to the extent of the excess over $40,000 of the amount receivable by all other beneficiaries as insurance under policies taken out by the decedent upon his own life. Sec. 403. That for the purpose of the tax the value of the net estate shall be determined — (a) In the case of a resident, by deducting from the value of the gross estate — (i) Such amounts for funeral expenses, administration expenses, claims against the estate, unpaid mortgages upon, or any indebtedness in respect t'o, property (except, in the case of a resident decedent, where such prop- erty is not situated in the United States), losses incurred during the set- tlement of the estate arising from fires, storms, shipwreck, or other casualty, or from theft, when such losses are not compensated for by insurance or otherwise, and such amounts reasonably required and actually expended for the support during the settlement of the estate of those dependent upon the decedent, as are allowed by the laws of the jurisdiction, whether within or without the United States, under which the estate is being ad- ministered, but not including any income taxes upon income received after the death of the decedent, or any estate, succession, legacj', or in- heritance taxes ; (2) An amount equal to the value of any property forming a part of the gross estate situated in the United States of any person who died within five years prior to the death of the decedent where such property can be identified as having been received by the decedent from such prior decedent by gift, bequest, devise, or inheritance, or which can be identified as having been acquired in exchange for property so received : Provided, That this deduction shall be allowed only where an estate tax under this or any prior Act of Congress was paid by or on behalf of the estate of such prior decedent, and only in the amount of the value placed by the Com- missioner on such property in determining the value of the gross estate of such prior decedent, and only to the extent that the value of such property is included in the decedent's gross estate and not deducted under paragraphs (i) or (3) of subdivision (a) of this section. This deduction shall be made in case of the estates of all decedents who have died since September 8, 1916; (3) The amount of all bequests, legacies, devices, or transfers, except bona fide sates for a fair consideration in money or money's worth, in con- templation of or intended to take effect in possession or enjoyment at or after the decedent's death, to or for the use of the United States, any I790 ' REVENUE ACT OF 1921 State, Terrilui-y, any political subdivision thereof, or the District of Colum- bia, for exclusively public purposes, or to or for the use of any corporation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, including the encouragement of art and the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual, or to a trustee or trustees exclusively for such religious, charitable, scien- tific, literary, or educational purposes. This deduction shall be made in case of the estates of all decedents who have died since December 31, 1917; and (4) An exemption of $50,000; (b) In the case of a nonresident, by deducting from the value of that part of his gross estate which at the time of his death is situated in the United States — (i) That proportion of the deductions specified in paragraph (i) of subdivision (a) of this section which the value of such part bears to the value of his entire gross estate, wherever situated, but in no case shall the amount so deducted exceed 10 per centum of the value of that part of his gross estate which at the time of his death is situated in the United States ; (2) An amount equal to the value of any property forming a part of the gross estate situated in the United States of any person who died within five years prior to the death of the decedent where such property can be identified as having been received by the decedent from such prior decedent by gift, bequest, devise, or inheritance, or which can be identified as having been acquired in exchange for property so received : Provided, That this deduction shall be allowed only where an estate tax under this or any prior Act of Congress was paid by or on behalf of the estate of such prior decedent, and only in the amount of the value placed by the Com- missioner on such property in determining the value of the gross estate of such prior decedent, and only to the extent that the value of such prop- erty is included in that part of the decedent's gross estate which at the time of his death is situated in the United States and not deducted under paragraphs (i) or (3) of subdivision (b) of this section. This deduction shall be made in case of the estates of all decedents who have died since September 8, 1916; and (3) The amount of all bequests, legacies, devises or transfers, except bona fide sales for a fair consideration, in money, or money's worth, in contemplation of or intended to take effect in possession or enjoyment at or after the decedent's death, to or for the use of the United States, any State, Territory, any political subdivision thereof, or the District of Columbia, for exclusively public purposes, or to or for the use of any do- mestic corporation organized and operated exclusively for religious, chari- table, scientific, literary, or educational purposes, including the encourage- ment of art and the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stock- holder or individual, or U> a trustee or trustees exclusively for such religious, REVENUE ACT OF 1921 1791 charitable, scientific, literary, or educational purposes within the United States. This deduction shall be made in case of the estates of all decedents who have died since December 31, 1917. No deduction shall be allowed in the case of a nonresident unless the executor includes in the return required to be filed under section 404 the value at the time of his death of that part of the gross estate of the non- resident not situated in the United States. For the purpose of this title stock in a domestic corporation owned and held by a nonresident decedent shall be deemed property within the United States, and any property of which the decedent has made a transfer or with respect to which he has created a trust, within the meaning of subdivision (c) of section 402, shall be deemed to be situated in the United States, if so situated either at the time of the transfer or the creation of the trust, or -at the time of the decedent's death. The amount receivable as insurance upon the life of a nonresident de- cedent, and any moneys deposited with any person carrying on the bank- ing business, by or for a nonresident decedent who was not engaged in business in the United States at the time of his death, shall not, for the purpose of this title, be deemed property within the United States. Alissionaries duly commissioned and serving under boards of foreign missions of the various religious denominations in the United States, dying while in the foreign missionary service of such boards, shall not, by reason merely of their intention to permanently remain in such foreign service, be deemed nonresidents of the United States, but shall be pre- sumed to be residents of the State, the District of Columbia, or the Territories of Alaska or Hawaii wherein they respectively resided at the time of their commission and their departure for such foreign service. In the case of any estate in respect to which the tax has been paid, if necessary to allow the benefit of the deduction under paragraphs (2) and (3) of subdivision (a) or (b) the tax shall be redetermined and any excess of tax paid shall be refunded to the executor. Sec. 404. That the executor, within two months after the decedent's death, or within a like period after qualifying as such, shall give written notice thereof to the collector. The executor shall also, at such times and in such manner as may be required by regulations made pursuant to law, file with the collector a return under oath in duplicate, setting forth (a) the value of the gross estate of the decedent at the time of his death, or in case of a nonresident, of that part of his gross estate situated in the United States; (b) the deductions allowed under section 403; (c) the value of the net estate of the decedent as defined in section 403 ; and (d) the tax paid or payable thereon ; or such part of such in- formation as may at the time be ascertainable and such supplemental data as may be necessary to establish the correct tax. Returns shall be made in all cases where the gross estate at the death of the decedent exceeds $50,000, and in the case of the estate of every non- resident any part of whose gross estate is situated in the United States. 1/92 REVENUE ACT OF 1921 If the executor is unable to make a complete return as to any part of the gross estate of the decedent, he shall include in his return a description of such part and the name of every person holding a legal or beneficial interest therein, and upon notice from the collector such .person shall in like manner make a return as to such part of the gross estate. The Commissioner shall make all assessments of the tax under the authority of existing administrative special and general provisions of law relating to the assessment and collection of taxes. Sec. 405. That if no administration is granted upon the estate of a decedent, or if no return is filed as provided in section 404, or if a return contains a false or. incorrect statement of a material fact, the collector or deputy collector shall make a return and the Commissioner shall assess the tax thereon. Sec. 406. That the tax shall be due and payable one year after the decedent's death ; but in any case where the Commissioner finds that pay- ment of the tax within such period would impose undue hardship upon the estate, he may grant an extension or extensions of time for payment not to exceed three years from the due date. The executor shall pay the tax to the collector or deputy collector, and to such portion of the tax, not paid within one year and six months after the decedent's death, interest at the rate of 6 per centum per annum from the expiration of one year after such death shall be added as part of the tax irrespective of any extension or extensions of time that may have been granted for the payment of the tax, or any portion thereof. Sec. 407. That where the amount of tax shown upon a return made in good faith has been fully paid, or time for payment has been ex- tended, as provided in section 406, beyond one year and six months after the decedent's death, and an additional amount of tax is, after the ex- piration of such period of one year and six months, found to be due, then such additional amount shall be paid upon notice and demand by the collector, and if it remains unpaid for one month after such notice and demand there shall be added as part of the tax interest on such additional amount at the rate of 10 per centum per annum from the expiration of such period until paid, and such additional tax and interest shall, until paid, be and remain a lien upon the entire gross estate. The collector shall grant to the person paying the tax duplicate re- ceipts, either of which shall be sufficient evidence of such payment, and shall entitle the executor to be credited and allowed the amount thereof by any court having jurisdiction to audit or settle his accounts. If the executor files a complete return and makes written application to the Commissioner for determination of the amount of the tax and dis- charge from personal liability therefor, the Commissioner, as soon as possible and in any event within one year after receipt of such application, shall notifj^ the executor of the amount of the tax, and upon payment thereof the executor shall be discharged from personal liaibility for any I I REVENUE ACT OF 1921 1 793 additional tax thereafter found to be due, and shall be entitled to receive a receipt or writing showing such discharge : Provided, however, That such discharge shall not operate to release the gross estate from the lien of any additional tax that may hereafter be found to be due while the title to such gross estate remains in the heirs, devisees, or distributees thereof ; but no part of such gross estate shall be subject to such lien or to any claim or demand for any such tax if the title thereto has passed to a bona fide purchaser for value. Sec. 408. That if the tax herein imposed is not paid on or before the due date thereof the collector shall, upon instruction from the Com- missioner, proceed to collect t'he tax under the provisions of general law, or commence appropriate proceedings in any court of the United States, in the name of the United States, to subject the property of the decedent t'o be sold under the judgment or decree of the court. From the proceeds of such sale the amount of the tax, together with the costs and expenses of every description to be allowed by the court, shall be first paid, and the balance shall be deposited according to the order of the court, to be paid under its direction to the person entitled thereto. If the tax or any part thereof is paid by, or collected out of that part of the estate passing to or in the possession of, any person other than the executor in his capacity as such, such person shall be entitled to re- imbursement out of any part of the estate still undistributed or by a just and equitable contribution by the persons whose interest in the estate of the decedent would have been reduced if the tax had been paid before the distribution of the estate or whose interest is subject to equal or prior liability for the payment of taxes, debts, or other charges against the estate, it being the purpose and intent of this title that so far as is practicable and unless otherwise directed by the will of the decedent the tax shall be paid out of the estate before its distribution. If any part of the gross estate consists of proceeds of policies of insurance upon the life of the decedent receivable by a beneficiary other than the executor, the executor shall be entitled to recover from such beneficiary such portion of the total tax paid as the proceeds, in excess of $40,000, of such policies bear to the net estate. If there is more than one such beneficiary the executor shall be entitled to recover from such beneficiaries in the same ratio. Sec. 409. That unless the tax is sooner paid in full, it shall be a lien for ten years upon the gross estate of the decedent, except that such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration, allowed by any court having jurisdiction thereof, shall be divested of such lien. If the Commissioner is satisfied that the tax liability of an estate has been fully discharged or provided for, he may, under regulations prescribed by him with the approval of the Secretary, issue his certificate, releasing any or all prop- erty of such estate from the lien herein imposed. If (a) the decedent makes a transfer of, or creates a trust with re- 1794 REVENUE ACT OF 1921 spect to, any property in contemplation of or intended to take effect in possession or enjoyment at or after his death (except in the case of a bona fide sale for a fair consideration in money or money's worth) or (b) if insurance passes under a contract executed by the decedent in favor of a specific beneficiary, and if in either case the tax in respect thereto is not paid when due, then the transferee, trustee, or beneficiary shall be personally liable for such tax, and such property, to the extent of the de- cedent's interest therein at the time of such transfer, or to the extent of such beneficiary's interest under such contract of insurance, shall be subject to a like lien equal to the amount of such tax. Any part of such property sold by such transferee or trustee to a bona fide purchaser for a fair consideration in money or money's worth shall be divested of the lien and a like lien shall then attach to all the property of such transferee or trustee, except any part sold to a bona fide purchaser for a fair consideration in money or money's worth. Sec. 410. That whoever knowingly makes any false statement in any notice or return required to be filed under this title shall be liable to a penalty of not exceeding $5,000, or imprisonment not exceeding one year, or both. Whoever fails to comply with any duty imposed upon him by section 404, or, having in his possession or control any record, file, or paper, containing or supposed to contain any information concerning the estate of the decedent, or, having in his possession or control any property com- prised in the gross estate of the decedent, fails to exhibit the same upon request to the Commissioner or any collector or law officer of the United States, or his duly authorized deputy or agent, who desires to examine the same in the performance of his duties under this title, shall be liable to a penalty of not exceeding $500, to be recovered, with costs of suit, in a civil action in the name of the United States. Sec. 411. (a) That the term "resident" as used in this title includes a citizen of the United States with respect to whose property any probate or administration proceedings are had in the United States Court for China. Where no part of the gross estate qf such decedent is situated in the United States at the time of his death, the total amount of tax due under this title shall be paid to or collected by the clerk of such court, but where any part of the gross estate of such decedent is situated in the United States at the time of his death, the tax due under this title shall be paid to or collected by the collector of the district in which is situated the part of the gross estate in the United States, or, if such part is situated in more than one district, then the collector of such district as may be designated by the Commissioner. (b) For the purpose of this section the clerk of the United States Court for China shall be a collector for the territorial jurisdiction of such court, and taxes shall be collected by and paid to him in the same manner and subject to the same provisions of law, including penalties, as the taxes collected by and paid to a collector in the United States. REVENUE ACT OF 1921 1 795 (c) The proviso in the Act entitled "An Act making appropriation for t'he Diplomatic and Consular Service for the fiscal year ending June 30, 1921," approved June 4, 1920, which reads as follows : "Provided, That in probate and administration proceedings there shall be collected by said clerk, before entering the order of final distribution, to be paid into the Treasury of the United States, the same inheritance taxes from time to time collected under the laws enacted by the Congress of the United States from the estates of decedents residing within the territorial juris- diction of the United States," is hereby repealed. • TITLE X.— SPECIAL TAXES. Capital Stock Tax Sec. iooo. (a) That on and after July i, 1922, in lieu of the tax imposed by section 1000 of the Revenue Act of 1918 — (i) Every domestic corporation shall pay annually a special excise tax with respect to carrying on or doing business, equivalent to $1 for each $1,000 of so much of the fair average value of its capital stock for the preceding year ending June 30 as is in excess of $S,ooo. In estimating the value of capital stock the surplus and undivided profits shall be in- cluded ; (2) Every foreign corporation shall pay annually a special excise fax with respect to carrying on or doing business in the United States, equivalent to $1 for each $1,000 of the average amount of capital employed in the transaction of its business in the United States during the preceding year ending June 30. (b) The taxes imposed by this section shall not apply in any year to any corporation which was not engaged in business (or, in the case of a foreign corporation, not engaged in business in the United States) during the preceding year ending June 30, nor to any corporation enumerated in section 231, nor to any insurance company subject to the tax imposed by section 243 or 246. (c) Section 257 shall apply to all returns filed with the Commissioner for purposes of the tax imposed by this section. TITLE XIIL— GENERAL ADMINISTRATIVE PRO- VISIONS. Laws Made Applicable Sec. 1300. That all administrative, special, or stamp provisions of law, including the law relating to the assessment of taxes, so far as applicable, are hereby extended to and made a part of this Act, and every person liable to any tax imposed by this Act, or for the collection thereof, shall keep such records and render, under oath, such statements and returns, 1796 REVENUE ACT OF 1921 and shall coniplj- with such regulations as the Commissioner, with the approval of the Secretary, may from time to time prescribe. Penalties Sec. 1302. (a) That any person required under Titles V, VI, VII, VIII, IX, X, or XII, to pay, or to collect, account for and pay over any tax, or required by law or regulations made under authority thereof to make a return or supply any information for the purposes of the com- putation, assessment, or collection of any such tax, who fails to pay, collect, or truly account for and pay over any such tax, make any such return or supply any such information at the time or times required by law or regulation shall in addition to other penalties provided by law be subject to a penalty of not more than $1,000. (b) Any person who willfully refuses to pay, collect, or truly account for and pay over any such tax, make such return or supply such informa- tion at the time or times required by law or regulation, or who w-illfully attempts in any manner to evade such tax, shall be guilty of a mis- demeanor and in addition to other penalties provided by law shall be fined not more than $10,000 or imprisoned for not more than one year, or both, together with the costs of prosecution. (c) Any person who willfully refuses to pay, collect, or truly account for and pay over any such tax shall in addition to other penalties provided by law be liable to a penalty of the amount of the tax evaded, or not paid, collected, or accounted for and paid over, to be assessed and collected in the same manner as taxes are assessed and collected: Provided, Iwivever. That no penalty shall be assessed under this subdivision for any offense for which a penalty may be assessed under authority of section 3176 of the Revised Statutes, as amended, or for any offense for which a penalty has been recovered under section 3256 of the Revised Statutes. (d) The term "person" as used in this section includes an officer or employee of a corporation or a member or employee of a partnership, who as such officer, employee, or- member is under a duty to perform the act in respect of which the violation occurs. ■ Rules and Regulations Sec. 1303. That the Commissioner, with the approval of the Secretary, is hereby authorized to make all needful rules and regulations for the enforcement of the provisions of this Act. The Commissioner, with such approval may by regulation provide that any return required by Titles V, VI, VII, VIII, IX, or X to be under oath may, if the amount of the tax covered thereby is not in excess of $10, be signed or acknowledged before two witnesses instead of under oath. Fractional Parts of a Cent Sec. 1306. That in the paynieiU of any ta.\ under this Act not payable by stamp a fractional part of a cent shall be disregarded unless it amounts to one-half cent or more, in which case it shall be increased to i cent. REVENUE ACT OF 1921 1797 Returns Sec. 1307. That whenever in the judgment of the Commissioner neces- sary he may require any person, by notice served upon him, to make a return or such statements as he deems sufficient to show whether or not such person is Hable to tax. Examination of Books and Witnesses Sec. 1308. That the Commissioner, for the purpose of ascertaining the correctness of any return or for the purpose of making a return where none has been made, is hereby authorized, by any revenue agent or inspector designated by him for that purpose, to examine any books, papers, records, or memoranda bearing upon the matters required to be included in the return, and may require the attendance of the person rendering the return or of any officer or employee of such person, or the attendance of any other person having knowledge in the premises, and may take his testimony with reference to the matter required by law to be included in such return, with power to administer oaths to such person or persons. Unnecessary Examinations Sec. 1309. That no taxpayer shall be subjected to unnecessary examin- ations or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Commissioner, after investigation, notifies the tax- payer in writing that an additional inspection is necessary. Jurisdiction of Courts Sec. 1310. (a) That if any person is summoned under this Act to appear, to testify, or to produce books, paper or other data, the district court of the United States for the district in which such person resides shall have jurisdiction bv appropriate process to compel such attendance, testimony, or production of books, papers, or other data. (b) The district courts of the United States at the instance of the United States are hereby invested with such jurisdiction to make and issue, both in actions at law and suits in equity, writs and orders of in- junction, and of ne exeat republica, orders appointing receivers, and such other orders and process, and to render such judgments and decrees, granting in proper cases both legal and equitable relief together, as may be necessary or appropriate for the enforcement of the provisions of this Act. The remedies hereby provided are in addition to and not exclusive of any and all other remedies of the United States in such courts or otherwise to enforce such provisions. (c) Paragraph Twentieth of section 24 of the Judicial Code is amended by adding at the end thereof the following new paragraph : "Concurrent with the Court of Claims, of any suit or proceeding, commenced after the passage of the Revenue Act of 1921, for the recovery of any infernal-revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected 1798 REVENUE ACT OF 1921 without authority or any sum alleged to have been excessive or in any manner wrongfully collected, under the internal-revenue laws, even if the claim exceeds $10,000, if the collector of internal-revenue by whom such tax, penalty, or sum was collected is dead at the time such suit or pro- ceeding is commenced." Amendments to Revised Statutes Sec. 131 1. That sections 3164, 3165, 3167, 3172, 3173 and 3176 of the Revised Statutes, as amended, are reenacted, without change, as follows : "Sec. 3164. It shall be the duty of every collector of internal revenue having knowledge of any willful violation of any law of the United States relating to the revenue, within thirty days after coming into possession of such knowledge, to file with the district attorney of the district in which any fine, penalty, or forfeiture may be incurred, a state- ment of all the facts and circumstances of the case within his knowledge, together with the names of the witnesses, setting forth the provisions of law believed to be so violated on which reliance may be had for con- demnation or conviction. "Sec. 3165. Every collector, deputy collector, internal-revenue agent, and internal-revenue officer assigned to duty under an internal-revenue agent, is authorized to administer oaths and to take evidence touching any part of the administration of the internal-revenue laws with which he is charged, or where such oaths and evidence are authorized by law or regulation authorized by law to be taken. "Sec. 3167. It shall be unlawful for any collector, deputy collector, agent, clerk, or other officer or employee of the United States to divulge or to make known in any manner whatever not provided by law to any person the operations, style of work, or apparatus of any manufacturer or producer visited by him in the discharge of his official duties, or the amount or source of income, profits, losses, expenditures, or any particular thereof, set forth or disclosed in any income return, or to permit any income return or copy thereof or any book containing anj' abstract or particulars thereof to be seen or examined by any person except as provided by law; and it shall be unlawful for any person to print or publish in any manner whatever not provided by law any income return, or any part thereof or source of income, profits, losses, or expenditures appearing in any income return ; and any offense against the foregoing provision shall be a misdemeanor and be punished by a fine not exceeding $1,000 or by imprisonment not exceeding one year, or both, at the dis- cretion of the court ; and if the offender be an officer or employee of the United States he shall be dismissed from office or discharged from em- ployment. "Sec. 3172. Every collector shall, from time to time, cause his deputies to proceed through every part of his district and inquire after and con- cerning all persons therein who are liable to pay any internal-revenue tax, and all persons owning or having the care and management of any objects REVENUE ACT OF 1921 1799 liable to pay any tax, and to make a list of such persons and enumerate said objects. "Sec. 3173. It shall be the duty of any person, partnership, firm, as- sociation, or corporation, made liable to any duty, special tax, or other tax imposed by law, when not otherwise provided for, (i) in case of a special tax, on or before the thirty-first day of July in each year, and (2) in other cases before the day on which the taxes accrue, to make a list or return, verified by oath, to the collector or a deputy collector of the district where located, of the articles or objects, including the quantity of goods, wares, and merchandise, made or sold and charged with a tax, the several rates and aggregate amount', according to the forms and regulations to be prescribed by the Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury, for which such person, partnership, firm, association, or corporation is liable: Provided^ That if any person liable to pay any duty or fax, or owning, possessing, or having the care or management of property, goods, wares, and merchandise, articles or objects liable to pay any duty, tax, or license, shall fail to make and ex- hibit a list or return required by law, but shall consent to disclose the particulars of any and all the property, goods, wares, and merchandise, articles, and objects liable to pay any duty or tax, or any business or occupation liable to pay any tax as aforesaid, then, and in that case, it shall be the duty of the collector or deputy collector to make such list or return, which, being distinctly read, consented to, and signed and verified by oath by the person so owning, possessing, or having the care and management as aforesaid, may be received as the list of such person : Provided further. That in case no annual list or return has been rendered by such person to the collector or deputy collector as required by law, and the person shall be absent from his or her residence or place of business at the time the collector or a deputy collector shall call for the annual list or return, it shall be the duty of such collector or deputy collector to leave at such place of residence or business, with some one of suitable age and discretion, if such be present, otherwise to deposit in the nearest post office, a note or memorandum, addressed to such person, requiring him or her to render to such collector or deputy collector the list or return re- quired by law within ten days from the date of such note or memorandum, verified by oath. And if any person, on being notified or required as afore- said, shall refuse or neglect to render such list or return within the time required as aforesaid, or whenever any person who is required to deliver a monthly or other return of objects subject to tax fails to do so at the time required, or delivers any return which, in the opinion of the collector, is erroneous, false, or fraudulent, or contains any undervaluation or understatement, or refuses to allow any regularly authorized Govern- ment officer to examine the books of such person, firm, or corporation, it shall be unlawful for the collector to summon such person, or any other person having possession, custody, or care of books of account containing entries relating to the business of such person or any other person he may l8oo REVENUE ACT OF 1921 deem proper, to appear before him and produce such books at a time and place named in the summons, and to give testimony or answer inter- rogatories, under oath, respecting any objects or income Hable fo tax or the returns thereof. The collector may summon any person residing or found within the State or Territory in which his district lies ; and when the person intended to be summoned does not reside and can not be found within such State or Territory, he may enter any collection district where such person may be found and there make the examination herein authorized. And to this end he may there exercise all the authority which he might lawfully exercise in the district for which he was commissioned : Provided, That 'person,' as used in this section, shall be construed to in- clude any corporation, joint-stock company or association, or insurance company when such construction is necessary to carry out its provisions. "Sec. 3176. If any person, corporation, company, or association fails to make and file a return or list at the time prescribed by law or by regu- lation made under authority of law, or makes, willfully or otherwise, a false or fraudulent return or list, the collector or deputy collector shall make the return or list from his own knowledge and from such information as he can obtain through testimony or otherwise. In any such case the Commissioner may, from his own knowledge and from such information as he can obtain through testimony or otherwise, make a return or amend any return made by a collector or deputy collector. Any return or list so made and subscribed by the Commisioner, or by a collector or deputy collector and approved by the Commissioner, shall be prima facie good and sufficient for all legal purposes. "If the failure to file a return or list is due to sickness or absence, the collector may allow such further time, not exceeding thirty days, for making and filing the return or list as he deems proper. "The Commissioner of Internal Revenue shall determine and assess all taxes, other than stamp taxes, as to which returns or lists are so made under the provisions of this section. In case of any failure to make and file a return or list within the time prescribed by law, or prescribed by the Commissioner of Internal Revenue or the collector in pursuance of law, the Commissioner of Internal Revenue shall add to the tax 25 per centum of its amount, except that when a return is filed after such time and it is shown that the failure to file it was due to a reasonable cause and not to willful neglect, no such addition shall be made to the tax. In case a false and fraudulent return or list is willfully made, the Commissioner of Internal Revenue shall add to the tax 50 per centum of its amount. "The amount so added to any tax shall be collected at the same time and in the same manner and as a part of the tax unless the tax has been paid before the discovery of the neglect, falsity, or fraud, in which case the amount so added shall be collected in the same manner as the tax." Final Determinations and Assessments Sec. 1312. That if after a determination and assessment in any case REVENUE ACT OF 1921 1801 the taxpayer lias without protest paid in wliole any tax or penalty, or accepted any abatement, credit, or refund based on such determination and assessment, and an agreement is made in writing between the taxpayer and the Commissioner, with the approval of t'he Secretary, that such determin- ation and assessment shall be final and conclusive, then (except upon a showing of fraud or malfeasance or misrepresentation of fact materially affecting the determination or assessment thus made) (r) the case shall not be reopened or the determination and assessment modified by any officer, employee, or agent of the United States, and (2) no suit, action, or proceeding to annul, modify, or set aside such determination or assess- ment shall be entertained by any court of the United States. Administrative Review Sec. 1313. That in the absence of fraud or mistake in mathematical calculation, the findings of facts in and the decision of the Commissioner upon (or in case the Secretary is authorized to approve the same, then after such approval) the merits of any claim presented under or authorized by the internal-revenue laws shall not be subject to review by any other administrative officer, employee, or agent of the United States. Retroactive Regulations Sec. 1314. That in case a regulation or Treasury decision relating to the internal-revenue laws made by the Commissioner or the Secretary, or by the Commissioner with the approval of the Secretary, is reversed by a subsequent regulation or Treasury decision, and such reversal is not im- mediately occasioned or required by a decision of a court of competent jurisdiction, such subsequent regulation or Treasury decision may, in the discretion of the Commissioner, with the approval of the Secretary, be applied without retroactive effect. Refunds Sec. 1315. That section 3220 of the Revised Statutes, as amended, is reenacted without change, as follows : "Sec. 3220. The Commissioner of Internal Revenue, subject to reg- ulations prescribed by the Secretary of the Treasury, is authorized to remit, refund, and pay back all taxes erroneously or illegally assessed or collected, all penalties collected without authority, and all taxes that appear to be unjustly assessed or excessive in amount, or -in any manner wrongfully collected ; also to repay to any collector or deputy collector the full amount of such sums of money as may be recovered against him in any court, for any internal revenue taxes collected by him, with the cost and expenses of suit; also all damages and costs recovered against any assessor, assistant assessor, collector, deputy collector, agent, or inspector, in any suit brought against him by reason of anything done in the due performance of his official duty, and shall make report to Congress at the beginning of each regular session of Congress of al! transactions under this section." i8o2 REVENUE ACT OF 1921 Sec. 1316. That section 3228 of the Revised Statutes is amended to read as follows : "Sec. 3228. All claims for the refunding or crediting of any internal revenue tax alleged to have been erroneously or illegally assessed or col- lected, or of any penalty alleged to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrong- fully collected, must be presented to the Commissioner of Internal Revenue within four years next after payment of such tax, penalty, or sum." This section, except as modified by section 252, shall apply retroactively to claims for refund under the Revenue Act of 1916, the Revenue Act of 1917, and the Revenue Act of 1918. Sec. 1317. That the paragraph of section 3689 of the Revised Statutes, as amended, reading as follows: "Refunding taxes illegally collected (in- ternal revenue) : To refund and pay back duties erroneously or illegally assessed or collected under the internal revenue laws," is repealed from and after June 30, 1920; and the Secretary and Treasury shall submit for the fiscal year 1921 and annually thereafter, an estimate of appropriations to refund and pay back duties or taxes erroneously or illegally assessed or collected under the internal-revenue laws, and to pay judgments, including interest and costs, rendered for taxes or penalties erroneously or illegally assessed or collected under the internal-revenue laws. Limitations upon Suits and Prosecutions Sec. 1318. That section 3226 of the Revised Statutes is amended to read as follows : "Sec. 3226. No suit or proceeding shall be maintained in any court for the recovery of any internal-revenue tax alleged to have been erro- neously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Commissioner of Internal Revenue, according to the provisions of law in that regard, and the regulations of the Secretary of the Treasury established in pursuance thereof. No such suit or proceeding shall be begun before the expiration of six months from the date of filing such claim unless the Commissioner renders a decision thereon within that time, nor after the expiration of five years from the date of the payment of such tax penalty, or sum." This section shall not affect any suit or proceeding instituted prior to the passage of this Act, but shall apply to all suits and proceedings in- stituted after the passage of this Act, whether or not barred by prior Acts of Congress. Sec. 1319. That section 3227 of the Revised Statutes is hereby repealed but such repeal shall not affect any suit or proceeding instituted prior to the passage of this Act. Sec. 1320. That no suit or proceeding for the collection of any in- ternal revenue tax shall be begun after the expiration of five years from REVENUE ACT OF 1921 1803 the time such tax was due, except in the case of fraud with intent to evade tax, or willful attention in any manner to defeat or evade tax. This sec- tion shall not apply to suits or proceedings for the collection of taxes under section 250 of this Act, nor fo suits or proceedings begun at the time of the passage of this Act. Sec. 1321. (a) That the Act entitled "An Act to limit the time within which prosecutions may be instituted against persons charged with violating internal-revenue laws," approved July 5, 1884, is amended to read as follows : "That no person shall be prosecuted, tried, or punished for any of the various offenses arising under the internal-revenue laws of the United States unless the indictment is found or the information instituted within three years next after the commission of the offense: Provided, That the time during which the person committing the offense is absent from the district wherein the same is committed shall not be taken as any part of the time limited by law for the commencement of such proceedings : Provided further, That the provisions of this Act shall not apply to offenses committed prior to its passage : Provided further. That where a complaint shall be instituted before a commissioner of the United States within the period above limited, the time shall be extended until the discharge of the grand jury at its next session within the district: And provided further, That this Act shall not apply to offenses committed by oflficers of the United States." (b) Any prosecution or proceeding under an indictment found or in- formation instituted prior to the passage of this Act shall not be affected in any manner by this amendment, but such prosecution or proceeding shall be subject to the limitations imposed by law prior to the passage of this Act. Assessments Sec. 1322. That all infernal revenue taxes, except as provided in section 250 of this Act, shall, notwithstanding the provisions of section 3182 of the Revised Statutes or any other provision of law, be assessed within four years after such taxes became due, but in the case of fraud with intent to evade tax or willful attempt in any manner to defeat or evade tax, such tax may be assessed at any time. Fraudulent Returns Sec. 1323. That section 3225 of the Revised Statutes of the United States, as amended, is reenacted without change as follows : "Sec. 3225. When a second assessment is made in case of any list, statement, or return, which in the opinion of the collector or deputy collector was false or fraudulent, or contained any understatement or un- dervaluation, such assessment shall not be remitted, nor shall taxes collected under such assessment be refunded or paid back, or recovered by any iuit, Holess it is proved that such list, statement, or return was not l8o4 REVENUE ACT OF 1921 willfully false or fraudulent and did not contain any willful understatement or undervaluation." Interest on Refunds and Judgments Sec. 1324. (a) That upon the allowance of a claim for the refund of or credit for internal revenue taxes paid, interest shall be allowed and paid upon the total amount of such refund or credit at the rate of one- half of I per centum per month to the date of such allowance, as follows : (i) if such amount was paid under a specific protest setting forth in detail the basis of and reasons for such protest, from the time when such tax was paid, or (2) if such amount was not paid under protest but pur- suant to an additional assessment, from the time such additional assessment was paid, or (3) if no protest was made and the tax was not paid pursuant to an additional assessment, from six months after the date of filing of such claim for refund or credit. The term "additional assess- ment" as used in this section means a further assessment for a tax of the same character previously paid in part. (b) Section 177 of the Judicial Code is amended to read as follows: "Sec. 177. No interest shall be allowed on any claim up to the time of the rendition of judgment by the Court of Claims, unless upon a contract expressly stipulating for the payment of interest, except that interest may be allowed in any judgment of any court rendered after the passage of the Revenue Act of 1921 against the United States for any internal-revenue tax erroneously or illegally assessed or collected, or for any penalty col- lected without authority or any sum which was excessive or in any manner wrongfully collected, under the internal-revenue laws." Payment of Taxes by Check or United States Securities Sec. 1325. That collectors may receive, at par with an adjustment for accrued interest', notes or certificates of indebtedness issued by the United States and' uncertified checks in payment of income, war-profits and excess- profits taxes and any other taxes payable other than by stamp, during such time and under such regulations as the Commissioner, with the approval of the Secretary, shall prescribe ; but if a check so received is not paid by the bank on which it is drawn the person by whom such check has been tendered shall remain liable for the payment of the tax and for all legal penalties and additions the same as if such check had not been tendered. Frauds on Purchasers Sec. 1326. That whoever in connection with the sale of lease, or offer for sale or lease, of any article, or for the purpose of making such sale or lease, makes any statement, written or oral, (i) intended or calculated to lead any person to believe that any part of the price at which such' article is sold or leased, or offered for sale or lease, consists of a tax imposed under the authority of the United States, or (2) ascribing a REVENUE ACT OF 1921 1805 particular part of such price to a tax imposed under the authority of the United States, knowing that such statement is false or that the tax is not so great as the portion of such price ascribed to such tax, shall be guilty of a misdemeanor and upon conviction thereof shall be punished by a fine of not more than $1,000 or by imprisonment not exceeding one year, or both. Tax Simplification Board Sec. 1327. (a) That there is hereby established in the Department of the Treasury a board to be known as the "Tax Simplification Board" (hereinafter in this section called the "Board"), to be composed as follows: (i) Three members who shall represent the public, to be appointed by the President; and (2) Three members who shall represent the Bureau of Internal Revenue and shall be officers or employees of the United States serving in such Bureau, to be appointed by the Secretary. (b) Any vacancy in the Board shall be filled in the same manner as the original appointment. The members representing the public shall serve without compensation except reimbursement for traveling, sub- sistence, and other necessary expenses incurred in the performance of the duties vested in them by this section. The members representing the Bureau of Internal Revenue shall serve without compensation in addition to that received for their service in such Bureau. (c) The Secretary shall furnish the Board with such clerical assist- ance, quarters and stationery, furniture, office equipment, and other sup- plies as may be necessary for the performance of the duties vested in them by this section. (d) It shall be the duty of the Board to investigate the procedure of and the forms used by the Bureau in the administration of the internal revenue laws, and to make recommendations in respect to the simplification thereof. The Board shall make a report to the Congress on or before the first Monday of December in each year. (e) The expenditures of the Board shall be paid upon vouchers ap- proved by the Board and signed by the chairman thereof. For the ex- penditures of the Board for the fiscal year ending June 30, 1922, there is authorized to be appropriated, out of any money in the Treasury not otherwise appropriated, the sum of $10,000. (f) The Board shall cease to exist on December 31, 1924. Consolidation of Liberty Bond Tax Exemptions Sec. 1328. That the various Acts authorizing the issues of Liberty bonds are amended and supplemented as follows : (a) On and after January i, 1921, 4 per centum and 4^4 per centum Liberty bonds shall be exempt from graduated additional income taxes, commonly known as surtaxes, and excess-profits and war-profits taxes, now or hereafter imposed by the United States upon the inc(jme or i8o6 REVENUE ACT OF 1921 profits of individuals, partnerships, corporations, or associations in respect to the interest on aggregate principal amounts thereof as follows: 9 Until the expiration of two years after the date of the termination of the war between the United States and the German Government, as fixed by proclamation of the President, on $125,000 aggregate principal amount ; and for three years more on $50,000 aggregate principal amount. (b) The exemptions provided in subdivision (a) shall be in addition to the exemptions provided in section 7 of the Second Liberty Bond Act, and in addition to the exemption provided in subdivision (3) of section I of the Supplement to the Second Liberty Bond Act in respect to bonds issued upon conversion of 3]4 per centum bonds, but shall be in lieu of the exemptions provided and free from the conditions and limitations im- posed in subdivisions (i) and (2) of section i of the Supplement to Second Liberty Bond Act and in section 2 of the Victory Liberty Loan Act. Deposit of United States Bonds or Notes in Lieu of Surety Sec. 1329. That wherever by the laws of the United States or regula- tions made pursuant thereto, any person is required to furnish any recognizance, stipulation, bond, guaranty, or undertaking, hereinafter called "penal bond," with surety or sureties, such person may, in lieu of such surety or sureties, deposit as security with the official having authority to approve such penal bond, United States Liberty bonds or other bonds or notes of the United States in a sum equal at their par value to the amount of such penal bond required to be furnished, together with an agreement authorizing such official to collect or sell such bonds or notes so deposited in case of any default in the performance of any of the conditions or stipulations of such penal bond. The acceptance of such United States bonds or notes in lieu of surety or sureties required by law shall have the same force and effect as individual or corporate sureties, or certified checks, bank drafts, post-office money orders, or cash, for the penalty or amount of such penal bond. The bonds or notes deposited here- under and such other United States bonds or notes as may be sub- stituted therefor from time to time as such security, may be deposited with the Treasurer of the United States, a Federal reserve bank, or other depositary duly designated for that purpose by the Secretary, which shall issue receipt therefor, describing such bonds or notes so deposited. As soon as security for the performance of such penal bond is no longer necessary, such bonds or notes so deposited, shall be returned to the depositor : Provided, That in case a person or persons supplying a con- tractor with labor or material as provided by the Act of Congress, ap- proved February 24, 1905 (33 Stat. 811), entitled "An Act to amend an Act approved August thirteenth, eighteen hundred and ninety-four, en- titled 'An Act for the protection of persons furnishing materials and labor for the construction of public works,' " shall file with the obligee, at any time after a default in the performance of any contract subject to REVENUE ACT OF 1921 1807 said Acts, the application and affidavit therein provided, the obligee shall not deliver to the obligor the deposited bonds or notes nor any surplus proceeds thereof until the expiration of the time limited by said Acts for the institution of suit by such person or persons, and, in case suit shall be instituted within such time, shall hold said bonds or notes or proceeds subject to the order of the court having jurisdiction thereof: Provided further. That nothing herein contained shall afifect or impair the priority of the claim of the United States against the bonds or notes deposited or any right or remedy granted by said Acts or by this section to the United States for default upon any obligation of said penal bonds : Proznded further. That all laws inconsistent with this section are hereby so modified as to conform to the provisions hereof : And provided further. That nothing contained herein shall affect the authority of courts over the security, where such bonds are taken as security in judicial proceedings, or the authority of any administrative officer of the United States to receive United States bonds for security in cases authorized by existing laws. The Secretary may prescribe rules and regulations necessary and proper for carrying this section into effect. Lost Stamps for Tobacco, Cigars, and So Forth Sec. 1330. That section 3315 of the Revised Statutes, as amended, is reenacted without change, as follows : "Sec. 3315. The Commissioner of Internal Revenue may, under regu- lations prescribed by him with the approval of the Secretary of the Treasury, issue stamps for restamping packages of distilled spirits, to- bacco, cigars, snuff, cigarettes, fermented liquors, and wines which have been duly stamped but from which the stamps have been lost or destroyed by unavoidable accident." Consolidated Returns for Year 1917 Sec. 1331. (a) That Title II of the Revenue Act of 1917 shall be construed to impose the taxes therein mentioned upon the basis of consoli- dated returns of net income and invested capital in the case of domestic cor- porations and domestic partnerships that were affiliated during the cal- endar year 1917. (b) For the purpose of this section a corporation or partnership was affiliated with one or more corporations or partnerships (i) when such corporation or partnership owned directly or controlled through closely affiliated interests or by a nominee or nominees all or substantially all the stock of the other or others, or (2) when substantially all the stock of two or more corporations or the business of two or more partnerships was owned by the same interests : Provided, That such corporations or partner- ships were engaged in the same or a closely related business, or one cor- poration or partnership bought from or sold to another corporation or partnership products or services at prices above or below the current mar- ket, thus effecting an artificial distribution of profits, or one corporation or REVENUE ACT OF 1921 partnership in any way so arranged its financial relationships with another corporation or partnership as to assign to it a disproportionate share of net income or invested capital. For the purposes of this section, public service corporations which (i) were operated independently, (2) were not physically connected or merged and (3) did not receive special per- mission to make a consolidated return, shall not be construed to have been affiliated ; but a railroad or other public utility which was owned by an in- dustrial corporation and was operated as a plant facility or as an integral part of a group organization of affiliated corporations which were re- quired to file a consolidated return, shall be construed to have been affiliated. (c) The provisions of this section are declaratory of the provisions of Title II of the Revenue Act of 1917. Alternative Tax on Personal Service Corporations Sec. 1332. (a) That if either subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of this Act is by final adjudication declared invalid, there shall, in addition to all other taxes, be levied, collected, and paid on the net income (as defined in section 2^2) received during the calendar years 1918, 1919, 1920, and 1921, by every personal service corporation (as defined in section 200) included within the provisions of such subdivisions, a tax equal to the taxes imposed by Titles II and III of the Revenue Act of 1918 and, in the case of income received during the calendar year 1921, by Titles II and III of this Act. (b) In such event every such personal service corporation shall, on or before the fifteenth day of the sixth month following the date of entry of decree upon such final adjudication, make a return of any income re- ceived during each of the calendar years 1918, 1919, 1920, and 1921 in the manner prescribed by the Revenue Act of 1918 (or in the manner prescribed by this Act, in the case of income received during the calendar year 1921). Such return shall be made and the net income shall be computed on the basis of the taxpayer's annual accounting period (fiscal year or calen- dar year, as the case may be) in the manner provided for other corpora- tions under the Revenue Act of 1918 and this Act. (c) If either subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of this Act is so declared invalid, claims for credit or refund of taxes paid under both such sections shall be allowed, if made within the time provided in subdivision (f) of this section. (d) In case the claims for credit or refund, filed within six months from such date of entry of decree, represent less than 30 per centum of the outstanding stock or shares in the corporation, the amount of taxes imposed by this section upon such corporation shall be reduced to that proportion thereof which the number of stock or shares owned by the shareholders or members making such claims bears to the total number of stock or shares outstanding. REVENUE ACT OF 1921 1 809 (e) The tax imposed by this section shall be assessed, collected, and paid upon the same basis, in the same manner, and subject to the same pro- visions of law, including penalties, as the taxes imposed by sections 230 and 301 of the Revenue Act of 1918 (or by sections 230 and 301 of this Act, in the case of income received during the calendar year 1921), but no interest or penalties shall be due or payable thereon for any period prior to the date upon which the return is by this section required to be made and the first installment paid. The amount of tax paid by any shareholder or member of a personal service corporation pursuant to the provisions of subdivision (e) of section 218 of the Revenue Act of 1918 or subdivision (d) of section 218 of this Act shall be credited against the tax due from such corporation under this section upon the joint written application of such corporation and such shareholder or member of his representatives, heirs, or assigns, if such application is filed with the Commissioner within six months from such date of entry of decree. (f) Notwithstanding any other provision of law, no claim for a credit or refund of taxes paid under subdivision (e) of section 218 of the Reve- nue Act of 1918 or subdivision (d) of section 218 of this Act, may be filed after the expiration of six months from such date of entry of de- cree : Provided, however. That a personal service corporation of which no shareholder or member has filed such claim within such period of six months shall not be subject to the tax imposed by this section. TITLE XIV.— GENERAL PROVISIONS Repeals Sec. 1400. (a) That the following parts of the Revenue Act of 1918 are repealed, to take effect (except as otherwise provided in this Act) on January i, 1922, subject to the limitations provided in subdivision (b) : Title II (called "Income Tax") as of January i, 1921 ; Title III (called "War-Profits and Excess-Profits Tax") as of Jan- uary I, 1921 ; Title IV (called "Estate Tax") on the passage of this Act; Title X (called "Special Taxes") ; Sections 1314, 1315, 1316, 1317, 1319, and 1320 of Title XIII (Ijeing certain administrative provisions) on the passage of this Act. (b) The parts of the Revenue Act of 1918 which are repealed by tliis Act shall (unless otherwise specifically provided in this Act) remain in force for the assessment and collection of all taxes whicli have accrued under the Revenue Act of 1918 at the time such parts cease to be in effect, and for the imposition and collection of all penalties or forfeitures which have accrued or may accrue in relation to any such taxes. In the case of any tax imposed by any part of the Revenue Act of 1918 repealed' by this Act, if there is a tax imposed by this Act in lieu thereof, the provision imposing such tax shall remain in force until the corresponding tax under l8io REVENUE ACT OF 1921 this Act takes effect under the provisions of this Act. The unexpended balance of any appropriation heretofore made and now available for the administration of any such part of the Revenue Act of 1918 shall be avail- able for the administration of this Act or the corresponding provision thereof. Increase in Treasury Savings Certificate Limit Sec. 1402. That section 6 of the Second Liberty Bond Act, as amended, is amended by striking out in the next to the last sentence thereof the figures "$i,ooo" and inserting in Heu thereof the figures "$5,000." Saving Clause in Event of Unconstitutionality Sec. 1403. That if any provision of this Act, or the application thereof to any person or circumstances, is held invalid, the remainder of the Act, and the application of such provision to other persons or circumstances, shall not be affected thereby. Effective Date of Act, Sec. 1404. That except as otherwise provided, this Act shall take ef- fect upon its passage. Approved, November 23, 1921, at 3.55 p. m. INDEX TO SECTIONS OF INCOME TAX LAW AND REVISED STATUTES (Principal references in heavy faced type) Section of Law Page Reference 2 I27I 200 ( I ) 64 (2) ' 1326 (3) ■ 324 (4) 383, 847 (5) 531, 823 201 (a) 705» 713 (b) 716, 728, 747, 991 (c) 748, 751 (d) 764 (e) 707 (f ) 728 202 (a) ( I ) 456 (2) 519, 619, 622 (3) 625 (b) (I) 569 (2) 570 (3) 570 (c) (i) 535, 545 (2) 535, 556, 557 (3) 536, 560 (d) (I) 590 (2) 505 (3) 591 (e) 592 (f) 488 203 452 204 (a) 1023 ?b) 804, 1022 (c) 804, 1028, 1364 (d) . . . 1026, 1364 205 (a) 163 (b) 165 (c) 791 206 (a) (1-6) 628 (b) 628 (c) 804 1811 l8i2 INDEX TO SECTIONS OF LAW Section of Law Page Reference 210 155, 1297 211 (a) (1-2) 156 (b) 159 212 (b) 64, 379, 847, 1332 (c) 65 213 (a) 401, 446, 640, 661, 693, 703 (b) (i) 352, 522 (2) 354 (3) 355, 518 (4) 359, 681 (5) •* 364, 952 (6) 351, 444 (7) 50 (9) 351. 411 (10) 362, 671 (11) 363, 422 (12) 363 (c) 1276 214 (a) (i) 852, 864. 870 (2) 923 (3) 938 (4) 977 (5) 977, 994 (6) 860, 978 (7) 1030 (8) 1050, 1 130 (9) 199, 1150 (10) 1167 (11) 1241 (12) 504 (b) 1292 215 (a) (i) 853 (2) 853, 1051 (3) 853, 1051 (4) 853, 894 (b) 1371 216 (a) 347, 704 (b) 350 (c) 171, 338 (d) 338 (e) 1295 (0 343 217 (a) (i) 1278 (2) 1279 (3-5) 1280 INDEX TO SECTIONS OF LAW 1813 Section of Law Page Reference (e) 1281 218 (a) 798 (b) 800 (c) 799 (d) 814, 820 219 (a) (i) 1329 (2-4) 1330 C^) 1335, 1338. 1365 (c) 1347, 1349, 1368 (d) 1349 (e) 1357 (0 1375 220 1260 221 (a) 1306 (b) 323. 324. 327, 33i» 1307 (c) 328 222 (a) (1-3) . . 942 (4) 943. 1368 (5) 943 (b-d) 943 223 (a) (1-3) 75 (b) (1-2) 78 (c) 77 224 788, 1302 225 (a) (1-5) 1330 (b) 1335 226 (a) 69 (b) 70 (c) 70, 167 22^ (a) 54. 55, 1304. 1331 (b) 63, 1304 228 143 229 796, 1657 230 (a) 161, 1297 (b) 161, 1297 231 (i) 34 (2) 35 (3) 36, 1401 (4) 37 (5) 39 (6) 39 (7) 43 (8) 43 (9) 44 (10) 1401 i8i4 INDEX TO SECTIONS OF LAW Section of Law Page Reference (ii) 44 (12) 46 (13)-. • 46 (14) 46 233 (a) 518, 522, 1394 (b) 1277 234 (a) (I) 852 (2) 923 (3) 679, 931, 939 (4) 978 (5) 1030 (6) 760, 1612 (7) 1050 (8) 1150 (9) "67 (10) 1396 (II) 1398 (12) 1400 (13) 1400 (14) 504 (b) 1292 235 853 236 (a) 350 (b) 172, 346, 1629 (c) (i) 940 (2) 941 -^zi 327, 1307 238 (a) 947 (b-d) 943 (e) 948 (f ) 948 239 (a) 90, 100, 102, 1328 (c) 104 240 (a) 106, 108, 1628 (b) 209, 1633 (d) 789, 1303, 1629, 1631 (e) 1574, 1628 241 (a) 1304 (b) 63, 1304 242 1378 243 • 1379 244 (a) 1380 (b) 1381 245 (a) (i) 1380 (2). 1381 INDEX TO SECTIONS OF LAW 1815 Section of Law Page Reference (3) 1382 (4) 1382 (5) 1383 (6) 1384 (7) 1383 (8) 1385 (9) 1386 (b) 1385 (c) 1386 246 (a) 1387 (b) (i) 1388 (2) 1389 (3) 1388 (4) 1388 (5) 1389 (6) 1391 (7) 1390 247 (a) (i) 1390 (2) 1391 (3) 1391 (4) 1391 (5) 1392 (6) 1392 (7) 1392 (8) 1393 (9) 1393 (b) 1394 250 (a) 217 (b) i35» 140, 209 (c) 223 (d) 195, 198, 202, 208, 241 (e) 144. 218, 243, 1357 (f) 227 (g) 214, 1298 (h) 1299 251 229 252 255, 262, 277 253 132, i37» 144 254 105, 301 255 302 256 292, 294, 298, 318, 320 257 115. 121, 123, 126 258 126 259 320, 1321 260 1322 i8i6 INDEX TO SECTIONS OF LAW Section of Law Page Reference 261 . 1323 262 (a) 1324 (1-2) 1324 (3) 1325 (b) ; 1325 301 (b) :- 1572 304 (c) 1568 320 231 325 (a) 1612 328 (b) 1640 335 (a) 1573, 1579 (b) 1580 401 1425. 1430 402 (a) 1432 (b) 1454 (c) 1457 (d) 1461 (e) 1462 (f) 1465 403 (a) (i) 1468 (2) 1477 (3) 1476. 1480 (4) 1484 (b) (1-2) i486 (3) 1485, i486, 1513 404 1489. 1496 405 1503 406 1504 407 1521 408 1522, 1523 409 1507. 1508 410 1510 411 1516 1000 (a) (i) 1528, 1533, 1537, 1548 (2) 1555 (b) 1535 1300 ' 53 1303 54 1307 54 1308 113 1309 182 1310 (a) 113 (b) 113 (c) 268 INDEX TO SECTIONS OF LAW 1817 Section of Law Page Reference 1311 56, 125, 131, 132, 134, 173, 174, 194, 1503 1312 210 1313 211 1314 182, 240 1315 262 1316 Ill, 257 1317 275 1318 263 1321 (a) 152 (b) 153 1323 276 1324 (a) 271 (b) 272 1325 224 1327 (a-f) 179 1328 683 1331 (a-c) 1627 1332 (a-f) 815 1400 1515 Revised Statutes 1046 153 1047 152 3224 249 3467 1514 INDEX TO ARTICLES OF REGULATIONS 62 (Also Regulations 37 and 50) (Principal references indicated in heavy faced type) Article Numbers Page References 12 159 13 159 21 376 22 375, 380, 849 23 379. 385, 847, 849 24 380, 1086 25 66 26 71 32 402, 414, 420, 444, 890, 892 33 430, 431, 438, 891 34 437 36 449 37 411 38 1408 39 55o> 587 40 652 41 549 42 488 43 503 44 498 45 498 46 500 47 676, 677, 758 48 694 49 506 50 519, 1006 51 513, 532, 649, 1045 52 388 53 388, 662, 673 72 351, 354, 444 73 355, 368 74 360, 665 75 361, 691 76 362, 705 82 685 83 683 84 689 1819 l820 INDEX TO ARTICLES OF REGULATIONS 62 Article Numbers Page References 85 686 86 364, 95^. 1285 87 51, 918 88 366, 404- 413 89 672, 1286, 1395 90 377. 417- 663, 676 91 916 92 1276 93 1289 94 1285 lOI 896 loia 864 103 911. 1058 104 862 105 875 106 734. 882 107 883, 887 108 888 109 701, 903, 906, 1099 no 141 o, 141 2 III no, 381, 919 121 924, 926, 931 122 932 131 957. 971 132 958, 959 133 967 134 962 135 957 141 803. 1002 142 997» 998 143 1 134 144 986, 988 145 1410, 1414. 1415, 1416 146 981 147 •• 994 151 452, 1030, 1037, 1040, 1043, 1045, 1047 152 1036, 1037 153 1044 154 1038, 1039 155 1031 161 1055, 1131 162 1056, 1057, 1058. 1088, 1095, 1098 163 1097 164 1068, 1071 165 1075 INDEX TO ARTICLES OF REGULATIONS 62 1821 Article Numbers Page References 166 1081, 1089 167 mo, iiii, 1112 168 1115 169 1065 170 1072 171 1413 181 531, 1151, 1159 182 1160 183 1154, 1158 184 1160 185 1162 186 , 1164 187 1165 188 1166 189 1 166 201 1 172, 1 173, 121 1, 12 16 202 1215 203 1224 204 1217 205 1 1 74 206 1175, 1178, 1181, 1182, 1186 207 1 193 208 1 183 210 1208 215 645, 1221, 1223 216 1213 217 1214 219 1 194. 1 196 222 1 104 224 1 105 225 1 107 227 1234 229 1234 230 1235 231 1 119 232 1120 233 1236 234 1237 235 1238 236 1239 251 1244, 1246, 1247, 1248 261 507 262 508 263 509 291 861, 863, 867, 869, 870, 893. 896 l822 INDEX TO ARTICLES OF REGULATIONS 62 Article Numbers Page References 292 855 293 648, 650, 891, 909, 913, 990, 1064, 1360 294 895 295 986, 1371 302 340 303 343 304- . • 340 305 1333 306 1296 311 1271 311a 1273 312 , 1272, 1517 313 1272 314 1275 315 1316 317 1279 319 1280 320 1296 323 1 282 324 1293 325 1294 326 1281 327 1282 328 1284 329 1295 331 790 332 791, 804 333 800 334 791 335 • 793, 794 336 819 337 821 338 819, 822 339 838 341 1338, 1352 342 1338 343 1335, 1358 344 1348 345 1350 346 345, 1368 347 1369 348 1375 351 1261 352 1261 353 1262 INDEX TO ARTICLES OF REGULATIONS 62 1823 Article Numbers Page References 361 337 362 294, 1310 364 1313 365 306, 318, 1309 366 310 367 310 368 310 369 311 370 315 371 298, 1318 372 1311 373 299 374 314. 1344 375 1319. 1320 382 951 383 953 384 955 385 945 401 75 402 78 403 84 404 1297, 1299 405 705, 1301 406 78 407 73, 138 411 1302 412 , 788 421 1330 422 1339 423 1340 424 102, 1341 425 1300, 1344 431 72 442 1333 443 57 444 58 445 59 446 54, 60, 63 447 86 451 144 511 47 512 35 513 35 514 36 l824 INDEX TO ARTICLES OF REGULATIONS 62 Article Numbers Page References 515 37 516 39 517 39 518 43 519 43 520 44 521 1402 522 45. 758, 1412 531 846 541 522, 640 542 • 670 543 -524, 909, 1017 544 520 545 523, 669, 1014 546 573 547 699 548 221 549 • 1394 550 1278 562 915. 1249 563 926, 979, 1016. 1017 564 926, 932 565 928, 971 567 902 568 1390 569 : 1396 570 1399 571 1400 572 1400 573 1293 581 1086 582 908, 909 601 1308, 1320 611 955 612 951 621 96, 221 622 102, 1341 623 1405 624 818 625 100, 1302 634 100 637 789, 1629 651 55 661 1379 671 1 380 INDEX TO ARTICLES OF REGULATIONS 62 1825 Article Numbers Page References 681 1381 682 1383 683 1383 684 1384 685 1385 686 1385 687 1386 691 1387 692 1389 693 1391 7Z'2' 1577 733 1577 751 1379 870 1620 912 1641 913 1642 1003 146 1004 133 1005 140 1006 202 1007 219 1009 231 loio • 232 loi 1 233 IOI2 194 IOI4 227 1032 245 1034 277 1035 278 1036 252 IO5I 274 1055 138, 321 1060 • 105, 302 1065 302 IO7I 293 1072 295 1073 303 1074 309 1075 301. 1320 1076 300 1077 316 1078 317 1079 299 1080 317 1090 n6, ii8, 119, 120 1826 INDEX TO ARTICLES OF REGULATIONS 62 Article Numbers Page References 091 117, 120 092 122 093 124 loi 127 III 320, 1322 121 1322, 1323 132 368, 1323 133 1323 502 91 503 92 504 1328 505 811 506 811 507 • 785 508 1378 509 787, 1271 510 103 521 1326 522 77. 1327 523 825 524 828 525 829 526 833 527 832 528 834 529 837 530 837 531 835 532 836 533 383, 1309 541 706, 707. 740 542 728 543 • 716, 991 544 750 545 749 546 744 547 734, 739/ 74i 548 751. 771, 774 561 570» 596, 984 562 619 563 620 564 536, 537 566 544, 545, 556, 561 567 590, 591 568 594 INDEX TO ARTICLES OF REGULATIONS 62 1827 Article Numbers Page References 1570 797, 806 1581 453, 454, 470 1582 457, 467 1583 460 1584 464 1585 481 1586 1416 1588 476 1601 1023 1602 1029 1604 1026 1605 1025 1623 163 1624 165 1651 629, 633, 1280 1652 638 1653 804 1721 172 1731 225 1 732 226 1736 816 Regulations 37 4 1429 5 1429 8 1426 9 1430 10 1431 II 1432 12 1433 13 1433 14 1435 15 1437, 1439, 1443, 1444, 1445, 1446, 1447 16 1448 17 1447, 1449 18 1449 19 1438 20 1452 21 1456 22 1457 23 1457 24 1459 25 1460 26 1460 l828 INDEX TO ARTICLES OF REGULATIONS 37 Artiij.. .m. .'.iijiiivo Page References 27 1461 30 1463 31 1464 32 1465 33 14S7 34 1467 ^6 1468 37 1469 38 1469 39 1470 40 1470 41 M7I 42 147^ 43 1472 44 1473 45 1473 46 1473 47 1474 48 1474 49 1436, 1474 51 1480 52 1479 53 1481 54 m8i 55 1483 56 1484 57 H84 58 1484 59 1487 61 1487 63 1487 64 1488 65 1489 67 1489 68 1490 69 1491 7'^ 1491 7' 1492 7- 1492 73 1493 74 1493 75 1494 75 (a) 1494 /6 1494. 1495 77 1497 INDEX TO ARTICLES OF REGULATIONS 37 jgoq AuTiCLE Numbers Pace References 78 1497 79 1498 80 1499 81 1500 82 1501 83 1501 84 1501 85 1502 86 1502 87 1503 88 1501 89 1503 90 1504 91 1505. 1506 92 1518 93 1518 94 1520 95 1520 96 1520 97 1522 98 1506 99 1509 100 1509 loi 1507 102 1510 103 1510 104 1510 105 1511 106 151 1 107 1511 108 1512 109 1512 no 1512 III 1513 112 1512 114 1514 115 1514 116 1522 117 1514 118 1514 119 1515 120 1515 I2T I516 1830 INDEX TO ARTICLES OF REGULATIONS 50 Article Numbers Page References Regulations .so 1 1528 2 1529 3 1531 4 1532 5 1532 6 1531 7 1531 8 1529 9 1555 10 1533. 1561 II 1534 12 1535 13 1538 14 1539 15 1539 16 1548 17 1555 18 1556 19 1557 20 1556 21 1557 26 1536 28 1537 30 1559 31 1538 32 1558 33 1548 34 1549 35 1550 36 1553 37 1559 39 1560 40 1560 41 1555 42 1554 43 1554 GENERAL INDEX [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 'v-2 Letter, Foi- additional tax payments, 201 nATEHEN'T Claims (See "Ciaimsfor Abate- ment") ir.-iENCE, Additional time allowed, 21 S I'enaities waived for, 150 vxouKTiNG Methods, (See also "Computation of tax") Accrual basis, 933 Former Procedure, 934 Amortization, 1164 Bad debts, 1032 Chnni-jes in, 384 Claims for incorrect, 1 1 1 Conversion of property, 506-508 Deductions, 847 Uninsured losses, loii Depletion, Deductible even if not on books, 1215 Mineral property, 1213-1214 Depreciation, 1052, 1067 Desirability of good, 848 Farmers, 141 9 Accrual basis, 1420 Gross income from business. 447 Holding companies, losses, 1018 Former procedure, 1019 Income from business, 448-449 Individuals, 383, 448 Apportioning income from joint owner- ship of U. S. bonds, 688-690 Instalment sales, 487-504 Inventories, 467 Liberty bonds. Accrual of interest, C87 Net losses, computation, 1 024-1 026 Non-resident aliens. Apportionment of deductions, 1294 Obsolescence, 1133 Partnership, Cash or accrual basis, 806 Distributive share of net income, 790 Fiscal years, 791-796 Gifts, 800 Patents, 650 Personal service corporations. Losses of subsidiary, 829 ■ Procedure, 379-391 Reconciled with returns, 162 Segregation of lump sum purchasps. lo'.? Separate ledger account, lAheriy ' • ' interest, 687 .\cc'ii;nting Methods — {Ciittiniied) "Short sales" inventories, 4S3 Treasury stock, 525-527 Accounting Period, Amortization claims, 1162 Change by individual, 69 Former procedure, 70 Changes in, 69, 163-171 For fiduciaries, 1332 1 921 law, 66, 448 Notice of change must be iiim, ; > , . Partnerships, 87, 805 Former procedure, 88 Penalties for failure to report changes, b8 Procedure for changing, 70 Former procedure, 70 Recognition as taxable year, 67 Twelve months established period, 72 Accounts Payable, Inventoried on basis of cost or market. Accounts Receivable, 452 Inventoried on basis of cost or iiKirkct, 393 'Suspense account," 517 Uncollectible, as bad debts, 452 Uncollectible, because of moratorium in Cuba, 1043 When taxable, 538 Accrual of Income, Adjustments on amended returns, 381 Amounts paid differ from, 955 Change from cash to, 384 Deductions determined Ijy, 8(7, 854, 933 Former procedure, 9,-i4 Interest accrued, when not deductible. 934 New York State franchise tax, 973 New York State income tax, 973 Permitted for deductions, 972 Permitted in accounting procedure, 413 Rents, 693 Sale of property ac(iuired before Marv.-!i '. 1913. 377 A'\ RUED Expenses, Deductible, 853 AiCRUEU OR Paid, Farm accounts, 1420 '■ ' ■ ' n indebtedness of bfc insurance ^s, 1385 ' .lii'sitii',' net income, 379, 381 '<'■ inpanics not deduct . ■' l>> Gifts, not income, 623 Land, 1142 ?.Iust have occurred during period when !av>' was effective, 583 OiTselting depreciation, 1063 Propert-y, 535 Realization of, in value of assets, tax- able, 567 Unimproved land on which lessees erect buildings, 695-696 Unrealized, not income, 809 Architect, Fees of, not deductible, 913 Army Officers (See also "Un'^-''-^'^''"' Personal expenses, 867 Assessments, (See also "Additional Tax Payments," "Claims for Abatement") Amortization claim or deduction tenta- tively allowed, 198 Appeals before (See "Appeals") As business expenses, deductible, 970 Authority to make, 194 Bank stock of decedent, not deductible, 1360 Changed interpretations retrnn^-tivp ' ui Claims for over, 235-290 Consolidated returns, 209 Erroneous or illegal assessed taxes must be paid, 223 Estates and trusts, 197 Final determination, 209-213 Five-year limitation, 196 Four-year limitation, 195 Fraudulent returns, no limitation period, 19S Limitation of period, 195-200 Extension of, 199 Local improvement, not deductible, 966- 968 Former procedure, 9C6 Local improvement, not increasing value of property, deductible, 968 On capital stock, 990 Protection of taxpayers, 237 Special assessments not deductible, 937 Special assessments when deductible, 966- 970 Stocl: ital Stock") Assessments — (Continued) Suits for restraining, 249 Taxpaj-er's right to question, 237 Assets (See also "Capital Assets") Intangible, Depreciation, 1098 Obsolescence, 1 1 44 Valuation of, 655 Assignee, Mv.st withhold, 1309 "' * -rns by, 102 \rroNS (See also under specific kinds. .: "Common Law Tru^fs" "InMit Stock Companies," etc.) As corporation, 91 Building and loan. Exempt income from, 310 Co-operative, farmers', 141 2 Dues to, as business expenses are de- ductible, 917 Gifts to be deductible must be made to public, 1 243 Law, 1916, 1329 Partnership banks as, 92 Partnerships vs., 92 Shipowners' mutual protection and in- demnity, 363 Trusts vs., 93, 1 328-1329 Attorney (See also "Lawyers") Before Treasury defined. iSo Fees, deductihl ■■ AroiTs, Returns, 194, 200 Authors, Income from royalties, 647 Returns, 647 .Vl U);.:o3ii,E Service, As compensation for personal services, 440 .\ utomobii.es. Dealers in second-hand, 486 Deduction for damages to, 860 Deductions for up-keep, 868 Farmers', 141 3 License fees deductible, 957 Travel by, 868, 869 Used, as part payment, 502 Bad Debts, 1030- 1049 Accounting method, 452, 1032 Accounts uncollectible because of mora- torium in Cuba. 1043 Bankruptcy claim, 1037, 1040 Bankruptcy, test of, 1043 Former Procedure, 1043 Banks, under government supervision. 1047 Bonds, worthless, 1038 Book entries required if deductions are claimed, 391 Claim against decedent's estate, 1037 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1837 A') DiiBTS — (Continued) (.'ollateral securities, 1043 Computation of, in instalment sales, 495- 497 Corporations under government super- vision, 1047 Deductions for taxable year 1931, 1031 Deductions, reported in return of income, 1036 Defined, 1039 Double deduction permitted for, 1921, 1032 Foreclosure of mortgage, 1044 Former Procedure, 1044 Gifts not deductible, 1035 Insurance companies, 1393 Personal loans, not deductible, 1035 Promissory notes endorsed, 1045 Reasonable addition to a reserve for, deductible, 1030 Recovery of, 513-51S, io45 Reserve for, deductible, 1030 Returns must be charged off within year, 1048 Former Procedure, 1048 Russian property, 1043 Special types, 1037 "Unsecured and nnpreferred debts" dis- tinguished from others in cases of bankruptcy, 1044 Valtiation, As of March 1, 1913, 1039, 1043 Worthless, defined, 1039, 1040 Bailments, Included in inventory, 455 B A X K ACCEPTAN CES, Profits from purchase and sale not in- terest, 1310 i'.AXK Accounts, Inspector's ri.-::'!- -.i'- taxpayer's. IIS iJANK Stock, Local taxes paid l)y l-.ank as equivakiu of dividend, 733 Local taxes paid by banks, Former procedure, 734 Taxes paid by bank not deductible by shareholders, 957 BANKRUPTCY, Basis for determining worthlessncss of debt, 1040, 1043 Corporations, penalties waived for, 151 Deductions for claims, 1037. '043 Referee in. Not a judge of inferior court, 403 Subject to income tax under Act of 1918, 403 Rentals to stockholders deductible from gross income, 727 Returns, 102 Validity of tax, 37s ISanks (See also "Federal Land Banks," "Mutual Savings Banks," "Nation-I Banks") [See also Estate, Capital Stock, Banks — (Cciitiinicd) As dealers in securities, 485 Assessment for insuring deposits, 903 Correction of ownership certificates by, 312 Depositors as preferred creditors, 1343- 1344 Duty of, regarding foreign items pre- sented without certilicates, 317 Interest on deposits, 667 Former procedure, 667 Liability as to ownership certificates, 313, 319 License required for collection of for- eign items, 330 May keep additional records for deprecia- tion purposes, 1065 Mutual savings exemptions, 33 Of deposit, Deductions for interest paid on de- posits, 927 Partnership bank as association, 93 Partnership bank as partnership, gz Private lanks as associations, 93 Responsibility of in accep'.ing incomplete ownership certificates, 308 Use of stamps and facsimile signatures, 319 "Base Stock" Method, Of taking inventories, 469 Baseball Players, Amount paid by club to secure services deductible, 917 Basic Date Deferred, 1173 Beneficiaries, Deductions for payments to, 1358, 1339 Dedncuohs, Foreign taxes, 943 For slninkage, 1369-1374 Losses, 1364 Depreciation claimed by, 1073 Distributive share must be incluiKi m tax return, 1338 Fxemptions, 345 Incjonie distributed by fidvxiaries subject to tax, 1330 Income received from estates or trusts, not units, when taxable, i3C>9-'374 Income received through fiduciaries, fax- able to, 1349-1350 Income tax paid by fiduciary, 1308 Net income taxes paid by, 1357 Net losses, deductible, 1028 Non-resident alien, 1300 Return by fiduciary, 1344 Right to inspect returns of estates, 119 Hen'EVOlrnt Societies (Scf "!•"• 'ikiI Beneficiary Societies") i;i: , ,-| ..; rS.-. ..',-" "'imiiblii ymenl of taxes. . ai.d -L-Cvcss Profits Iiv' 1838 GENERAL INDEX Board and Lodging, Taxable income, 438 When returnable, 296 Board of United States General Ap- praisers, Compensation for members subject to in- come tax, 403 Boards of Education, Gifts to, deductible, 1245 Boards of Trade, Dues paid to, deductible, 917 Exemptions, 43 Boilers, Depreciation, 1080, 1088 Bondholders, Purchase of assets by, 5^2 Bonds (See also "Exempt Bonds," "Farm Loan Bonds," "Liberty Bonds," "Municipal Bonds," "Tax-Free Cov- ent Bonds") Deposited with claim for abatement, 246 Discount on. Prorating of loss, 1013 Treated in same way as interest paid, 926 Fidelity (See "Fidelity Bonds") Foreign countries, information at source, 298 Interest from foreign, 316 Interest on, 668 Form for non-resident aliens, 13 13 Of agricultural and horticultural so- cieties in Michigan, not tax-exempt, 666 Withholding, 19 13 Withholding from in case of non-resi- dent alien, 1312 Matured, losses on, deductible, 1016 Mortgage indebtedness of municipalities and states not exempt, 665 Not required by receiver for abatement claim, 248 Ownership certificates, 306-319 Redemption of, 669 Registered, Foreign, information at source, 300 Ownership certificates, 315 Returns of information at source, 298 Surety, filed with Treasury, 229 War Finance Corporation, 350 Worthless, as bad debts, 1038 Bonus, As distribution of profits, 419 Deductible by lessee through depletion, 1226 Deductible if reasonable, 883 Distinguished from compensation for personal services, 417 Military and naval forces of the United States, tax-exempt, 411 Paid, Deductible as compensation paid, if reasonable, 419 Early delivery of steamship, deductible, 918 Bonus — (.Continued) Paid — (.Continued) For previous year, not deductible, 885 Taxable as expense, 419, 421 Received as stock, 523 Restoration of, to capital account of mineral property, 1223 To lessees and lessors of oil wells, 121 6, 1221 War service, exempt from tax, 363 Book Values, Increased valuations from writing up, not taxable, 582 Books, Depreciation, 1088 Books of Account (See also "Accounting Methods," "Examination of Books, Papers and Persons") Failure to keep, 65 Limitation period to examine, 199 Lump sum purchases, segregation of, 1067 Bootlegging, Income taxable, 447 Branches, Foreign, Payments to alien employees by, need not be reported, 303 Breach of Promise, Payments, not deductible, 870 Brokers, Deductions, Inventoried shrinkage in securities, 986 Former procedure, 986 Payments to customers need not be re- ported, 303 Returns on customers. Former procedure, 302 Payments to customers, 302 Building and Loan Associations, Exemptions, 27 In dividends, 362 Foreign, not exempt, 48 Shareholders* credits taxable, 671 Buildings, Amortization, 1158 Cost of demolition not deductible, 998 Depreciation, 1079, 1088 Destroyed, on leased land, deductions for, 694 Fireproof, obsolescence, 1141 Improvements on not deductible, 853 Loft, obsolescence of, 1142 Loss from demolition deductible, 997 New, built on leased ground, 694 Obsolescence, 1134, 1139, 1141, 1142 Payment for new, not deductible, 1051 Under construction, depreciation, 1090 Business, Income from. Bonus received in stock, 523 Taxable, 31 Types taxable and non-taxable, 516-328 Business Discontinued, Obsolescence procedure, 1139 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1839 Business Expense, Assessments deductible as, 970 Deductions, 851, 852, 855 Defined, 855 Distinguished from capital outlay, 85:, 907-915 Distinguished from gifts, 1248 Distinguished from personal expenses, 852, 854 Gifts of merchandise, 1254 Insurance, 851 Insurance companies, Deductions for, 1390 Life insurance companies, Deductions for investment expenses, 1383 Organization expenses, 907 Professional men, 862, 864 Rent (See "Rent as Expense") Segregation of, 857-859 Traveling expenses (See "Traveling ex- penses") ''Treating money" deductible, 1254 Business Leagues, Exemptions, 43 "Business or Trade," Definition of, 854 Business Taxes, Deductible, 958 Calculation of Tax (See "Computation of Tax") Calendar Year, Returns of information at source, 294 Returns on basis of, 297 Campaign Contributions, Not deductible, 915 Capital, Distribution of, should be coincident with reduction in capital stuck, 744, 745 Interest on taxpayer's own capital, not deductible, 932 Personal service corporations, permitted use of in, 835-837 ^ Repairs chargeable to capital if perma- nent, 1 064 Capital Assets (See also "Assets," "Gain or Loss," "Capital Net Gains") Adjustment by appraisal of various dates, 6X2 Appreciation, Supreme Court decision, 583 Defined, 628 Diminished value not to be deducted, 294 Inventory method, 588 Losses on sale of, 979, 989, 996 Obsolescence of, 1134 Patents, 651 Profits from sale or exchange. Law of 1 921, 804 Purchase of by bondholders, 562 Recoverable through depletion and depre- ciation, 1 224-1 227 Recovery not current expense, 380 Capital Assets — (Ccmtiniied) Reinvestment of proceeds of sale of, 1265 Revaluation, 1070 As of January i, 1909, 584 As of March i, 1913, 583 Not equivalent to inventories, 582 Sale of by corporation, 554 Former procedure, 554 Sale of should be added to gross in- come, 143 Should be transferred at gross book value, 1070 Surplus from sale of, distribution of, when necessary 1266 Valuation (See "Valuation") Capital Expenditures, Losses so considered, 1007 Capital Gains, Securities sold by estates, amelioration of surtax under tax on, 1374 Stock dividends carried 2 years, taxable as, 770 Capital Investment, Development costs may be added to, 1228 Capital Net Gain, Copyright, 640 Defined, 628 Patents, 640 Realized after December 31, 1921, under 1921 law, 567 Taxable, 162 Capital Stock, Assessments, 990 Not deductible, 909 Close corporation, 615 Expenses incurred in selling, 909 Federal reserve banks, dividends exempt, 362 Increase in, with cash dividend, taxable, 764 Interest paid on instalment subscriptions to capital stock, not deductible, 932 Redemption of by corporation, 1017 Sale of, at premium or discount, 524 Stockholders' voluntary assessments, tax- exempt, 520 Valuation, determination of, 614-616 Capital Stock Tax (See separate index on p. 1903) Capital Surplus (See also "Surplus Fund") Dividends from, 716, 746 Source of, 746 Case (Law) Defined, 210 Cases (See "Decisions") Cash. Income other than, taxable, 430 Instalment payments as, 489 Instalment payment equivalent of cash, 500 Instalment payments not equivalent of, 498-500 Notes not readily discountable, no equiva- lent for, 501 [See also Estate, Capital Stock, and Excess Profits Indexes] 1840 GENERAL INDEX Cash Basis (See also "Accrual of Income") Change to accrual method, 384, 414 Method of computing net income, 383 Cash Dividenps, Taxable, -jiz With increase in capital stock, taxable, 764 With option to buy, taxable, 764 Cash Registers, Depreciation, 1093 Casualties, Losses, 1008-1011 Deductions for, 860 (See also "Insur- ance") Former procedure, 1 008 "Catch-All" Provisiox, in Law, 373 Cattle (See "Live Stock") CE.V!iTERY COMPANIES, Exemptions, 39 Family, gifts not deductible, 1245 Cent, Fractional part of, 172 Certificates of Compliance, Citizen leaving country, 215 Certificates of Deposit, Interest on, deductible, 926 Certificates of Indebtedness (See also "Treasury Certificates of Indebted- ness") Of a staie territory, etc., deductions for, 928 Payment of tax by, 225 State, territory or subdivision, exempt, 361 Certificates of Ownership (See "Owner- ship Certificates") Certificates of Profit, As scrip dividends, taxable income, 742 Certificates of Sale, For non-payment of taxes not exempt, 360 Chambers of Commerce, Dues paid to, deductible, 917 Exemptions, 43 Charitable Organizations, Exemptions, 39 Gifts to, 1358, 1359 Deductions for, 1341 Charitable Purpose, Credit in separate returns of husband and wife, S Chart, Origin and roi-.^c ■•■' i.^rms, 307 CrilARTERS, Forfeited, penalties waived for, 15' Chemical Industry, Depreoiation, 1093 Cheques, Payment of tax, 224 Children (See "Minors") Christmas Gifts, Deductible, 886 When deductible, 1248 When nr.t taxable, 4-:o Church Dues, Deductible, 1245 fSep nV.o Estat ■ Church Pews, Rents, deductible, 1245 Churches, Gifts to, deductible, 1243 Citizens, Alien resident as, 344 Credits, Foreign taxes, 946 Deductions, Foreign taxes, 942, 946 Taxes, 938 Defined, 368 Employed by a foreigzi government, 365 Income, Sources within United States, 1378- 1281 Leaving country, Certificate of compliance, 215 Consular receipt for payment of tax, 216 Penalties for failure to file returns, 138 Naturalized, non-resident,, status, 1274 Residing abroad. Extension of time for filing returns, 59 Notice of payment sent to, 219 Payments by mail, 219 Penalties waived for, 150 Taxes, Deductions, 938 Civic Leagues, Exemptions, 43 Civil Service Employees, /Vraounts deducted from salaries for annuities should be reported for in- come tax, 413 Payments to by g:jvein!nent need n&t be reported, 303 Claims, In business, not income, 5'S Claims, Committee on. Cases before, 213 Claims for Ab.\tement, 111 Audititnal assessments, 200-313 "Bona fide claim," definition, 246 Claims for refund vs., 241 Collector's procedure, 241 Collector's right to require bond, 246 Community property of husband and wife, S3 Do not constitute appeal to Commissioner, -'6s Filing, 236, 241 Time for, 242 Five-year limit not applicable, 273 Interest, if claim denied, 143, 248 Former procedure, 143 Liquidating corporation, 269 Notice of denial should be sent, 213 Penalties when not bona fide, 246 Pending an appeal, 213 Procedure, 241 Receivers, 248 I'o.cctcl, by collector, 20S, 347 nd Excess Profits Indexes] GENERAL INDEX 1841 Claims for Abatement — {Continued) Stockholders' suits, 251 When allowable, 244 Claims for Allowance on Net Loss, Filing, 1029 Claims for Amortization, 1149-1151- 1165-1166 Claims for Credit, 277-286 (See also "Claims for Abatement," "Credit Against Income") Affiliated corpi rations, 2S3 Applied against income, war profits, or excess profits tax, 278 Community property of husband and wife, 83 Corporations, when successor may file claim, 284 Defined, 287 Excess profits tax, 283 Filing, Place when district is changed, 282 Procedure, 277 Time, 277 Husband and wife, 285 Interest allowable in suit, 271 Interest on, 244 Notice of denial sent, 213 Partnerships, 284 Patents, revaluations prior to 1917, 653 Personal service corporations, Allowed to stockholders, 838 Profits, undistributed, 285 Rejected, 278 Interest rates, 248 Procedure for, 248 Stock dividends, 780 Substitute claims for refund for, 278 Time when made or allowed, 280 Claims for Refund, 235-290 (See also "Amended Returns") Additional assessment, 207 Aliens, resident and non resident, 254 Appeal to Commissioner, 265 Appeals must be made before suit can be brought, 26^ Claims for abatement vs., 241 Community property of husband and wife, 83 Denied, 782 Dividends carried on margin, 781 Erroneously or illegally collected, 252 Failure to deduct such loss in original return, 381 Filing, 236, 241, 253, 278 Filing of not necessary in some cases, 254 Five-year limit, 255, 257 Four-year limit, 357 Fraudulent or undervalued returns, 276 Interest allowable in suit, 271 1913-16 returns, 112 1914 and prior not allowed, 261 1918 law, 256, 262 Losses sustained in tgi?, not offset, 97^' Not a suit against the Government, 252 Notice of denial to grant suit, 213 On establishment of residence, 1317 CL.iiiis roR Refund- — (Continurd) Patents, revaluations prior to 191 7, 653 Pajment (See "Refund, Payment") Payments withheld from non-resident aliens, 13 17 Power of attorney sufficient for filing, 253 Procedure, 252 Proof of appeal to Commissioner rests with taxpayer, 264 Receipt should accompany, 252 Stock dividends, 780 Stock dividends on shares carried by broker, 781 Suits against collector, 263 Five-year limit, 263 Former procedure, 263 Procedure, 273 Taxpayer's death, 252 Two-year limit, 257 Withholding of excessive tax, 330 Claims, Mining (See "Discovery of Mines") Clergymen, Compensation received, not taxable, 421 Fees received, taxable, 420 House rent exempt, 362, 422 Rental value of house not taxable, 362 Closed Transactions (See also "Continu- ing Transaction," "Sale of Property") Basis of net income of subscribers to stock, 786 Defined, 536 Depreciation allowances, 1070 Property transferred to corporation in exchange for stock, 544 Sale on instalment plan, 548 Sales covered by open drafts not con- sidered, 528 Clothing (See also "Uniforms") Deduction for, 868 Clubs, Gifts to make good deficit, not deduc- tible, 1245 Social, exempt, 44 Coal Mines (See "Mines") Collateral, Interest on securities used as, when deductible, 930 Collateral Securities, Depreciation, 1043 Collection of Accounts (See also "Bad Debts") Accounts uncollectible because of mora- torium in Cuba, 1043 Instalment payments, 497 Collection of Tax (See also "Payment of Tax") Py distraint, _•,; 1 Liens, 232 Xon-rcsident aliens, 1270 Collectors of Tax, 173 Authority to grant extension of linic for tiling returns, 56, 58 Claims for abatement, Payment dcnian" '■ 1 '■'•'- 1-' Returns, i(f. Gifts. Kew, Fiscal period, 65 Returns by, 99 Former procedure, og To evade taxation, 990 i\ot distributing earnings, as personal service corporations. 839 Former procedure, 839 Not organized for profits, penalties waived for, 151 Organization expenses not deductible, 907 Outlawed accounts taxable income, 520 Ownership certificates net required for re- gistered bonds, 313 Partnerships reorganized as, returns on basis of calendar year for employees' salaries, 297 I'aymen; of tax at source, 1306 Mot deductible, 332 Payments to, need not be reported, 303 Personal service corporations (See "I'er- sonal Service Ccr|)orations") Purchasing replacement property from si-l)sidiary, 509 Rate increase under law of 10:8. 13 Receiver appointed for. Reorganizations, 100 Exchange of securities ini l.ia.i^ih.-, -,., j To evade tax, 193 Retroactive incorporation for partner- ships, Law of 1921, 796 Returns, 53, 69, 75-129 Affidavits, 90 Annual basis for fraclii iial part of year, 167 Change of name, 100 Con.solidated (See "CoiiMilMi^n- 1 U: turns") Dividends pa'.!, m;, ioi Former ; Exempt, 8' ' Fiscal year ii.-is j^, im, 1 c 1 : Government contract corp.iia Former procedure. 103 Inactive cnrioralions, 95 [See also Estate, Capital Stock, and Excess Profits Indexes] 1846 GENERAL INDEX Corporations — (Continued) Returns — (Contini(ed) Incomplete corporations, 95 Inspection, 119, 123 Liquidating, 55, 102 Mergers, 100 New corporations, 99 Former procedure, 99 Place for filing, 63 Receivers, 402 Reorganizations, 100 Time for filing, 54 Time for filing extended to March 15, 58 When exempt from making, 89 Salaries paid by, 874 Sale of, penalties waived for, 151 Subsidiary (See "Affiliated Corporations") Tax-free covenant bonds, 322-333 Tax on net earnings, 703 Tax paid by, by contract, 1307 Tax paid on tax-free covenants, refund- able, when, 972 Tax rate applicable to, 160 Former procedure, 161 Tax rate, increased, 18, 31 Trading, when may qualify as personal service, 826-827, 829-832 Trustees in bankruptcy, returns by, 102 Undistributed profits, 1259-1325 Claims for credit, 285 With large government contracts not per- sonal service corporations, 839 Withholding interest on bonds, must re- port, 305 Corrected Returns (See "Amended Re- turns") Cost, Basis for ascertaining capital gain or loss, 569 Operating, mines, 11 82 Cost or Market Value (See also "Market Value") Accounts receivable and accounts pay- able inventoried on basis of, 393 Basis for obsolescence, 11 35 Inventories, 459-469 Cost Systems (See "Accounting Methods") Costumes, Theatrical, Depreciation, 1093 Cotton Exchanges, Shares carrying, dividend rights, Not exempt, 43 Council of National Defense, Gifts to, deductible, 1245 Counsel, Special (See "Special Counsel") Coupons, Interest coupons presented without own- ership certificates, 311 Matured interest coupons, 388 Used as purchase price for other securi ties, 67s Court Decisions (See "Decisions") Courts, State, Clerks of State courts employing clerical assistants, 406 Compensation of jurors of state, county or municipal court, not taxable, 412 No jurisdiction to determine federal taxes, 268-271 Receiver's compensation fixed by taxable income, 405 Cows (See "Live Stock") Credit Unions, Exemptions, 38 Credits Against Income, 845-850 (See also "Deductions," "Exempt Income") Allowable to estates and trusts, 1368 Former procedure, 1368 Amounts paid differ from accruals, 955 Claims, where accurate records are not kept, 960 Corporations, 172 Defined, 337 Dividends, 31, 155 Domestic corporation controlling foreign subsidiary, 948-951 "Former procedure, 948, 951 Estates and trusts. Payments to beneficiaries, 1358, 1359 Excess profits tax, 940 Former procedure, 801 For dependents. Not reduced on returns covering frac- tional part of year, 169 Not reduced on returns covering frac- tional part of year, former proced- ure, 169 For local or state tax, on account of taxes paid by bank on bank stock as equivalent to dividend, 734 Foreign corporations, 1296 Foreign countries which do and do not allow, for United States taxes, 945 Former procedure, 945 Foreign taxes, 942-944 Corporations, 947 Former procedure, 947 Forms to be used, 956 Limitation of, 943, 948 Procedure for securing, 953 Under fiscal year basis, 954 Former procedure, 954 Income on certain securities, 155 Individuals, 337-345 Insurance companies, 1393 Liberty bonds, interest, 31 Massachusetts trusts operating property in foreign country. Foreign tax credits not allowed, 956 Method of treatment, 845 Non-resident aliens, Filing returns, 1295 Former procedure, 1295 Normal tax, 155 Liquidating dividends, 749 [See also Estate, Capital Stock, and Excess Pr.'Qfit^ iQC^Qi^es] GENERAL INDEX 1847 Credits Against Income — iCcmtinucd) Partnerships, 800 Information needed to take advantage of, 802 Payments of tax at source, 333 Special, life insurance companies, 1386 Taxes, 937-974 Tax-free covenant bonds, 333 Criminal Proceedings, 152 Officers of the United States, 153 Crops, Insurance, 900, 1409 Rental paid in crop shares, not re- ported, 294 Cuba, Accounts uncollectible because of mora- torium in, 1043 CURLE, J. H. On interest rate of mines, 1 1 88 Customs Duties, Deductible, 959 Dairymen's Associations, Exemptions, 45 Damages, Alienation of wife's affection, not exempt, 352 Automobiles, 860 Awards by Arbitration Board, 514 Breach of promise suit not exempt, 352, 870 Claims for, vested before March i, 1913, not taxable, 514-515 Patents, damages received for infringe- ments, income or capital, 649 Personal injury, loii Proceeds from, not taxable, 444 Date (See "Basic Date") Date of Payment, Additional assessment extension of, 227 Last due date, 54, 57 Date of Tax Return, Determined for tax rate on dividends by date of dividend payment, 708-711 Death (See also "Decedents"), Penalties waived for, 150 Debentures, Holders must file ownership certificates, 308 Debtor Corporations (See "Returns of Information at Source") Debts, Secured debt laws, taxes paid states under. Deductible, 957 Debts, Bad (See "Bad Debts") Decedent, Assessment on bank stock, Not deductible, 1360 Claim for bad debts against estates, 1037 Penalty exemption for estates, 147 Decedent — {Continued) Status at time of death determines ex- emption, 343 Taxable income not realized on passage of estate from, to executor, 1358 Decisions, Court, Uncertainty of, 1063 Courts overrule treasury rulings, 238-239 Table of, ix Taxpayer's right to appeal from, '238 Deductions, 845-850 (See also "Deprecia- tion," "Interest," "Losses," etc.) Accounting method, 847 Accounts receivable, basis for, 1037 Accrual method, 847, 933, 972 Advances to salesmen, 878 Adjustment of taxes of prior years, 966 Agents' commissions, 890 Allowable, lists of, 845 Amortization of war facilities, 1149-1166 (For complete list of subjects see under "Amortization of War Facilities") Annuities by civil service employees, should be reported fo,r income tax, 413 Assessments deductible as business ex- pense, 970 Assessment on decedent's bank stock. Not deductible, 1360 Attorneys' fees, 141 5 Automobiles, Damages, 860 License fees, 957 Upkeep of, 868 Bad debts, 391, 1030-1049 (For full list of subjects see "Bad Debts") Bank charge on tax-exempt obligations, 938 Bank of deposit, for deposits, 927 Bank stock, taxes paid by banks not deductible by shareholders, 957 Baseball player's services, 917 Beneficiaries, Foreign taxes, 943 Bond discount, 926 Bonus, 883, 885, 918 (See also "Bonus") Buildings, demolished, 997 Business expenses, 851, 852, 855 (For full list of subjects see "Business Expenses") Business taxes, 958 Cancellation of contracts, 1000 ("apital deductions defined, 628 Casualties, 860, 1008-1011 Former procedure, 1008 Certificates of deposit, 926 Certificates of indebtedness of a state or territory, 928 Christmas gifts, 885 Church dues, 1245 Citizens of the United States, Foreign taxes, 942 Commuters' fare, 865 [See also Estate, Capital Stock, and Excess Profits Indexes] 1 848 GENERAL INDEX Deductions — (Cintinticd) Compensation for personal services, 8;u 878 (For full list see "Compensation for Personal Services") Construction if not capitalized, 929 Contributions by stockholders, 990 Corporations (See "Corporations") Criticism of, 936 Customs duties, 959 Damages (See "Damages") Debt recoverable only in part, 1030 Deferred payments to lessor, 907 Depletion, 1 197-1239 (See "Depletion") Limitation on, based on discovery value, 121 1 Depositors' guaranty fund, 902 Depreciation, 31, 693, 863. 1050-1129 (See "Depreciation") Allowed on estates, 1363 Determined by accrual of income, 854 Dividends paid by court order, 928 Dues to board of trade, 917 Dues to labor unions, 917 Duplicate to be avoided, 1132 Estates and trusts, Administration expenses not deductible, 1360 Charitable contribution, 1358, 1359 Current expenses, 1360 Federal estate tax, 1361 Former Procedure, 1361 Not treated as units, 1369-1374 Expenses for sale of property by estate, 1363 Fiduciaries, gifts, 1365 Local benefit taxes not deductible by estates and trusts, 1362 Losses, by estates, 1364 Stamp taxes on sale of property by executor, 1363 Unrealized loss not deductii)le by es- tates, 1362 Excess Profits Tax, Corporations, 940 Excise taxes, 958, 960 Former procedure, 960 Expenses, 31, 851-922 (For complete list of subjects see "Business Expenses," "Expenses") Former procedure, 852 Farmers, 1410, 1411 Federal income tax not deductible, 964 Former Procedure, 964 Federal tax paid by corporation under tax-free covenants not deductible, 971 Fidelity bonds. Premiums on, 896 Fire loss, 860, 1008-1011, 1415 Former procedure, roo8 Flood, 14 1 5 Foreign dividends, 944 Frost. 1415 Gambling, 1006 German investments, 987 - "Gifts") I'oiiiK'i- I'l-ofcdure, 124J I'oiding companies, 50 Ifoiding companies' losst-. Former procedure, 1018 Illegal Transactions, looG Improvements, 693, 853 Included in gross income, 1279 Income and excess profits taxes, 423 From foreign sources, 1270 Former procedure, 1270 Inconsistencies in lav.', 846 Individuals, 31, 831, 853 Foreign taxes, 943 Former procedure, 853 Tax on, 851, 852, 853 Taxes, 938 Former Procedure, 939 Inheritance tax, 937, 961 Insurance, As business expense, 851 Insurance companies, not life or mutual, 1390-1394 Insurance premiums, 869 Commissions paid on, 890 Croup, S95 Life. S93, 897 Paid by insured, 853 Property, 896 Workmen's compensation, 898 Interest, 31, 9^3-936 (For complete list of subjects see "Interest") From foreign subsidiaries, 678 Interest on indebtedness, 924 Interstate Commerce Commission, Payments to, 91S Judgments, Amounts paid on. 919 Former procedure, 919 Law of 1921, "Relief" provisions, 1021 Former procedure, 1021 Licenses, 958 Life insurance companies, 1380-1386 Limitation for, 929, 1020 Former procedure, 1029 Limitation period when tentatively allowed, 198 Limited to those specified in the statv.te, 845 Loans, 929 Secured to purchase or carry U. S. government bonds, not deductible, 924 Former Procedure, 924 Local improvement assessments not de- ductible, 966-968 Former Procedure, 966 Local improvement deduclil.i;-. v >^ Losses, 31, 975-1029 By theft or embezzlement, 3S1, 84S [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX Deductions — (Ctntiiiited) Luxury taxes, 960 Former procedure, 960 Machinery, scrapped, 997 Maintenance funds, 917 Maintenance of records, 914 Method of treatment, 845 Money borrowed on loan, 929 Mortgages, 926. Mutual Shipowners' Protection and In- demnity Association, 365, 1395 Net losses, 1023-1029 Non-resident aliens, 1 292-1 395 Apportionment, 1294 Filing returns, 1295 Obsolescence, 1130-1149 (For complete list of subjects sec "Obsolescence") Partnerships, S70, 892 For gifts, 799 Former procedure, 799 Foreign taxes, 943 Information needed to take advantage of, 802 Losses, 803 Patent litigation, 631, 11 12 Patents, Depreciation, not obligatory, 652 Penalty additions to taxes may or may not be, 966 Pensions, 888-889 Former procedure, 889 Pension, sick, insurance funds as com- pensation for personal services, 444 Personal expenses (See "Personal Ex- penses") Pew rents, 1245 Postage not deductible, 971 Profit participation by employee, 892 Property destroyed, 694 Property, Revaluation, 1002 Real estate. Buildings destroyed, on leased land, 694 Erection of buildings, 694 Mortgages, 926 Payment on cancellation of lease, 904, 905 Redetermination or examination of, 199 Rent except for business purposes, not deductible, 932 Rental of subleased apartment, 904 Rentals paid to stockholders in bank- ruptcy, 727 Repairs, incidental, 91 i Resident aliens, Foreign taxes, 942 Taxes, 938 Resid-?ntial property, 1002 Russian investments, 987 Salaries, 870-876 (For complete 1 s< of subjects see "Salaries") Sale of capital assets, 979 . I ^. , J ;>.j — (Ci. ntint(ed) Salesmen's commissions, 890 Scrip dividends, 926 Secured debt laws, taxes paid states under, 957 Securities given as collateral, 930 Shipwreck, 860 Special assessments, when, 960-970 Speculation, 996 Stamp taxes, 959 , State taxes, 937 Paid by banks, 734 Stockholders' commissions, 891 Storm, losses by, 860, 1415 Tax-exempt securities, 923, 924 Tax-free covenant bonds, 323-333, 677 Taxes paid, 31, 937-974 Criticism of law, 963 Federal not deductible, 927 Federal not deductible on tax-free covenant bonds, when paid by cor- poration, 928 Former Procedure, 928 Foreign, 937, 942-944, 946 Former procedure, 974 Overdue, federal, 927 Paid by husband for residence title to which is in wife's name, 963 Paid by tenant, 903 Paid for another person, 963 Teachers, 863 Theft, 860, 1008-1011 Former procedure, 1008 Trading stamps, 916 Former procedure, 916 Transactions entered into for profit, 999 Traveling expenses, 856 By automobile, 868, 869 Of commuters, 856 Undistributed surplus, tax on, not de- ductible, 971 X'ictory notes deductible, 925 Victory notes not deductible, 923, 924 Wages, 870-876 Welfare work, 887 Worthless stock, 988 Former procedure, 989 Deferred Charges, Advertising, 911 Defined, 490 Dividends, Deductible for life insurance com- panies, 1383 Deficiencv Tax (See "Additional Tax Payments") Dei-inoufncy (See "Failure to Make Re- turn") Ufn-.ny. G. a., On interest r-i'-- "f mlur^. iiSo Dependents, Exemptions, Allowed, j.iS, j|'i.i|3 Kot reduced on return conccrninR frac- lioual pari of year, K.0 I'lirmcr procedure, i( 348, 703 Dying during taxable year, 343 Former procedure, 338 Interest on certain securities, 15s Not reduced on returns covering frac- tional part of year, 169 Former procedure, 1 69 Reduction cf, 171 Status at end cf year determines, 343 Valid for normal tax only, 344 War service, 362 When exempt from v/ithholding, 331 Inheritances, 355359 Judges, United States, 365, 401 Jurors of a state, county, or municipal court, 412 Law of 1913, 9 Law of 1921, 20, 683 Lawyers employed by state, 409 Lfss than year, 686 Life insurance benefits, 352-355 Life insurance policies, 675 Former procedure, 675 Minister's house, rental value en, 362, 422 Minors, 341 ExuMPT Income — ' l- aiuuiiicd) Municipal employees, 366 Mutual savings banks without capital stock, 35 National G'uard, partly exempt, 409 Non-profit making organizations, 34 Non-resident aliens. Benefit of exemptions and credits, 299 Employee, 13 16 Former procedure, 1295 Income passing through banks for col- lection, 316 Tax-free covenant bend interest, 299 United States bonds, 692 ?Jotary public, 407 Pensions, for milicary or naval service. 351 President of the U. S., 365, 401 Profits f rr ni sale of vessels, 369 Former procedure, 369 Receivers appointed by state courts, ^0^ Referee in drainage, 405 Rfturns should be filed, 33 Soldiers and ?-'' ' : .ier procrdu:e, 410 Sources, 681 Special counsel ft;' stai.e comptroller, 408 Special counsel to city net an emploj-ee, 408 ^ \ Special exemptions, 0^2-684 State bonds, 33, 34 State officers and employ^lss, 33, 366, 403 State pensicns, tax-exempt,^ States and territ:;ries for ii^ome from public utilities, 50 United States bonds, 33, 34 War Finance Corporation bonds, 3'^ War risk insurance, 351 Exempt Organizations, 34-51 Agricultural, 34 Associations crganiz;d to carry freight by boat, 43 Banks, Federal land, 46 Mutual savings, 35 Boards of trade, 43 Building and loan associations, 37 ■lusncss leagues, 43 Cemetery companies, 39 Chambers cf Commerce, 43 Charitable, 39 Civic leagues, 43 Clearing House associations, 43 Clubs, 44 Community funds, 39 Cc-operative, 44 Co-operative banks v.ithout capital stock, 37 Corporations, 34-51 Designed for scientifie purposes, 39 Personal service corpcrations, 46 Former procedure, 46 Serving exempt corporations, 46 Former procedure, 46 Credit unions, 38 Dairymen's, 45 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1857 Exempt Organizations — {Continued) Educational, 39 Fairs, county, 35 Farmers', 44 Federal land banks, 46 Fraternal beneficiary societies, 36, 1401 Fruit growers', 44 Holding companies, 50 Former procedure, 50 Horticultural, 34 Insurance, 1401-1406 Insurance departments in mutual sav- ings banks, 35 Labor, 34 Literary societies, 39 Mutual insurance of certain kinds, 1401- 140S National farm loan associations, 46 Non-profit making, 34 Orchestral societies, 40 Procedure to establish exemption, 47 Purchasing agencies for farmers, 45 Religious associations, 39 Savings banks, mutual, 35 Scientific societies, 39 Shipowners' mutual protection and in- demnity association, 363, 1395 Societies for the prevention of cruelty to children or animals, exemptions, 39 Former procedure, 39 Exempt Securities, Building and loan associations, 362 Certificates of indebtedness of a state, territory, etc., 361 Exemption periods depending on termi- nation of war with Germany, 685 Farm loan bonds, 33, 34, 361 Federal Reserve Bank stock dividends, 362 Filing of returns, 33 Interest from, need not be reported, 76 Interest on loan to purchase, not deduc- tible, 1385, 1391 Interest on tax-exempt bonds, 801 Interest on, when used as collateral, not deductible, 930 Interest paid to carry, 923, 924 Law of 1921, 22 Liberty bonds, 350 Ownership certificate not required, 319 Philippine 4 per cent bonds of 1914-34, 361 Sale of, when taxable, 554 State bonds, 33, 34, 360 Statement of, not required, 360 Territorial bonds, 34, 360 United States bonds, 33, 34 Unlimited as to time, 684 Victory notes, 350 War Finance Corporation bonfls, 34, 350 Exemption Certificates, Non-resident aliens, 1313-1314 Exemption of Person, Definition, 32 Exhaustion (See "Depreciation") Expenses, Accounting in instalment sales, 497 Accounting procedure, 380 Accrued, deductible, 853 Army officers, 867 Business (See "Business Expenses") Cumulative depreciation allowances for, 1058, Deductions, 31, 419, 851-922 Former procedure, 852 On real estate owned by insurance companies, 1384 Farmers, 1412, 141 3 Improvements deductible, if not perma- nent, 1059 Incurred in purchase of Treasury stock not deductible, 910 Lobbying, 915 Organization, depreciation, 11 09 Personal (See "Personal Expenses") Traveling (See "Traveling Expenses") Uncertain, deduction for, 929 Export Business, Income from, 527-528 Profit from unpaid drafts, 377 Extension of Time for Payment, Additional assessment, 227 Extension of Time for Filing Returns, Absence, 56-58 Authority of Commissioner, 56, 58 Former procedure, 56 Authority of local collectors, 56, 58 Causes must be explained, 58 Citizens residing abroad, 59 Does not authorize delay in filing re- turns of information, 303 Foreign corporations, 1305 Granted to corporations to March 15, 1922, 58 Instalment payments, 217 Former procedure, 217 Joint returns by husband and wife, 56 Non-resident aliens, 1305, 1331 Non-resident enemies, 60 Partnerships, 788 Penalties waived for, 149 Sickness, 56-58 Soldiers and sailors, 86 Tentative return, 57 Termination of war, 61 63 Time for filing, 60 Facsimile Signatures, Ownership certificate, 319 Substitute certificates, 319 Factories (See "Buildings," "Industrial llants") Failure to Make Return, Ad valorem or percentage penalty, 134 Citizen leaving country, 138 [See also Estate, Capital Stock, and Excess Profits Indexes] 1858 GENERAL INDEX Failure to Make Return — (Ccmtinued) Collector to supply deficiency, 131 Legal reasons for, 132 Penalties, 131-139 Former procedure, 133 Specific fine, 132 Willful neglect, 131, 137 Fair Market Value (See "Market Value") Fairs, County, exemptions, 35 Gifts to, by agricultural corporations not deductible, 1233 False Returns (See "Fraudulent Returns") Fakm (See "Farmers") Definition of, 1410 Farm Loan Associations, Exemptions, 46 Farm Loan Bonds, Interest on loans secured for purchase of, not deductible, 929 Tax-exempt, 33, 361, 680, 681, 682, 691 "Farm-Price Methods," Inventory, 1 417-14 18 Farmers, 1407-1420 ' Accounting, 1419 Accrual basis, 1420 Allowance for living expenses unjust, 1407 Assessment of tax difficult, 1407 Attorneys' fees deductible, 1415 Automobiles, 1413 Upkeep, 1413 Commercial and otherwise, 1410 Computing income on crop basis, 1409 Deductions, 14 10 Depreciation, 1414 Depreciation of land, 1099 Depreciation on farm buildings, 1056 Deterioration of held products, 1415 Development expenses, 1413 Exchange of produce for merchandise, 1409 Expenses deductible and otherwise, 141 2, 1413 Form 1040 F optional, 1419 "Gentlemen," definition of, 1410 Inventories, 462 Former procedure, 462 Inventory methods, 1416-1419 Inventory system, 1408 Items included in income, 1408 Live stock, 14 13 Losses, 1410, 1411, 1414 Death of live stock, 141 6 Frost, storm, flood or fire, 1415 May be applied against profits of suc- ceeding years, 1419 Former procedure, 1419 Machinery and buildings, 141 3 Orchards, depreciation of, 1414 Proceeds of crop insurance, 1409 Rents received in crop shares, 1409 Sale of machinery, etc., 1409 Taxable on sale of property, 1408 Tools, 14 13 Farmers' Associations, Exemptions, 44, 46, 141 2 Federal Agencies, Right to inspect returns, 120-121 Federal Employees (See "Government Employees") Federal Land Banks, Dividends exempt, 361 Exemptions, 46 Federal Reserve Banks, Dividends on capital stock exempt, 362, 705 Federal Taxes (See "Income Tax," "Taxes," etc.) Fees, Architects, 913 Jury, 412 Lawyer or attorney, from illegal transac- tion not deductible, 921 Paid to secure employment, deductible, 918 Received as income from professions or vocations, 401 Received by clergyman, taxable, 420 Received by notaries public, not taxable, 407 Fidelity Bonds, Premium on, deductible, 896 Fiduciaries, 1326-1376 Accounting period. Other than calendar year, 1332 Agent vs., 1327 Alien Property Custodian not a, 1327 Associations vs. trust, 1328-1329 Beneficiaries, Deduction for shrinkage in securities not allowed, 986 Capital gains provision. Effect on sales by fiduciaries, 1374 Deductions, Depreciation allowed to, 1363 Expenses for sale of property, 1363 Federal estate tax, 1361 Former procedure, 1361 Gifts, 1365 Losses, 1364 Stamp taxes on sale of property, 1363 Defined, 77, 1326 Depreciation claimed by, 1072 Estate of an enemy alien, 1355 Executor as, 1332-1335 Exemptions from penalties, 1337 Former procedure, 1326, 1332, 1333, 1341, 1348, 1349. 1351 Income, Accumulated in trust, 1330 Distributable to beneficiaries, 1330 Held for future distribution, 1330 Income of discretionary trust taxable to, 1351 Income of minors taxable to, *348 Liberty bond interest, when taxable, 690 Net income taxes paid by, 1357 Non-resident aliens, 1331 Ownership certificates, 314, 1344-1345 Payment of tax, 1347-1357 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1859 Fiduciaries — (.Continued) Payment of tax at source, 1306 Payments to beneficiaries not taxable to, 1349 Penalties, exemptions, 147 Receivers, not all classed as, 1328 Responsibility of, 1328, 1335 Returns, 87, 1330-1346 Beneficiaries, 1339 Beneficiaries, distributive share includ- ed in, 1338 Committee for incompetent, 1339 Determination of net taxable income during administration, 1358, 1359 Forms of, 1346 Guardian for minors, 1339 Information at source, 297, 1344-1346 Joint fiduciaries, 1330, 1335 Non-resident alien beneficiary, 1344, 1356 Place for filing, 1331 Receivers, 1341-1344 Revocable trust, 1340 Salaries, 297 Several trusts, 1340 Trustee in bankruptcy, 1341 When due, 1331 When required, 1330 Revocable and irrevocable trusts, 1340, 1350 Grantor taxable, 1352-1354 Salaries paid to fiduciaries, included in returns, 297 Several trusts, separate incomes taxable, 1340, 1352 Taxable income not realized on passage of estate from decedent to executor, 1358 Taxable income under profit sharing plan, 1375 Taxed for estates and trusts, 1368 Former procedure, 1368 Unrealized losses not deductible, 1362 Fifty Per Cent Penalty, 134 Filing of Return (See "Failure to Make Return," "Returns") Fines (See "Penalties") FiNLAY, J. R., On interest rate of mines, 11 88 Fire Losses, 978, 1008-1011, 1415 Deductions for, 860 Former procedure, 1008 Fire Relief Certificates, Exempt, 360 Fiscal Years (See also "Accounting Per- iod") Application of different rates, 794-796 Former procedure, 795 Chang'es in making returns, 64-71, 163- 166 Former procedure, 66, 71 New corporations, 65 Corporations, Ended in 1921, 164 Ended in 1922, 165 Penalties waived for, 151 Fiscal Years — (.Continued) Credits for foreign taxes under, 954 Former procedure, 954 Defined, 64 Ending in 1921, 164, 165 Ending in 1922, 165 Individuals, 448 Ending in 1921, 164 Fractional part of year, 170 Net losses deductible, 1026 1920-1921, Apportionment of partnership income to each year, 791 Computation of net income, 792 1921-1922, Apportionment of partnership income to each year, 791 Computation of net income, 792 Partnerships, 164, 791-796, 806 Former procedure, 297, 791 Personal service corporations, 164, 819- 823 Returns on basis of, 64-71 Fixtures (See "Furniture and Fixtures") Flood, Losses, 1415 Florists, Inventories, 1418 Food Administration Grain Corporation Notes, Tax-exempt, .667 Foreign Bank, Interest on drafts subject to withholding, 1308 Foreign Branches, Assets and liabilities as inventory items, 393 Domestic corporations owning, 392 Foreign Corporations (See also "Payment of Tax at Source — Foreign Corpora- tions") Building and loan associations, not ex- empt, 48 Consolidated returns not permitted, 105 Co-operative banks not exempt, 48 Credits, 1296 Deductions allowable,- 1292-1295 Defined, 90 Deriving income from U. S. and I'orto Rico, 1323 Dividends, Exempt, 348 Information at source, 298 Paid by, need not be reported, 303 When eligible for credits or deductions, 802 Exempt income. United States bonds, 692 "Foreign" defined, 1271 Gross income, defined, 1276 Income, From dividends of taxable domestic corporations, 711-712 From operation of ships, when exempt, 1286 Rulings regarding sources wilhiii Uni- ted States, 1286-1292 [See also Estate, Capital Stock, and Excess Profits Indexes] i86o GENERAL INDEX Foreign Corporations — {Continued) Interest on deposits with domestic banks not taxable, 1309 Method of dividend return, 712 Non-resident, Defined, 300 Payment of tax at source, 330 Not personal service corporations, 838 Ownership certificates, 315, 316 Payment of tax at source, 1307, 1308 Not required if doing business in United States, 328 Philippine Islands, 349 Porto Rico, 349 Resident and nonresident, 1271 Consolidated, 1303 Former procedure, 1303 Returns, Dividends paid, 302 Dividends paid, former procedure, 301 Extension of time for filing, 1305 Filed by agent, 100 Forms required, 1302 Made by resident agent, 1303 Time and place for filing, 1304 Should notify stockholders of right to credit, 349 Tax rate, 1297 With fiscal agent here, withholding pro- cedure, 1312 Withholding from, 327 Withholding returns. Form used, 310 Foreign Countries, Bonds, information at source, 298 Citizens leaving for, 215 Defined under section 238(a), 234(a), 951 Former procedure, 952 France, practice of taxation in gambling, 447-448 Great Britain, practice of taxation in betting, 447 List of, which do and do not allow United States citizens credits for United States taxes, 945 Former procedure, 945 Ownership certificates required with bonds of, containing tax-free covenant clause, 316 Foreign Diplomatic Ministers, 364 Foreign Exchange (See "Exchang'e, For- eign") Foreign Governments, Defined, 364 Income received by exempt but should be reported, 316, 364 Income, when taxable, 1285 Foreign Insurance Companies (See '"In- surance companies," "Life insurance companies," "Mutual insurance com- panies") Foreign Items, Defined, 300 Income from, when deductible, 1287 Licenst for collection of, 320, 1321 Foreign Items — (Continued) Ownership certificates, items for, 299 Presented without ownership certificates, 317 Return of information at the source, 299 Source of information, 300 Foreign Partnerships (See also "Partner- ships") Not affected by withholding provisions, 1306 Ownership certificates for bonds of, 316 Returns required, 301 Foreign Taxes, Credits against income, corporations, 947 Former procedure, 947 Deductions, 946 Forgiveness of Indebtedness, 519, 520 Forms of Returns (See list preceding Ap- pendix B) 1040 F optional, 1419 Formulas, Deductible if worthless, 1096 Foundries, Depreciation, 1 096 Fractional Part of Cent, 172 Fractional Part of Year, Liquidating corporation, 55, 220 Returns covering, 167, 169, 170 Fraternal Beneficiary Society, Defined, 37 Exemptions, 36, 1401 Fraudulent returns, 109-127 Action to recover refunds, 276 Extent of, 191-194 No limitation period for, 198 Penalties, 133-138 Compromise of, 149 Freight Bills, Need not be reported, 303 Frost, Losses, 1415 Fruit Growers' Associations, Stock owned outside association — not ex- empt, 45 Furniture and Fixtures, Depreciation, 1056, 1096 Obsolescence, 1142 "Future" Contracts, Inventories, former procedure, 472 With reference to inventories, 472-474 "Future" Delivery of Goods, 479-48O "Futures," Speculation in, 448 Gain or Loss (See also "Capital Gains," "Capital Net Gains," "Exchange of Property," "Sale of Property") Application of "tax-free" distribution, 582 Appreciation. Accrued prior to March i, 1913, 567 As of March i, 1913, 583 Of property must have occurred during period when law is effective, 583 Ascertainment of, 569-582 Ascertainment of net earnings, 604-612 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX ibOl Gain or Loss — {Continued) Basis for ascertaining when appreciation is realized, 569-582 Bonus received as stock, 523 Buildings or improvements destroyed, on leased land, 694 Claims due March i, 1913, defined, 378 Comparative value of similar property, 614 Computations, 577-581 Tax-free distributions, 725 Corporations, property acquired by gift, sale of, 519 Cost as basis for determining apprecia- tion, 588 Defined, 628 Exchange of property by continuing trans- action, 589-595 Former procedure, 567, 568, 569 Instalment houses, 491-497 Law of 1921, 627 Partnerships, distributive share, 790 Property acquired after February 28, 1913, 569 Property acquired before March i, 1913, 569 Property acquired by inheritance, 625-627 Property requisitioned or destroyed, 504- 508 Prorating land and crop values, 614 Prorating method, 616-619 Provisions, 1921 law, 17 Real estate development work, 503 Real estate in lots, 503 Real estate on instalment payment, 498- 504 Revaluations, 582-586 Sale of goodwill, 602-612 Sale of mines, 599 Limitation of surtax, 159 Sale of oil and gas wells, 599 Sale of property by continuing transac- tions, 589-595 Securities, When shares of same issues are bought and sold at different dates, 587 Securities sold, 587 Between interest dates, 674 Surplus arising from reappraisals not tax- able, 582 Tax limitation not applicable to corpora- tions, 161 Taxable, 567 Treasury interpretation, 432 Value of claims for infringements, judg- ments, etc., 602 "Wash sales," 591, 993-995 By partnerships, computation of net in- come, 794 When none recognized, 590 Gambling (See also "Betting," "Race Track") French practice of taxation, 447-448 Games, taxable, 447 Losses, 1006 Gas Property, Depreciation, 1078, 1107 Gas Wells (See "Wells, Oil and Gas") Gasoline, Depletion on, absorbed from gas, 1203- 1204 Farmers, 141 3 Genius, Not subject to depreciation, 1058 "Gentlemen" Farmers, Definition of, 1410 German Investments, When worthless, 987 Gifts, Abandonment of terms, "Gifts, dona- tions," etc., in books of account sug- gested, 125 1 American Legion, 1242 Annuities as, 677 Appreciation of, not income, 623 "Back pay," 416 Bad debt, not deductible, 1035 Boards of education, deductible, 1245 By partnerships, when ground for de- ductions or credits, 803 Former procedure, 803 Charitable organizations, 1241 When deductible, 886, 1248 Clubs, gifts to make good deficit not de- ductible, 124s Colorable, 357, 624 Community chests, 1242 Corporations receiving, when not taxable, 374, 518 Corporations, when deductible, 1249 Former procedure, 1251 Council of national defense, 1245 Deductions, 851, 1241-1255 Fiduciaries', 1365 Former procedure, 1242 Depreciation of property acquired by, 1073, 1247 Distinguished from business expenses, 1248 Former procedure, 1248 Distinguished from compensation for per- sonal services, 417 Domestic corporations, 1242 Educational organizations, 1241 Exemptions, 355-359 Fairs, not deductible by agricultural cor- porations, 1253 Family cemetery corporation, gifts nut de- ductible, 1245 Forgiveness of indebtedness, 519-520 Fraudulent, 357 Fund for vocational rehabilitation, 1242 Homestead acquired from government, Income from sale or exchange of property acquired by, 619-625 Individuals, may deduct up to 15 per cent on net income, 1241 Literary organizations, 1241 Losses from sale of, 995 Marriage settlements, 355 Memorial associations, deductible, 1244 Memorial funds, not deductible, 1245 [See also Estate, Capital Stock, and Excess Profits Indexes] 1 862 GENERAL INDEX Guts— {Contin ued) Merchandise, to charitable and religious organizations, deductible, 1254 Municipalities, deductible, 1242 National dry federation, not deductible, 1245 Non-resident aliens, when deductible, 1293 Partnership, Deductible up to 15 per cent, 799 Former procedure, 799 Individual credits for, 1247 May deduct gifts in the nattire of busi- ness expenses, 1241 Pensions as, 359 Pensions to widows, as, 421 Pledges, when deductible, 1246 Police pension funds, deductible, 1245 Premiums on life insurance policy as, 1246 Procedure in reporting, 1246 Property bequeathed to state institution, 361 Provisions of 1921 law, 20 Public high school, not deductible, 1245 Public purposes. Former procedure, 1242 Railroad passes, 357 Real estate for park purposes, 1244 Reconstruction work in Porto Rico, 1244 Red Cross, by corporations, not deductible, 1247, 1253 Former procedure, 1248 Religious organizations, 1241 Requirements for deductibility, 1242, 1243 Scientific organizations, 1241 States of United States, deductible, 1242 Street railway company, 'donation to in- duce to extend track, not deductible, 1250 Treasury rulings holding gifts deductible, 1244 Treasury rulings holding gifts not de- ductible, 124s "Treating money" deductible, 1234 United States, deductible, 1242 Valuation, 1247 Former procedure, 1247 War chest funds, 1242 Goods Purchased But Not Delivered, 469- 472 Goodwill, Considered as source of dividends, 746, 780 Deductible as advertising expenses, 1254 Depreciation, 1097 Obsolescence, 1144 Of liquor business, 1146 Patents, 652, 654 Payment for, not deductible, 91s Proceeds from sale of, taxable, 549 Treasury allows no depreciated on pur- chased, 609 Valuation of, 602-612, 807 Government Bonds (See "United States Bonds") Government Contracts, Adjustments, 533-534 Amortization allowances, 531-532 Cancelled, losses deductible, 1001 Copies should be filed, 106 Corporations must make separate returns, 105 Former procedure, 105 Defined, 106, 528, 530 Former procedure, 107 Form not enforcible, 530 Income from, 528-534 Law of 1921 concerning, 528 Personal service corporations, 531 Provisions will not affect income in and after 1922, 531 Returns for corporations formed for pur- pose, 105 Supplemental contracts as, 530 Treasury ruling concerning, 529 Government Employees (See also "Civil Service Employees") Compensation, 401 In District of Columbia, Porto Rico, Philippine Islands, subject to tax, 410 Under Act of 1918, 403 Must make return on payments at source, 293 Not exempt from income tax unless spe- cifically designated, 401 Payments to by government need not be reported, 303 Government Officials, Personal expenses, 867 Gross Income, Business life insurance premiums, ex- cluded from, 522 Citizens, sources within United States, 1278-1281 Computation for tax, 155, 379 Contractors, 449 Corporations, items, 31 Deductions for rentals paid to stock- holders, allowable, 727 Deductions from, to ascertain net income, 155 Defined, 376, 446, 681, 703 Dividends on corporate stock, 389 Exclusions from, 1284-1286 Dividends, 715 Interest from building and loan asso- ciation shares, 671 Loss sustained from warrants received for public work done, 411 Foreign corporations. Computation by, 1277 Defined, 1276 Inclusions in. Income derived from dividends, 703 Sale of capital assets, 142 Income of revocable trust included in grantor's, 1352-1354 Individuals, 75 Items, 31 Returns, 52 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1863 Gross Income — iConiinued) Insurance companies, 1387, 1388 Interest on matured coupons, 388 Interest to be reported, 661 Life insurance companies, 1380 Mutual insurance companies, 1394 Mutual marine insurance companies, 1400 Non-resident aliens, 1269 Computation by, 1277 Defined, 1276 Former procedure, 1276 Sources within United States, 1278-1281 Former procedure, 1290 Sources wathout United States, 1281-1284 Taxable distribution made by corporation, included in, 707 Taxable, if $5,000 or over, 1330 Group Insurance, 431 Premiums deductible, 895 Guardians (See also "Fiduciaries") As fiduciary, 1326 Returns filed by, 77 Returns for minors, 1339 H Hammond, John Hays, On interest rate of mines, 11 89 Hat Factories, Depreciation, 1098 Hawaii, Citizen of, taxed as non-resident alien, 1322 Compensation of government employees, not exempt, 401 Compensation of teachers taxable, 410 Head of Family, Defined, 340 Dependents residing elsewhere, 341 Kxemptions, 338 Minors as, 341 Unmarried person as, 75, 77, 341 Heat and Light, As compensation for personal services, 440 Holding Companies, Exemptions, 50 Former procedure, 50 Losses, Accounting methods, 1018 Former procedure, 1019 Returns, 1020 Must be filed, 99 Required on exempt income, 50 Ho^^ESTEADS, Value at date of acquisition, 624 Hoover, H. C., JDn mining risks, 1188 Horses (See also "Live Stock") Depreciation, 1098 Race track winnings paid to non-resident alien not subject to withholding, 310 Horticultural Organizations, Exemptions, 34 Interest on bonds in Michigan, not tax- exempt, 666 Hoskold's Formula, Table based on, 600 HOTIiLS, Obsolescence, 1141 Humane Societies, Gifts to, 1242 Husband and Wife, Alimony, 367, 870 Former procedure, 367 Claims for credit, 285 Community property, 82, iii, 395 Amended returns, 82 Change of domicile, 84 Credits, 338 Deductions for taxes paid by husband on residence title to which is in wife's name, 963 Exempt income, 338 Exemptions, 171, 338 Extension of time for filing joint return, 56 Incompetency of one, 344 Joint exemptions, 171, 338, 343 Joint returns, 76, 79 Claims for credit, 285 Computated on aggregate income, 79 Extension of time, 56 Inspection, 118 When desirable, 79, 80, 82 Returns, 75, 78-84 Losses, 80 Separate returns, 76, 78, 80, 82 Separation of necessitates separate re- turns, 79 Surtax, 79, 80 What constitutes living with husband or wife, 343 Wife takes no personal exemption, 81 Illegal Transactions, Losses, Deductible, 1006 Illness, Penalties waived for, 150 Improvements, Deductible as expense if not pcrniaTicnt, 1059 Deductions not allowable, 853 Depreciation, 1086 Expenses for on property owned by life insurance companies not deductible, 1384 Made by lessee, 693 Made by lessee, destroyed, deduction for, 694 Permanent, 693 Not deductible, 1051 Obsolescence when business is discon- tinued, 1 139 Income, 371-400, 446-534 ('See also "Gross Income," "Income from Business," "Net Income," "Royalties as Income," "Unc.inicil Income") [See also Estate, Capital Stock, and Excess Profits Indexes] i864 GENERAL INDEX Income — (Continued) Accruing abroad, rate of exchange, 392 Accumulated in trust subject to tax, 1330 Annuities, when taxable, 677 "Back pay" as, 416 Bad debts, 513-SiS. 1030-1036 Bonus, 422 Capital gains as, 567-638 "Catch-all" provision, in law, 372 Community property of husband and wife, 8j. Ill, 395 Compensation for personal service tax- able, 375 Compensation paid other than cash, 430- 445^ Copyrights, 647 Credited but not paid, 295 Credits for normal tax on certain securi- ties, 155 Damages from patent infringement, 649 Defined, 373 Distribution of, 4 Dividends (See "Dividends"') As prima facie income of record owner, 705 Earned and unearned, 23 Fixed and determinable. Defined, 294 Subject to withholding, 1310 From dividends (See "Dividends") Future distribution through fiduciaries, 1330 General treatment, 371-375 Government contracts provision concern- ing, 531 Inheritance, property acquired by, 625627 Instalment payments as, 489 Insurance companies, 1387-1390 Investment income, 1388 Interest accrued on bonds sold between dates, 674 Interest due, 686 Liberty bond interest, 680-691 Non-resident aliens, 1269 Exemptions, 1285 Rulings, regarding income sources with- in United States, 1286-1292 Ordinary net income, defined, 628 Outlawed accounts taxable, 520 Partnerships, 784-813 Patents, 640 Sale of, 648 Personal service corporations, 813-841 Prior, Limitation on, 195-200 Limitation on, former procedure, 196- 197 Profit on goods sold by consignee, 384 Profit-sharing, 422, 1375 Promissory notes, 437 Received from estates or trusts, not units, when taxable, 1369-1374 Rents (See "Rent as Income") Royalties, 640-649 Sale and exchange, 536 Income — (Continued) Sale and exchange of capital assets, 567- 638 Sale or exchange of property acquired by gift, 619-625 Sinking fund interest or gains, taxable, 670 Sources, 372, 430, 447 Sources within United States, 1278-1281 Former procedure, 1290 Sources without United States, 1281-1284 Statistics, 126-127 Stockholder of personal service corpora- tions, 822 Tax (See "Payment of Tax at Source") Tax collected from non-resident aliens, 1306 Tax paid by vendee for vendnr, con- sidered taxable income to vendor, 521 Taxable defined, 371-400 Taxable, under profit-sharing plan, Defined, 1375 Unearned, Insufficiently taxed, 859 United States bonds, 680-691 Income from Business, 446-534 Accounting procedure, 448-449 Bottlegging, 447 Contractors, 449 Exports, 527-528 Gambling, 447 Gifts received by corporations, 374, 518 Government contracts, 528-534 Instalment plan sales, 487-504 Partial sales of stock, 474-475 Proceeds from business life insurance benefits, 523 Self-purchase of bonds and stocks, 524 Types taxable and non-taxable, 516-528 Income Tax, Administration, 173-234, 238 Civil War period, 7 Collectors, 173 Cost of administration, 4 Deduction of, in ascertaining net learn- ings, 604-607 English system effective, 10 History, 7 Law, General provisions, 372 M-ethod of calculating, 428-430 Not deductible, 937 Principles, 1-27 Sixteenth Constitutional Amendment, 7 Source of revenue, 4 State, 6 Statistics, 5 • Wben payable, 1305 Income Tax Collector, Examination of returns by, 203 Income Tax Inspectors, Duties, 114 Income Tax, State, Dividends, when taxable, 704 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1865 Income Tax Unit, Appeals before, 203-208 Decision sent by registered mail, 206 Organization, 183-188 Chart, 184 Incompetents, Husband or wife, 344 Returns by fiduciary, 77, 1339 Indebtedness, Forgiveness for, 519-520 Individuals, Tax on, 688-690 (See also "Aliens," "Non-Resident Aliens," Resi- dent Aliens") Accounting methods, 383 Accounting procedure, 448 Corporations, Losses, when deductible, 1005 Credits, 155, 337 Credits for foreign taxes, Forms to be used, 956 Deductions, 851, 852, 853 (See also "De- ductions") For losses, 977 Former procedure, 975 Former procedure, 853 Gifts, 1241 Dependents, 338 Earning power of, 1058 Exempt income (See "Exempt Income, Individuals") Extension of time for filing returns, 55-59 Fiscal year basis, 64, 164 Foreign taxes. Limitation of credit, 943 Gross income, Sources within United States, 1278- 1281 Head of family, Defined, 340 List of taxpayers posted,- 126-127 Losses," Deductible, looi "Wash sales" of securities, 993-995 Member of corporation, should make re- turns as a corporation, 89 Members of partnerships, 784 Members of personal service corporations, 784 Net income, determination of, 155 Net losses, 1024- 1026 Net losses, when deductible, 980 Normal tax, 155 Partnerships, Accounting period, 80s Losses deductible, 1005 Payment at source, 1306 Penalties, Former procedure, 137 Personal expenses, Losses not deductible, 1004 Personal injury, damages for, Not deductible, loii Personal residence, Loss from sale not deductible, 1002 Rate payable, 155 Former procedure, 155 Individuals — {Ccntintied) Retroactive incorporation of partnerships permitted, 796 Returns, 52, 75-129 Annual basis for fractional part of year, 169 Extension of time, 59 Fiscal year basis, 164 Inspections, 1:8 Place for filing, 63 Time for filing, 54 Unmarried persons, 52, 75 Surtax, 155 Withholding exemptions, 331 Industrial Plant, Fund to induce to locate, not deductible, 124s Information at Source (See "Returns of Information at 'Source") Infringement of Patents (See "Patent Infringement") Inheritance, Property acquired by. Former procedure, 625 Income of, only, taxable, 355 Valuation of, 625-627 Securities acquired by, 625-627 Inheritance Tax, Deductions 927, 961 Injunction, Not granted in suits to restrain collection of taxes, 250 Stockholders, 250 Injuries, Compensation to 'employees for sickness or injuries need not be reported, 303 Insolvency, Corporations, penalties waived for, 151 Inspection of Returns, 116-125 Attitude of inspectors toward deprecia- tion, 1053 By beneficiary of trust, 119 By federal agencies, 120-121 Former procedure, 120 By stockholder, 119, 123 Former procedure, 123 Estates and trusts, 119 Husband and wife, 118 Individuals, 118 Partnerships, 11 8- 119 Penalties for disclosure of information, 124-125 Procedure to secure permission, ii6, 122 State officers have access to corporation returns, 118, 121 Former procedure, 121 Who has right to, 1x5-116 Instalment Payments, Allocated to particular accounts, 495 Application of, 495 As bad debts, 495-497 As cash, 489 As income, 489 Business life insurance benefits received as, arc taxable income, 523 [See also Estate, Capital Stock, and Excess Profits Indexes] 1 866 GENERAL INDEX Instalment Payments — {Conlinucd) Initial payments, 501 Inventories of sales under, 487-504 Mortgages given as, 498 Obligation of purchaser equivalent of cash, 500 Obligation of purchaser not equivalent of cash, 498-500 On capital stock. Interest not deductible, 932 Reserve fund, 497 Ruling on repossession of real estate. 503 Sales of property. When taxable, 548 Used automobiles as, 502 Instructions to Taxpayer, With intent to defraud^ 138 Insurance (See also "Premiums") Accident, Exemption for benefits, 351, 444, 895 As a business expense, 851 Business, Benefits from an income, 522 Contributions for, deducted from salaries or wag'es, are income, 444 Crop, 1409 Reserves not deductible, 900 Fire, Affected by book valuations, 1052 Funds, "self-insurance" reserves not de- ductible, 522 Health, Benefit exemption, 351, 444 Life (See also "Life Insurance Com- panies") Benefit exemptions, 352-355 Former procedure, 352 Deductions on premiums when bene- ficiary is charitable corporation, 1246 Distributions on paid-up policies are corporate dividends, subject to sur- tax by individual, 7S7-7S8 Dividends, 354 Policies, cash surrender value, 677 Policies, exemptions, 675, 1359 Former procedure, 1359 Policies, income from, 675 Premiums, deductions and allowances, 893-897 Premiums on group insurance, 431 Premiums on gruup insurance deduc- tible, 895 Returns on basis of investment income only, 100 Policies, Policies, combined, on weekly premium payment plan, 1398 Method of calculating profit on ex- change, 553 Premiums paid on, to secure loans, 896 Value of as of March i, 1913, 378 Premiums, Commissions paid or deductible, 890 Deductions and allowances, 853, 869 Paid in advance, 902 Insurance — {Continued) Proceeds, when taxable and net taxable, 444 I : Former procedure, 444 Property, Premiums, when deductible, 896 Reserves to equalize profits not deduc- tible, 900 Reserves to protect bank deposits, when deductible, 902 Returns, 100 "Self-insurance" reserves, 898 War risk, Exemptions, 351 Workmen's compensation, 898 Exemption for benefits, 351, 444 State funds exempt, 51 Insurance Companies, 1377-1406 (See also "Life Insurance Companies," "Mutual Insurance Companies") Agency run by building and loan asso- ciation not exempt, 38 Deductions, Depreciation, 1393 Dividends, 1392 Expenses, 1390 Interest, 1393 Not allowed, 1391 Defined, 1378 Exemptions for departments in mutual savings banks, 35 Exempt from tax, 1401-1406 Expenses incurred, defined, 1390 Foreign, Net income, 1387 Taxable income, 1393 Former procedure, 1377 Gross income, 1387, 1388 Income, Classes of, 1387-1390 Investment income, 1388 Life (See '"Life Insurance Companies") Losses, 1391, 1406 Bad debts, 1392 Mutual marine, Exemptions, 363 Net income, 1387, 1389 Net losses, deductible, 1028 Not life or mutual, 1387-1394 Premiums earned, defined, 1389 Returns, 1405 Specific credits, 1393 Tax rates, 1387 Taxes paid or accrued not deductible, 1391 Underwriting income, 1388 Intent to Defraud (See "Fraudulent Re- turns") Interest, 661-679 Accounting in instalment sales, 497 Accounting procedure. Accrual basis permitted, 933 Former procedure, 934 Accrued, But not collected, taxable, 662 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1867 Interest — {Continued) Accrued — {Continued) But not collected, former procedure, 663 Liberty bonds, 687 Not deductible, 934 Prior to January i, 1909, not taxable, 663 Prior to March i, 1913, 378, 663 Former procedure, 663 Upon conversion of Victory notes, 685 Additional assessments, 208 Awards under power of eminent domain, 66s Bank deposits taxable, 667 Non-resident aliens, 131 1 Bonds, Form for non-resident aliens, 1313 Bonds of irrigation districts, 664 Bonds paid at or before maturity, tax- able, 668 Building and loan association shares, 671 Chargtd to construction, not taxable, 668 Claims for abatement, 143, 242 Not bona fide, 246 Rejected, 248 Claims for corrections should be made before interest is charged against tax- payers, 23s Claims for credit, 271 Claims for refund, 271 Community property of husband and wife under Texan law, 400 Coupons presented without ownership certificate, 311 Credits for, in partnerships, 800 Deductions, 923-936 Bank charges on tax-exempt obliga- tions, 928 Bank of deposit, for deposits, 927 Certificates of deposit, 926 Construction if not capitalized, 929 Corporations, 923 Criticism of, 936 For interest on indebtedness, when al- lowed, 924 Individuals, 923 Insurance companies, 1393 Life insurance companies, 1380 Money borrowed on loan, 929 Not permitted, 929 Overdue Federal taxes, 927 Real estate mortgages, 926 Scrip dividends, 926 Securities given as collateral, 930 State taxes, 927 Victory notes in original subscriber's hands, indebtedness incurred to buy, 92s Defined, 661 Derived from accounts charged by stock- brokers, 670 Dividends on preferred slock not dccuc- tiblc, 932 Interest — {Continued) Dividends paid by court order. Deductible, 928 Drafts, 1308 Exempt from normal tax, 350 Exemptions, special, 682-684 Federal taxes assumed by corporation issuing tax-free bonds, 931 Federal taxes, overdue. Deductions for, 927 Food Administration Grain Corporation notes, tax-exempt, 66y Foreign subsidiaries, 678 Ground rents deductible as rent, 931 Included in gross income, 1278 Income from, taxable, 31 Income of year when due, collected or not, 686 Liberty bonds. Accounting method, 687 Loans to subscribers not exempt, 667 Life insurance policies, 354 Limitations for deductions, 929 Loans to purchase or carry U. S. gov- ernment bonds, not deductible, 924, 929, 1385, 1391 Former procedure, 924 Loans to purchase securities, 1385, 1391 Matured coupons, 388 Mortgage indebtedness assumed by muni- cipality, 664-665 Obligations of states and political sub- divisions, 664 Paid but not used, taxable, 388 Paid on instalment subscriptions to cap- ital stock, not deductible, 932 Paid on taxpayer's own capital not de- ductible, 932 Paid to carry tax-exempt securities, 123, 924 Paid to carry Victory notes, 923, 924 Paid to partners, 935 Former procedure, 935 Payment of tax at source, 1306 Promissory note of state, territory, 'etc., exempt, 361 Rate on mining investments, 1187-1191 Received by legatee, 674 Rental equivalent, by corporations, 699 Scrip dividends. Deductible, 926 Securities acquired behvcen interest dates, 674 Sinking fund, interest or gains taxable, 670 Subject to surtax and excess profits tax, 682 Former procedure, 682 Tax-exempt, excluded from gross income, 681 Tax-exempt securities, 801 Former procedure, 801 United States bonds. Held by partnerships, 802 Former procedure, 802 Loans to purchase, 929, 1385, 1391 [See also Estate, Capital Stock, and Excess Profits Indexes] i868 GENERAL INDEX Interest — (Ccntinucd) Unpaid taxes, 144-147, 217, 220 When time of payment of deficiency is extended, 228 Interest "Imputed," Defined, 932 Internal Revenue Bureau, Administration of, 173 Organization, 183-188 Chart, 184 Procedure, 174 Report, 1921, 3 Interstate Commerce Commission, Amounts paid to by railroads deductible, 918 Inventories, 386, 452-512 Accounting methods, 467 Bailments, 455 "Base Stock" method, 469 Cost or market values, 393, 459-469, 1213 Date for taking, 453 Dealers in foreign exchange, 486 Dealers in personal property, 488 Dealers in real estate, 486 Dealers in securities, 481-489 Defined, 454-456 Depreciation not permissible, 1057 Dry goods dealers, 475-478 Estimate not permitted, 453 Farmers, 462, 1416-1419 Florists, 1418 Former procedure, 452, 456, 462, 472, 481, 498, 504, 512, 520, 522, 523, 524, 531. 533 "Future" contracts, 472-474 Goods in process and finished, 478-479 Goods purchased but not delivered, 469- 472 Goods sold for future delivery, 479-480 Live stock raisers, 462 Losses established by, 985 Former procedure, 986 Lumber industry, 462 Market or eost values, 459-469, 1213 Obsolete items, 474 Partial sales of stock, 474-475 Prohibition ruling, 475 Repossession of real estate ruling, 503 Required under 1918 law, 452 Revaluations of capital assets not equiva- lent, 582 Second-hand automobiles, 486 Securities, Dealers may deduct inventoried shrinkage, 986 "Short Sales," 483 Taxpayer's notices to Treasury of method adopted, 480 Tobacco industry, 461 Use of to determine losses, 979 Valuation, general basis, 456-459 Valuation, in organization change, 486 Investment Companies, Undistributed profits invested in market- able securities, taxable, 1262 Investment Income, Insurance companies, 1388 Investment Information Bureau, Not exempt, 43 Investments, Expenses for, Deductible for life insurance com- pany, 1383 German, 987 Russian, 987 Irrigation Districts, Interest on bonds, 664 Former procedure, 664 Joint Adventures, Not associations, 91 Joint Exemption for Husband and Wife (See "Husband and Wife") Joint Ownership, Depreciation divisible between, 1074 Not necessarily partnership, 785-787 Joint Returns of Husband and Wife (See "Husband and Wife") Joint Stock Companies, Defined, gi Judges, Territorial courts. Compensation for judges subject to income tax, 403 United States, Not exempt, 365, 401 Judgments, Amounts paid on, deductible, 919 Former procedure, 919 Valuation of claim, 602 Jury Fees, Deductions and exemptions, 412 K Kentucky, Pensions to Civil War veterans, subject to tax, 409 State law concerning irrevocable trusts, 1350 Labor Organizations, Dues paid to, deductible, 917 Employment associations of, not exempt, 35 Exemptions, 34 Land (See also "Real Estate") Appreciation of, when building on it be- comes obsolete, 1142 Depreciation, 1070, 1098, 1106 Sold for non-payment of taxes, 665 Last Due Date, Defined, 54 Extension of time for filing returns, 57 Law of 1909, 7-8 Decisions on corporate losses, 1015 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1869 Law of 1913, 9, 447 Law of 1916, 11 .Association vs. trust, 1329 Law of 1917, 12 Compared with igi3-:gi6, 1214 Law of 1918, 14-17 Compared with previous laws, 447 Deductions for property losses, 983 Former procedure, 983 Holding companies, consolidated returns, 1020 Instalment plan sales, 488 Limitation period, 196 Net losses, 1022 Requiring inventories, 452 Law of 1921, 17-25 Amortization provisions, 1149 Capital gains under, 567, 804 Compared with previous laws, 447 Deductions for property losses, 983 Features, 154 Fiscal year for individuals, 448 Limitation period, 197 Loss on sale of property acquired by gift, 995 Net losses, "relief" provisions,! 1022 Non-resident aliens, taxable income, 1269 Prorated replacement "cost", 512 Repeal of profits tax, 531 Retroactive provisions, 24 Lawyers, Employed by state, not subject to tax, 409 Fees paid by maker of illegal sales, not deductible, pai Special counsels, 408 Leaseholds (See also "Lessees and Lessors," "Rent") Coal and oil lands, 643-647 Depreciation, 11 00 Value of, at March i, 1913, may be used for depreciation, iioi Leaving Country, Certificate of compliance, 215 Consular receipts, 216 Legal Holiday, When last due date, 54 Legatees (See "Beneficiaries," "Estates and Trusts") , Legislation Alternative, Constitutionality of, 816 Lessees and Lessors (See also "Lease- holds," "Royalties as Income") Advance royalties, depletion basis, 1229 Corporations as, dividends or interest as rental equivalent, 699 Cost of lease may be apportioned over term as rent, 906 Deductions for payment on cancellation of lease, 905 Deductions where property destroyed, 694 Deferred payments to lessor deductible when accrued, 907 Depletion allowance, 1216-1226 Lessees and Lessors — (.Cotitiniied) Depletion, apportionment between, 1223 Depreciation allowance, 695 Depreciation of residences rented part of year, 1056 Depreciation of residences used partly for business, or sublet, 1056 Erection of buildings, deduction for, 694 Improvements made by, 693 Life tenant, stock dividend property of, 783 Limited leases subject to depreciation, 1097 Former procedure, 1097 Market value of property leased prior to March i, 1913, 695-696 Mines, interest rate on, 1190 Mining lease as distinguished from sale, 1227 Payment of tax at source, 1306 Premium paid to secure leasehold, 90s Rental of subleased apartment, 904 Royalties on oil and gas wells, 1198 Tax liabilities, 693 Taxes, expenditure, 700-701 Former procedure, 700-701 Taxes paid by tenant, 903 Liabilities, Not used to reduce income of subsequent years, 381 Liability of Tax, By lessor, 693 By fiduciaries, 1348 By receivers, 248 Residuary legatee, 1352 Several trusts, separate incomes, 1352 Liberty Bonds (See also "United States Bonds") Accepted as security, 247 Corporation holdings in, 740 Distributed as dividends, 740 Distributed in dividends, losses on, 988 Estate tax, subject to, 680 Exemption periods depending on termina- tion of war with Germany, 685 Exemptions, 681 Interest, Accounting method, 687 Accrual of, 687 Exempt, 31, 350 Law of 1921, 20 Loans to subscribers not exempt, 667 Payment of tax by, 226 Special exemptions from additional taxes, 682-684 License, Collection of foreign items, 1321 Required for collection of foreign items, 320 License Fees, Automobile licenses deductible, 957 Deductible, 958 F-iens, For non-payment of tax, 23a [See also Estate, Capital Stock, and Excess Profits Indexes] 1870 GENERAL INDEX Life Insurance (See "Insurance, Life") Life Insurance Companies (See also "In- surance Companies," "Mutual Insur- ance Companies") Credits, specific, 1386 Deduction, Depreciation, 1384 Dividends of certain kind, 1382 Expenses on real estate owned by, 1384 Interest, 1380 Interest on loans to purchase other securities, 1385 Investment expenses, 1383 Real estate owned by, 1384 Rental value must be included on re- turns, 1385 Reserve fund earnings, 1381 Taxes paid in real estate owned by, 1384 Defined, 1378 Domestic, tax rate, 1379 Foreign, Tax rate, 1379 Taxable income of, 1386 Gross income, 1380 Interest on loans, deductible and other- wise, 1385 Net income, 1380 Not subject to excess profits tax, 1379 Reserve funds defined, 1381 Stockholder, deductions for taxes im- posed upon, 1384 Tax rate, 1379 Light, , As compensation for personal services, 440 "Like Kind" Property of, defined, 545, 558 Limitation Period for Assessments (See "Assessments") Limited Partnerships, (See also "Partner- ships") As corporation, 90, 811 Defined, 784 Dissolved, Disposition of surplus, 563 Distinctions between, 811 Former procedure, 811 Distribution of profits, 813 Liquidating, 563 Ohio, 812 Pennsylvania type, 812 Virginia, 812 Liquidating Corporations, Claims for abatement, 269 Compensation of trustees not exempt . from tax, 408 Disposition of surplus, 563 Law of 1921, 221 Liability of receiver or trustee, 221 Liability of stockholder, 222 Market value of assets basis for de- preciation, 1070 Liquidating Corporations — iCcmtinued) Payment of tax, 220 Returns, S5 Returns by receiver or trustee, 102 Liquidating Dividends, In excess profits tax, as dividends, 749 Provisions under 1917 and prior laws, 7S3-7S5 Provisions under 1918 law, 751-753 Tax-exempt if paid from capital surplus at March i, 1913, 748 Taxable, 749 Liquidating Partnerships (See also "Limited Partnerships, Liquidating") Liquor Business (See also "Bootlegging") Ooodwill, 1146 Obsolescence due to prohibition, X144- 1149 List of Individuals, Making returns to be posted, 126 Literary Organizations, Gifts, 1 24 1 Literary Societies, Exemptions, 39 Live Stock, 1413 Accounting, 1419 Death of, 1416 Live Stock Raisers, Inventories, 462 Former procedure, 463 Loan Associations (See "Building and Loan Associations") Loans, Interest not deductible, secured to buy or carry U. S. bonds, 924 Former procedure, 924 Interest, when deductible, 929 Personal, not deductible, 1035 Premiums paid on insurance policies to secure, 896 Lobbying Expenses, Not deductible, 915 Local Improvement Taxes, Not deductible, 938, 939. Lodge System, Defined, 36 Losses (See also "Amortization," "Bad Debts," "Gain or Loss," "Net Losses") Adjustment of losses must be made dur- ing taxable year, 1137 As capital expenditure, 1007 Assessments on stock, 990 Business, 729-730, 999 Cancellation of contracts, 1000 Capital, in estates and trusts, how de- ducted, 1372 Casualties, 860, 1008-1011 Former procedure, 1008 Collateral security, 1043 Contributions by stockholders, 990 Corporations, Bonds, sold or redeemed, 1016 Deductions for, 978 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1871 Losses — (Continued) Corporations — (.Cc»ttinued) Individual's share, when deductible, loos Securities issued and redeemed, 1013- 1018 Deductions for, 31, 975-1029 Computation, 1009 Estates, 1364 Limitations, 1020 Depreciation (See "Depreciation") Embezzlement, 381 Erosionr 1099 Farmers', 1410, 141 1, 1414 Applied against profits of succeeding years, 14 19 Former procedure, 14:9 Fire, 860, 978, 1008-1011, 1415 Former procedure, 1008 Flood, 141S Frost, 141 s Holding companies, Accounting methods, 1018 Former procedure, 1019 Husband and wife, 80 Illegal transactions, 1006 Individuals, Deductions, 977 Former procedure, 975 Insurance companies, 1391, 1406 Inventories to establish, 985 Former procedure, 986 Lawful gambling, 1007 Law of 1921, "relief" provisions, 1021 Liberty bonds as dividends, 988 Limitation on. Former procedure, 1029 Live stock, 1416 Non-resident aliens, when deductible, 1293 Obsolescence, 1134-1149 Partnership, Deductions, 803 Individual share deductible, 1005 When deductible, 980 Property, Determination and measurement, when deductible, 982-985 Revaluation, 1002 Scrapping of buildings and machinery, 997 Replacement fund, 505-512 Reserve against mutual insurance com- panies, not deductible, 1397 Reserves for, 729 Russian investments, 1042 Sale of capital assets, 996 Sale of property acquired by gift, 995 Sale of securities, 989 Shipwreck, 860, 978 Speculation, 996 Former procedure, 996 Storm, 860, 978, 1415 Losses — {Continued) Sustained after March i, 1913, deducti- ble, 982 Former procedure, 982 Tax-free distributions, 991-993 Theft or embezzlement, 381, 848, 860, 978, 1008-1011 Former procedure, 1008 Uninsured, accounting methods, loii Unrealized loss not deductible by es- tates, 1363 "Wash sales" to establish, 993-995 Former procedure, 993 Year when deductible, 980 Former procedure, 980 Lumber Industry (See also "Timber") Inventories, 462 Luxury Taxes, j Deductions, 960 Law of 1918, 15 M Machinery, Amortization, 11 58 Depreciation, 1054, 1080, 1102, 1119 Depreciation when replaced by new in vention, 1057 Farm, 1413 Leased, Depreciation, 1061 Obsolescence, 1134 Replacement vs. supplies, 1060 Sale of, 1409 Scrapped, Loss deductible, 997 Mail, Notices from Income Tax Unit sent by, 206 Sending return by, 63 Maintenance Funds, Required by law, deductible, 917 Manufacturers, Production and distribution both within and without United States, Allocation of income, 1 282-1 284 Taxes payable by, not deductible by con- sumer, 960 March i, 1913 (See also "Market Value") Basis for valuation. In sale of property, 589 Mines, oil wells, 642 Basis of appreciation, 569 Changes in value in, compared to Feb- ruary 38, 1913, 615 Date for revaluation. Supreme Court Decision, 583 Determination of value as of, 596 Income accruing before, not taxable, 377 Patent valuation as of, 648, 651-659 Property, Valuation of acquired before, 982-984 Marine Insurance Companies, Gross income, 1400 [See also Estate, Capital Stock, and Excess Profits Indexes] I«72 GENERAL INDEX Market Price, Defined, 431 Fair market values, 542 March i, 1913, 596 Market Value (See also "Cost or Market Value," "March i, 1913") As of March i, 19 13 Basis for ascertaining capital gain or loss, 569 Buildings erected on unimproved land, 695-696 Defined, 464, 539 Fair, 539, 543, 597 Fair market value defined, 11 73 Goods in process and finished, 478-479 Mines, 1175 Net selling prices vs., 466-467 Patents, 651, 655659 Property, Acquired before March i, 1913. 982-984 Leased, prior to March i, 1913, 695-696 "Readily realizable market value." Defined, 539 Received as compensation for personal services, 431 Timber, how determined, 1237 Wells, oil and gas. Fair market value must exceed cost, 1205 Marriage Settlements, Considered gifts, 355 Married Persons (See "Husband and and Wife") Massachusetts Trusts, As associations, 93 As trust, 93 Operating property in foreign country, Credits for foreign taxes not deducti- ble, 956 Memorial Association, Gifts to, deductible, 1244 Memorial Fund, Gifts to funds distributing income to charities, not deductible, 1245 Merchandise, Gifts of, to charitable and religious or- ganizations, deductible, 1254 Merchandise Bills, Need not be reported, 303 Merchant Marine Act, 1920, 369 Mergers, Defined, 558 Penalties waived for, 151 Returns, 100 When not closed transactions, 556 Michigan, Interest on bonds of agricultural and horticultural societies, not tax-exempt, 666 Mileage, As compensation for personal services, 443 To military and naval forces of the United States, tax-exempt, 411 Military and Naval Forces (See also "Sailors," "Soldiers") How far taxable, 440 Penalties waived for, 150 Military Uniforms, Depreciation, 1123 Mine Equipment, Depreciation, 11 04-11 07 Mineral Deposit, Defined, 1174 Determination of quantity of ore in mine, 1183-1186 Valuation, 11 81 Mineral Property, Accounting methods for deduction of depletion of, 1213 Capital adjustments, 645-647 Former procedure, 645 Defined, 11 73 Income adjustments, 645-647 Former protedure, 645 Returns for deduction for depletion of, 1214 In case of fractional interests and leaseholds, 1214 Royalties received from, 644-647 Valuation of, 657 Minerals, Defined, 1174 Depreciation through depletion not per- missible, 1057 Mines (See also "Discovery of Mines") Amortization table, 11 79 Average selling price of mineral de- posit, 1 1 83 Depletion, Basis of, 1 167 "Discovery value" of mines and oil bases for, 160 Of copper mines, 1209 Of silver mines, 1210 Resources, unworkable, 1231-1233 Depreciation, 1079 Determination of quantity of ore in mine, 1 183-1 186 Discovery of, 1194 By improvements, 1195 Value 30 days after, 11 96 Dividends from depletion reserves, 1231 Fair market value, 11 75 Intensive production, 1183 Interest rate on, 1187-1192 For lessors, 1190 Lease as distinguished from sale, 1227 Life of, II 83 Proven tract or lease, 1196 Repairs and replacements. Factor of operating cost, 11 82 Revaluations, 1196 Risks, 1 1 87 Royalties and depletion charges, 640-647 Royalties from, 644-647 Depletion basis, 1229 Sale of, limitation of surtax, 159 Sinking funds for, not established, 11 79 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX i«73 Mines — (Continued) Valuation, 1174-1196 Aflfected by life of mine, 11 83 As of March i, 1913, 599 Calculation, 11 86 Fair rate of interest, 11 87 Mineral deposits, 1181 Tables, 600 Mining Partnerships, As association, 91 Ministers (See "Clergymen") Minors, Allowance to not deductible, 861 As head of family, 341 Emancipation of, defined, 85 Making own returns, 342 Not exempt, 84, 342 Parent's right to earnings, 85 Returns by, 1348 Returns by fiduciary, 77, 84 Former procedure, 84 Wages paid to, 861 Moratorium, In Cuba, accounts uncollectible, because of, 1043 Mortgages, As compensation, 438 As instalment payments, 498 Assumed by municipality, 664-665 First mortgage bonds. Ownership certificates required, 319 Foreclosure as a bad debt, 1044 Former procedure, 1044 Interest on, deductible, 926 Receiver's returns on foreclosures, 103 Municipal Bonds, Interest, On loans secured for purchase of, not deductible, 929 Ownership certificates not required, 319 Sale of, at a discount, 666 Municipal Government, Returns of information at source, 303 Municipal Officers and Employees, Exempt, 366 Special counsel. Definition of term, 408 Municipalities, Gifts to, deductible, 1242 Musical Organizations, Gifts to, deductible, 1245 Orchestral societies. Exemptions, 40 Mutual Insurance Companies, 1394-1401 (See also "Insurance Companies," "Life Insurance Companies") Automobile owners insurance exchanges exempt, 1404 Certain kinds exempt, 1401 Combined policy on weekly premium pay- ment plan, 1398 Deductions, 1395 Net additions to reserve funds, 1396- '399 Mutual Insurance Companies— (Ct/i- tiniied) Deductions — (.Continued) Premium deposits returned or retained, 1400 Unearned premium fund of fire com- panies, 1396 Gross income, 1394 Marine, Gross income of, 1400 Reciprocal indemnity. Exchange not necessarily exempt, 1404 Reserve funds, 1396-1399 Returns, 100 Shipowners' Mutual Protection and In- demnity Association, 363, 1395 State created mutual liability company not exempt, 1403 Mutual Savings Banks, Exemptions, 35 Run for speculation, not exempt, 36 N National Banks, Liquidation of, procedure for receiver, 1342 Stock dividends, 766 National Dry Federation, Gifts not deductible, 1245 National Farm Loan Associations, Exemptions, 46 National Guard, Compensation, partly exempt, 409 Natural Resources (See "Mines," "Wells, Oil and Gas") Naval Uniforms, Depreciation, 11 22 Negligence (See also "Failure to Make Returns," "Penalties") Returns, 109-127 Without intent to defraud, Defined, 140, 142 Net Income, Accounting methods to reflect true in- come, 379, 414 Adjustments on amended returns for prior years, 112 Amortization period, 11 62 Ascertained, 155 Cash or accrual method of computing, 383 Changing from cash or accrual method of computing, 384 Computation of tax, 70, 155, 379, 414 Corporations, items, 31 Deductions for bad debts, 1031 Defined, 376, 697, 719, 846 Estates and trusts. Credits allowable, 1368 Foreign life insurance company, 1386 Individuals, 31, 71, 155 Insurance companies, 1387, 1389 Interest on tax-exempt bonds excluded, 801 [See also Estate, Capital Stock, and Excess Profits Indexes] i874 GENERAL INDEX Net Income — {Caiitinued) Inventory of merchandise on hand, 380 Life insurance companies, 1380 No specific method prescribed, 414 Obsolescence deducted from, 11 30 Outlawed accounts, included in, 520 Partnerships, Accounting period, 805 Defined, 799 Fiscal years, 1 920-1922, 792-795 How determined, 798 Identity of income limited, 801 Method of distribution, 790 Taxable on individuals, 790 Periods for which computed, 380, 384 Sources both within and without United States, Computation, 1282 Under $3,000, Penalties waived for, 150 Net Losses, Computation, 1024-1026 Deduction based on discovery value, 121 1 Deductions for, 72, 1023-1029 Former procedure, 72 Transactions entered into for profit, 999 Defined, 1023 Filing claim, 1029 Fiscal year, 1026 Former procedure, 1027 Individuals, Deductions, 999, looi Law of 1 92 1, 1022 Partnerships, 804 Personal service corporation, 838 Presupposes depreciation, 1052 Net Selling Prices, Versus market value, 466-467 New York State Franchise Tax, Accrual basis, 973 Prorated when reporting on calendar year basis, 973 New York State Income Tax, Accrual method, 973 No Par Value Stock, As element of capital surplus, 746 Non-Resident Aliens, 1269-1325 (See also "Aliens," "Resident Aliens") Agents of. Responsibility for making return, 1299 Beneficiaries, Returns for, 1300 Citizens of U. S. possessions taxed as, 1322 Collection of taxes, Methods, 1270 Credits, 1295 Filing returns, 1295 Former procedure, 1295 Deduction allowable, 1292-1295 Deductions, Apportionment, 1294 Filing returns, 1295 Gifts, 1242 Non-Resident Aliens — {Continued) Deductions for losses, 977 Defined, 1271 Dividends, record vs. actual owner of stock, 705 Estates taxable, 1354-1355 Exempt income. Income passing through banks for col- lection, 316 United States bonds, 692 Exemptions, 1269 Extension of time for filing returns, 1331 Fiduciaries, Withholding of tax at the source, 1356 Form for interest payments on foreign bonds when no withholding required, 1313 Form for personal exemption on tax- free covenant bond interest, 1313 Gross income. Defined, 1269, 1276 Income, From operation of ships, when ex- empt, 1286 Rulings regarding sources within United States, 1 286-1 292 Sources within and without United States, 1278-1292 Specific exemptions, 1285 Must include gross payments in returns, 1306 New law applying to Philippine Islands, 1324 Ownership certificates, For registered bonds, 309, 315, 316 Payment at source, 330 (For full entries see "Payment of Tax at source — non-resident aliens") Returns, 1297 Extension of time for filing, 1305 Forms required, 1301 Of information as to payments to, 1320 Required for sailing permits, 1297 Responsibility of agent for, 1399 Time and place for filing, 1304 Tax rate, 1297 Tax-exempt income, 1 284-1 286 Tax-free covenant bonds, 2% withheld, 299 Widow, Status of, 1274 Withholding from, 1306-131 1 Withholding returns, Form used, 310 Non-Resident Foreign Corporations (See "Foreign Corporations") Non-Resident Foreign Partnerships (See "Partnerships — Foreign") Normal Tax (See also "Credits Against Income") Exemptions, 337 Individuals, 155 Personal exemption only valid, 344 Notary Public, Fees received by, exempt, 407 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1875 Notes Receivable, Basis for, 1037 Notice, Claims denied, 313 Notice and Demand for Payment, Citizens abroad, 319 Delinquent assessment payable upon, 223 Penalties cannot be imposed until sent, 218 Reasonable time must be given, 219 Oaths, Administration of, 78 Obsolescence, 1130-1 149 (See also "Amor- tization of War Facilities," "Deple- tion," "Depreciation") Abandonment of property, necessary to claim, 1 146 Accounting methods, 1133 Former procedure, 1135 Accrued prior to 191 8 not accumulative, 1138, Accrued prior to January i, 1918, not deductible, 1138 Adjustment of accounts, 1136 Apartment houses, 1141 Basis for value of property acquired after March, 1913, 1135 Basis for value of property acquired prior to March 1, 1913, 113s Buildings, 1134, 1140 On appreciated land, 1142 Business discontinued, 1139 Capital assets, 1134 Deducted from net incoine, 1130 Estimation of, 1 133 Extraordinary, X134 Fireproof buildings, 1141 Fixtures, 1143 Future, 1137 Goodwill, 1142 Of liquor business, 1146 Hotels, 1 141 Improvements, 11 39 Intangible assets, 1142 Inventories, 474 Land, 1143 Liquor business due to prohibition, 1144- 1149 Loft building, 1142 Machinery, 1134 Not retroactive beyond January i, 1918, 1138 Ordinary, included in annual deprecia- tion allowance, 1130 Property, 1134 Value as of March i, 1913, 1134 Vineyards, 1146 Office, In owned residence, 864 In rented residence, 863 Officers (See also "Army Officers," "School Officers") Definition of term, 405 Of the United States, criminal proceed- ings, 153 Ohio, Partnership taxable as corporation, 812 Oil and Gas Wells (See "Wells") Oil Property, Depreciation, 1078, 1107 Oil Wells ('See "Wells, Oil and Gas") Operating Lessee of Mine (See "Lessees and Lessors") Operating Owner, Depletion allowance, 1215 Vs. operating lessee, deduction for de- pletion, 1225 Options, When taxable, 538, 552 Orchards, Depreciation, 1109, 1414 Orchestr^vl Societies, Exemptions, 40 Organizations, ExTempt (See "Exempt Organizations") Incomplete, Penalties waived for, 150 Trade associations dues as business ex- pense are deductible, 917 Organization Expenses, Depreciation, 11 09 Not deductible, 907 OvER-AssESSMENTS (Sce "Assessments") Overpayments (See "Claims for Refund") "Overtime," Depreciation due to, 1080 Ownership Certificates, 306-319 A-ctual owner, use of form 1087 (rev.) to disclose, 318 Bonds sold between interest dates, 313 Former procedure, 314 Correction of, by bank or other collect- ing agencies, 312 Debentures, holders of must file, 308 Defined, 120 Facsimile signatures, 319 Fiduciaries, 314 Use of proper, 1344 Filed when no actual withholding, 310 Filed with interest payments, transmitted to Commissioner, 299 First mortgage bonds, 319 Foreign corporations, 316, 317 Foreign items, 299, 316 Presented without certificates, 317 Forms used, 304 When withholding is required, 309 Information, should be complete, 30S Interest coupons presented without, 311 Joint owners of bonds, 314 Liability of b.nnks and agrnts, 312 Marital status of owner eliminated on, 308 Necessary, even whore exempt ion certi- ficates arc filed, 13 14 [See also Estate, Capital Stock, and Excess Profits Indexes] 1876 GENERAL INDEX Ownership Certificates — ^Continued) Non-resident aliens, 316, 1312 Claiming exemption on tax-free cove- nant bonds, form used, 309 Partnerships, F'oreign, 316 Holding registered bonds, 315 Payer has right to demand name and address of recipient of income, 320 Personal service corporations, 315 Procedure when not accompanying cou- pons, 311 Promissory notes, 319 Registered bonds, 315 Substitute certificates, 310 Withholding agent should forward with monthly returns, 298 Tax withheld at source. Forms used, 309 To disclose actual owner, 317 Withholding agent should forward with monthly returns, 298 Paid or Accrued, Defined, 383, 847 Paid or Incurred, Defined, 383 Parks, Gifts of real estate for, deductible, 1244 Partnerships (See also "Domestic Part- nerships," "Limited Partnerships") Accounting method, Cash or accrual basis, 806 Personal and partnership accounts dif- fer, 87 Former procedure, 88 Accounting period, 805 Affiliations, Former procedure, 104 Associations vs., 92 Banks, As associations, 92 As partnership, 92 Changes during taxable year, 797 Changes in organization, Procedure, 806-809 Claims for credit, 284 Composed of corporation, 810 Computation of tax. Fiscal years 1920-1921, 1921-1922, 791-796 Consolidated returns, 788 Former procedure, 789 On excess profits tax when affiliated with corporations, Former procedure, 104 When affiliated with corporations, Former procedure, 104 Credits, For certain dividends and interest, 800 For foreign taxes, forms to be used, 956 Information needed to take advantage of, 802 Partnerships — (Cc-ntinued) Deductions, 870 For gifts, 799, 1241 Former procedure, 799 For losses, 803 Foreign taxes, 943 Information needed to take advan- tage of, 802 Defined, 784, 785, 787 Dissolution, procedure, 806-809 Distributions other than in cash, 809 Distributive shares of members. Deduction of notarial fees received under state commission, 407 Included in gross income, 155 Profits, 155 Shown on return of firm, 407 Taxability, 790 Fiscal year, 791-796, 806 Former procedure, 791 Foreign (See also "Foreign partner- ships") Defined, 1271 Forms for returns, 1302 Not affected by withholding provisions, 1306 Gifts individual credits for partnership gifts, 1247 Identity of income, Former procedure, 801 Limited, 801 Income from, 784-813 Income from Liberty bonds. Apportionment to mtmbers, 688690 Incorporated, should make returns as a corporation. 89 Information at source, 292 Interest paid to partners, 935 Former procedure, 935 Inventory valuation when changed to corporate form, 486 Joint ownership of property not partner- ship per se, 785 Former procedure, 785 Joint venture in stock subscription, not partnership, 785 Joint venture of corporation and indi- vidual, not partnership, 785 Law of 1 92 1, right to incorporate, 796 Limited (See "Limited Partnerships") Liquidating, Procedure, 806-809 Losses, Individual's share deductible, loos When deductible. 980 Mining, as association, 91 Net income. Defined, 799 How determined, 798 Net loss provision, 804 Net lossces, deductible by partners, 1028 Not taxed as such, 690 Former procedure, 690 Ownership certificates for registered bonds, 315 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1877 Tartnerships — (Cmttiinicd) Participation in profits by employee de- ductible, 892 Partners, Considered as persons, 87, 337 Not exempt from withholding, 331 Payment of tax at source, 1306 Personal service corporations grouped with, iss Personal service corporations included. 813 Profits, 389 Distributive shares included in gross income, 155 Return of estimated, on joint accounts, . 786 Reorganized as corporations. Returns on bases of calendar year for employees' salaries, 297 Return by receiver, 797 Returns, S3, 87, 297, 787-789 Fiscal year basis, 64, 164 Former procedure, 64, 297 Former procedure, 788 / Individual partners, 87 Inspection, 1:8 Inspection by single partner, 119 Purposes, 798 Salaries paid to partners, 892 Included in returns, 297 Withholding in case of, 1308 Withholding returns. Form used, 310 Patent Infringement, 381 Damages received, income or capital, 649 Profits from, 641 Recoveries for, 513 Value of claim, 602 Patents, Accounting methods, 650 Applications for, Valuation of, 659 Capital net gain, 640 Deduction for depreciation not obliga- tory, 652 Depreciation, 1095, 1109-1113 Based on fair market value at March I, 1913, nil Former procedure, 1 1 1 1 Of royalties, 660 Since Feb. 28, 1913, 652 Development costs, 650 Distinguished from goodwill, 652, 654 Income from, 640, 641, 648-660 Intangible property, 651 Life of, in foreign countries, 11 14 Litigation expense deductible, 651 Litigation on, deductible, 11 12 Royalties, 648 Former procedure, 648 Tax on royalties withheld, 1310 Valuation, as of March i, i9'3. 651-659 Readjustment permitted on accounts prior to 1917. 653 Valuation method, 433, 651 Patriotic Organizations, Not exempt, 36 Patterns, Depreciation, 11 14 Tavment of Refund (See "Refunds") Payment of Tax, Adjustment for prior years, 112, 256 By mail, 219 Citizens traveling or residing abroad, 218 Erroneous or illegally assessed taxes must be paid, 223 Instalment method, 216 Citizens abroad, 219 Former procedure, 216 Notice and demand for, 218 Understatement of tax, 217 Interest on instalment overdue, 217 Interest on unpaid, 220 Liquidating corporation, 220 Methods, 224-227 Notice for unpaid, 218 Penalties for failure or delay, 144-147 Penalties for unpaid, 144-147, 220, 244 Protests for additional assessments, 286- 289 Receipt for, 229 Suit to restrain, not maintainable, 249 Payment of Tax at Source (See also "Income Tax") Agreements to pay tax, 1307 Assignee, 1309 By individuals, corporations, and part- nerships, 1306 Corporations, Amount to be withheld, 324 Corporations not having tax-free bonds, 330 Discussion, 322 Domestic corporations. Not required to withhold, 328 Payments to foreign corporations, 1310 Exemptions, 331 Foreign corporations, 1307, 1308 Certificates showing place of business, 1320 Filing of return does not relieve with- holding, 1309 Former procedure, 1309 Form for interest on bonds, 13 13 Not required to withhold, 328 With fiscal agents here, 13 12 Foreign partnerships not affected by, 1306 Former procedure, 323 Interest on drafts accepted l)y foreign bank subject to withholding. 1308 Interest paid after due, 330 License for collection of foreign items, 1321 Nonresident aliens. And corporations, 330 Bond interest and ownership certifi- cates, 13 1 2 Citizens of U. S. possessions, 1322 Definition of fixed and determined an- nual or periodical income, 1310 [See also Estate, Capital Stock, and Excess Profits Indexes] 1878 GENERAL INDEX Payment of Tax at Source — (Ccmttnued) Non-Resident Aliens — {Contimted) Duties of employers, 1315 Exemption certificates, 1313. 1314 Exemption of employee, 13 16 Interest on bank balances, 131 1 Forrner procedure, 131 1 No withholding on bond interest due prior to March ij 1913, 299 Owner of foreign item unknown, 1314 Partnerships, 1308 Procedure of Alien Property Custo- dian, 1320 Race track winnings not subject, 13 10 Rates on bond interest, 1315 Refunds, 1317 Return of tax withheld, 13 18 Former procedure, 1318 Returns of withholding agent, 13 19 Ships' captains, 131 1 Obligor corporation, amount withheld by, 324 Owner unknown, 327, 329, 1307, 1314 Penalties, 1321 Personal service corporations, 328 Relief from does not make income non- taxable, 13 II Returns, 305 Tax collected from non-resident aliens, 1306 Tax paid by withholding agents, 328 Tax-free covenant bonds, 1306 (See also "Tax-Free Covenant Bonds") Withholding agent. Defined, 324, 1309 Not liable, 328 Penalties, 109-127, 128-153 Abatement claims, False, 246 Additions, to taxes may or may not be deductible, 966 Ad valorem, 134 Appeals from, 143 Apply only after notice and assessment, 147 Certain cases exempt from, 1357 Citizen leaving country, Failure to make return, 138 Community property of husband and wife under Texan law, 400 Compromise of, 149, 152, 333 Bars prosecution, 153 Deceased person's estates, 148 Delinquency in filing returns, 152 Disclosure of information of returns, 124-125 Failure or delay in payment, 144:47 Failure to make returns, 131-139 Former procedure, 132, 133, 137 False or fraudulent returns, 133-138 Fifty per cent, 134 Fraudulent amended returns, 136 Interest on instalment overdue, 217 Interest on unpaid taxes, 144-147 Negligence, 140 Penalties — {Continued) Non-resident aliens, failure to make re- turn for sailing permit, 1298 Not subject to suit, 149-151 Notice and demand must be sent before imposing, 218 Recovery of, for taxes illegally paid, 148 Former procedure, 148 Returns of information at source re- fused, 321 Specific, not subject to suit, 149 Suits at law, 271 Barred after 5 years, 152 Specific penalties not subject of suit, 149 Synopsis, 128-131 Tentative returns, 57-59 Understatement, 135, 139-144 Unpaid taxes. Interest on, 220 Waived, 140 When applicable, 1357 Pensions, As gifts, 359 , Deductions for are income, 444 Military or naval, exemptions, 351 Not taxable, 411 Former procedure, 411 Police pension funds. Gifts to, deductible, 1245 Retired pay allowances paid by United States, not taxable as income, 411 State, tax-exempt, 411 To Civil War veterans, not exempt in Kentucky, 409 To employees, deductible, 888 United States, to widows, not taxable, 421 Per Diem Allowance, As compensation for personal services, 443 Personal Expenses, Alimonj^, 870 Army officers, 867 Breach of promise, 870 Clothing, deductions for, 868 Deductions, 851, 855 Defined, 855 Distinguished from business expenses, S57 Importance of precise distinction, 858 Government officials, 867 Premiums on insurance (See "Insurance premiums") Personal Injuries, 381 Personal Property, Dealers in, inventories, 488-489 Income from sale or exchange, 1282-1284 Personal Residence (See "Property De- preciation") Personal Service (See "Compensation for Personal Service") Personal Service Corporations, Abolished by law of 1921, 18 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1879 Tersonal Service Corporations — (Con- tinued) Accumulated dividends should be de- clared, 841 Affiliated corporation, Losses, accounting procedure for parent company, 829 Alternative tax provision, 814-817 Amended returns, when establishing sta- tus as, 841 Capital, use of in, 835-837 Change of tax basis, 820 Changes in ownership, 837 Classed with partnerships, 155, 164 Former procedure, 349 Computation of tax when corporation is partly, 839 Considered as partnerships, 813 Corporations, Not distributing earnings, may be classed as, 839 Former procedure, 839 With large government contracts may not qualify, 839 Defined, 823-825 Distributions that are not dividends, 713 Dividends, 349 Distribution, 705-706 During or subsequent to 60 days of taxable year, 729 When taxable, 713-714 Earnings from stockholders' services, 833 Excess profits tax. Forms to be used for credits, 956 Excluded, stockholders' principal duties being supervisory, 834 Exemptions, 46 Former procedure, 46 Fiscal years, 819-823 Foreign corporations cannot be classed as, 838 Government contracts not considered, 531 Holding companies, when may qualify, 828 Income, 813-841 Income from Liberty bonds. Apportionment to members, 688-690 Net loss provision, 838 Ownership certificates, 315 Percentage of stock held by those con- ducting, 837 Personal service, what constitutes, 829- 833 Profits undistributed, 155 Returns, 53, 90, 818-819 Dividends paid, 108, 302 Former procedure, 301 Fiscal year basis, 164 Information at source, 297 What must be included, 714 Salaries paid to members, included in return, 297 Specific examples, 832 Stockholders, Credits allowed, 838 Ex'emptions, 690 Personal Service Corporations — (Coii- tinued) Stockholders — (Continued) Income to be reported, 8.'2 Status of, 840 Tax liability, 155 "Trading" corporations cannot qualify, when, 826 "Trading" corporations may qualify, when, 827 Trading corporations, when may qualify, 827 Types of organizations classed as, 829- 840 ^J Undistributed profits, 155 With substantial capital may qualify, 827 With substantial income from personal service, may qualify, 825 Withholding of, after 1921, 329 Withholding returns on tax-free cove- nant bonds. Form used, 310 Personal Services, Income from (See "Compensation for Personal Services") Philippine Islands, Compensation of government employees not exempt, 410 Corporations in, classed as foreign, 349 Dividends, how treated, 704 New taxation law, 1324 Not included in 1921 law, 368 Taxation of non-residents of, 1323 Physicians, Depreciation claims, 11 16 Pilots, Compensation not exempt, 409 Pledges, When deductible, 1246 Political Subdivision of State or Ter- ritory, Defined, 664 Income from public service corporations exempt, 50 Interest on obligations exempt, 360, 664, 681 Ownership certificates not required, 318 Political Subdivision of U. S., Defined, 360 Porto Rico, Compensation of government ciuiiloyees not exempt, 410 Corporations in, classed as foreign, 349 Dividends, how treated, 704 Gifts for reconstruction work, deduc- tible, 1244 Not included in 1921 law, 368 Taxation of corporations, 1323 Taxation of nonresidents of, 1323 Postage, Not deductible as tax, 971 Postal Savings, Deposits exempt, 680 Former procedure, 680 Postmasters, Cannot administer oallis, 78 [See also Estate, Capital Stock, and Excess Profits Indexes] i88o GENERAL INDEX Premiums (See also "Insurance-Prem- iums") As earned income, 1389 As taxable income, 445 Capital stock redeemed, not a deductible loss, 1 01 7 Included in gross income of mutual in- surance companies, 139S Life insurance policy, deduction when beneficiary is charitable corporation, 1246 Mutual insurance companies, Deposits returned or retained, deduc- tions for, 1400 Mutual marine insurance companies, 1400 Of business life insurance, excluded from gross income, 522 Payment of tax at source, 1306 Received by mutual marine insurance companies paid out for reinsurance not included as gross income, 1393 Unearned, of fire insurance companies, 1396 Present Worth, Tables, 600 President of the U. S., Income not exempt, 365, 401 Prices, March i, 1913 and February 28, 1913. 61S Market, at March i, 1913, 596 Printing, Depreciation, 1116 Prior Years (See also "Amended Re- turns") Limitation on assessment for, 195-200 Former procedure, 196-197 Proceedings at Law (See "Suits at Law") Production Decline Curves for Gas and Oil Wells, 1197 Professional Men, Business expenses of, 862 Depreciation claims, 1116 Depreciation on residences used for busi- ness, 1056 Office in owned residence, 864 Office in rented residence, 863 Rentals paid by, 907 Professional Services, Charges for, need not be reported, 303 Fees received as income from, 295, 401 Professors, Salaries in land-grant and states' colleg'es not taxable, 412 Profit and Loss, Affected by erroneous depreciation state- ments, 1051 Profit-Sharing, Actual payment from fund allowable de- ductions, 436 Distributions from, distinguished from compensation for personal servicts, 417 Employees' Profit-sharing Fund, as com- pensation, 436 Profit-Sharing — (Ccntinued) Income from fund taxable as firm's in- come, 436 Problems in, 425-430 Taxable income under. Defined, 1375 Profits (See also "Gains," "Capital Gains," "Capital Net Gains") "Accumulated," defined, 729 "Appropriated," 389 As a source of dividends, 720-725, 729 Copyrights, Computation of, 648 "Credited or set apart," 389 Defined, 976 Distribution of. Limited partnerships, 813 From patent infringements, 641 From sale of patents and copyrights, 640 Operating, defined, 1174 Outlawed accounts as, 520 Partnerships, 389 Partnership, Return of estimated, on joint ac- counts, 786 Patents, 640, 648 Realized from sale of property, 31 Sale or exchange of capital assets, Law of 1 92 1, 804 Sales, consignment, 384 Tax-free distribution of, Losses, 991-993 Undistributed, 1259-1286 Accumulations taxed if evasions pur- poseful, 1261 Accumulations taxed if unreasonable, 1262 Not retroactive, 1263 Claims for credit, 285 Common stock, reduction of, 1264 Individual stockholders taxable, 1259 Former procedure, 1259 Investment of accumulations in U. S. obligations, 1264 Limited partnerships, 813 Personal service corporations, 155 Reinvestment of proceeds of sale of capital assets, 1265 Retirement or purchase of preferred stock with, 1264 Former procedure, 1264 Stockholders taxed on distributive shares if so elected, 1268 Surplus from sale of capital assets or from excess funds, 1266 Surtax payable by corporation, 1259 Former procedure, 1259 Prohibition, Obsolescence due to, 1144-1149 Ruling concerning inventories, 475 Promissory Notes, As compensation, 437 Discounted, accounting for proceeds, 437 Not equivalent of cash unless readily discounted, 548 Ownership certificates not required, 319 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1881 Property (See also "Capital Assets," "De- preciation," "Exchange gf Property," "Sale of Property") Accounting in conversion of, 506-508 Acquired by gift. Losses from sale of, 995 Ai)preciation (See "Appreciations") Corporations, Sale of property acquired by gift, 519 Depreciation (See also "Depreciation") Aquired by gift, 1247 Personal residence, 1228 Discovery value ascertained, 541 Expenses for replacement, 509 Expenses of obtaining return of from Alien Property Custodian not deduc- tible, 913 Fair market value March i, 1913, basis of determining loss, 982-984 Former procedure, 982 Held March i, 191 3, not taxable, 982 Income from sales and exchanges, 535- 566, 1282-1284 Intangible, Depreciation, 1098 Patents, 651-659 Inventories to establish losses, 985 Former procedure, 986 "Like kind" of, Defined, 545 "Like kind or use" of. Defined, 558 Losses, Determination and measurement when deductible, 982-985 Market price, 982 Notes given for, treated as instalment payments, 502 Obsolescence, 1134 Proceeds of property requisitioned or destroyed, 504 Profits from sale taxable, 31 Prorating replacement, 512 Replacement in kind, 508 Restoration of, not deductible, 1051 Revaluation, Losses deductible, 1002 Scrapping of buildings and machinery. Losses deductible, 997 Subject to depreciation, 1057 Use of, not taxable, 374 Valuation, basis for determining, fair market value, 543 Prorating Method, Land and crop values, 613 Validity of, 616-619 Public Employees (See "Government Em- ployees") Public Grant (See "Homestead") Public High School, Gifts not deductible if used for athletic purposes, 1245 Public Service Corporation, Fiscal year fixed by state, 69 Income of states from, exempt, 50 Public Utility, May deduct earnings paid to city, state, etc., 918 Publishing, Depreciation, 1096 Purchasing Agencies, Farmers', Exemptions, 45 Race or Race Track Associations, Not exempt, 1310 Race Track Winnings, Of non-resident alien, not subject to withholding, 1310 Radium, Depreciation, iii6 Kailroads, Commuters' fares, not deductible. 865 Compensation of employees, subject to tax, 400 Deduction for amortization denied, 1154 Depreciation of roadway, 1061 May deduct amounts paid to Interstate Commerce Commission, 918 Passes on. As compensation for personal services, 441 As gifts, 357 Sidings, depreciation, 11 17 Railroad Fare (See "Traveling Expenses") Rates, Tax (See "Computation of Tax," "Tax Rates") Ration Money, To military and naval forces of the United States, tax-exempt, 411 Real Estate (See also "Building," "De- preciation," "Lessee and Lessor," "Property," "Rent as Income," "Title to Property") Acquired by inheritance, 627 Carrying charges on, 914 Corporations holding for profit, deduc- tions for, 848 Cost of development work, 503 Damages for condemned projicrty, wlicii taxable, 514 Depreciation, Not permissible, 1057 Of residences, 1056 Exchange of, by dealers, taxability of, 547 Gifts of, for park purposes deductible, 1344 Inventories, 486 Obsolescence of buildings, 1139 Owned by life insurance companies, de- ductions for, expenses and taxes, 1384 Payments to increase value not de- ductible, 1051 Hesidcnce of clergymen, not taxable, 423 [See also Estate, Capital Stock, and Excess Profits Indexes] 1 882 GENERAL INDEX Real Estate — (.Continued) Sale of, 498-504 In lots, 503 Or exchange, included in gross in- come, 1280 Valuation, Inventory method, 985 Former procedure, 986 Receipts, Distinguished from accrual, 387, 414 For taxes, issued only on request, 229 Receivers, All not classed as fiduciaries, 1328 Appointed by state court, 405 Claims for abatement, 248 Commissions received, when appointed by state, not taxable, 405 Compensation fixed by state court. Approved by federal court, 405 Not taxable, 405 Taxable income, 405 Compensation of, partly state, partly federal, 405 Liquidating corporation, 221 Partnership returns made by, 797 Procedure in liquidation of national banks, 1342 Responsibility in filing returns, 1343 Returns by, 102, 1341-1344 Returns of information by, 294 Reciprocal Indemnity Exchange, Not necessarily exempt, 1404 Record vs. Actual Owner of Stock, Non-resident aliens, 705 Records, Claims, where accurate records are not kept, 960 Recoveries, Bad debts, 513 Charged off, 1045 Damages, awarded by arbitration board, S14 Of claims, if vested before March i, 1913, 514-315 Patent infringement, 513 Red Cross, Donations to, by corporations, not de- ductible, 1247, I2S3 Former procedure, 1248 Maintenance for service in, as compen- sation for personal services, 444 Referee, In bankruptcy, not a judge of inferior court, 403 In drainage, Appointed by district judge of state judicial district, 405 Exempt from income tax under Act of 1918, 405 Refunds, 252-277 (See also "Claims for Refund") Excess tax on oil royalties, 641 Interest on, under 1921 law, 21 Payment, 262, 27s Under protest, 286-289 Regulations, Retroactive, 182 Treasury interpretations, 188-191, 238, 239 Rkligious Organizations, Compensation received by members of, when taxable, 420 Exemptions, 39 Gifts to, 1 24 1 Remainderman, Stock dividend property of, 782 Rent, Payment of tax at source, 1306 Rent as Expense, 852 Deductible, 855 Life insurance companies, item must be included in return to receive deduc- tion, 1384, 1385 Minister's house exempt, 362, 422 Office, In owned residence, 864 In rented residence, 863 Paid to real estate agents need not be reported, 303 Paid to stockholders, not dividends, 903 Payment for cancellation of lease de- ductible, 904 Permanent improvements, 903 Premium paid to secure leasehold, 905 Rental of subleased apartment de ductible, 904 Taxes paid by tenant, 903 When deductible, 902 Rent as Income, 693-703, 1280 Accrual basis, 693 Cash basis, 693 Cash or its equivalent must be returned for taxation, 702 Defined, 693 Depreciation of residences. Rented part of year, 1056 Used partly for business, or sublet. 1056 Dividends, guaranteed, as rental cquiva lent, by corporations, 699 Expenditure by lessees for taxes, 700 Ground rent. Defined, 932 Not deductible as income, deductible as rent, 931 Not deductible as interest, 931 Houses occupied rent-free, 702 Housing of employee as taxable income, 438-440 Interest as equivalent of, 699 Must be reported by agent, 303 Not reported when paid in crop shares, 294 Permanent improvements, 693 Report of, on accrual basis or actual receipt basis, 693 Securities as payment for, 699 Subject to taxation, 693 Taxable, 31 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1883 Reorganization, Closed transaction, may constitute, tliough control remains in former owner, 560 Defined, 557 Depreciation computation in case of, 1069 Exchanges of securities not taxable, 556 Purchase of assets by bondholders, 562 Returns, 100 Securities exchanged in, not taxable, 556, 558 Tax question where change in sub- stance or form of securities exchanged, 559, 563 When continuing transactions, 536 When not closed transactions, 556 Former procedure, 556 Repairs, And replacements, included in operating costs of mines, 11 83 Capital expenditures in some cases, 1063 Incidental, deductible, 911 Distinguished from replacement items, 1061 Not to be confused with depreciation, 913 Replacement Cost, Future, not a factor in depreciation charge, 1069 Replacement Funds, Cash received as return of property through Alien Property Custodian, 512 For losses, 505-512, 591 Rulings concerning, 510-512 Reserve Funds, Bad debts, deductible, 1030-1035 Fire insurance companies, 1396 For depreciation, 1074 Reserves, For discount, 451 For obsolescence, 1131 Instalment business, 497 Insurance companies, For unpaid losses not a deduction, 1397 Issuing combined policies, 1397 Net additions to, deductible, 1396 Life insurance companies, Deductions, 1381 Defined, 1381 Mutual insurance companies. Additions to deductible, 1396 "Self-insurance," 898 To equalize profits, 900 To protect bank deposits, 902 Residences, Co-operatively owned apartments, 46 Cost of not deductible by depreciation, 1057 Deduction for taxes paid by husband for residence title to which is in wife's name, 963 Depreciation of, 1056 Residences — (Continued) Establishment, refund claims on, 1317, 1318 Loss on sale not deductible, 1003 Tax on individual's own residence, rental value -of which is not taxable, deductible, 963 Tax on taxpayer's residence, deductible, 968 Resident, Defined, 368 Resident Aliens (See also "Aliens," "Non- resident Aliens"), Credits, Foreign taxes, 946 Deductions, Foreign taxes, 942, 946 Taxes, 938 Withholding upon change of status, 1275 Resources, Unworkable, Depletion, 1231-1233 Retailers, Inventories, 475-478 Retroactive Regulations, 182 Retroactive Taxation, Stock dividends, 783 Returns (See also "Amended returns," "Forms of Returns," "Inspection of Returns," "Returns of Information at Source"), Access to, 117 Alien Property Custodian, 1304 Amended (see "Amended returns") Affidavit, 77, 78 Agents, 77 Form tc be used, 77 Annual basis (see also "Returns, Fiscal Year Basis") Fractional part of year, 167 Assignee's returns, loa Auditing of, 194, 200 Bad debts, Reported, to be deducted, 1036 Books of account reconciled with, 162 By oath, 78 Certified copies of as evidence in suits at law, 120 Change in accounting period, procedure, 6S Community property of husband and wife, filed separately, 82 Confidential rights, 117 Consolidated (see "Consolidated Re- turns") Foreign corporations. Former procedure, 1303 Contractors, 449-450 Corporations (see "Corporations, re- turns") Dealers in securities, 484-485 Defined, 52 Depletion, statement of, 1214 Tn case of fractional interests and Iciscliolds, 1314 [See also Estate, Capital Stock, and Excess Profits Indexes] 1 884 GENERAL INDEX Returns — (.Continued) Each year's must be complete, 848 Erroneous information, penalties waived for, 150 Executors make, for estates, 1355 Exempt securities need not be listed, 360 Extension of time for filing (see "Ex- tension of Time for Filing Returns") Failure to make, 131-139 Former procedure, 133 Fiduciaries, 87, 1330-1346 Beneficiaries, 1339 Committee for incompetent, 1339 Distributive share of beneficiaries, 1338 Estates and trusts not treated as unit, 1336-1338 Form to be used, 77, 1346 Guardian for minors, 1339 Information at the source, 1344-1346 Joint, 1330,1335 Non-resident alien beneficiary, 1344 Place for filing, 1331 Property turned over to, 1339-1340 Receivers, 1341-1344 Revocable trust, 1340 Several trusts, 1340 Trustee in bankruptcy, 1341 When due, 1331 When required, 1330 Filing (see also "Failure to Make Re- turns") Amortization claim with 1921 return, 1150 By mail, 63 Delinquency in, 152 Exempt securities, 33 Filed on time, penalties waived for, 149 Foreign corporations, 1309 Partnerships, 787-789 Wrong district, penalties waived for, 150 Final (see "Final Returns") Closing of, 209-213 Fiscal year basis, 163-166 Foreign corporations, 1296 Agent responsible, 1303 Agent's return, 100 Consolidated returns, 1303 Extension of time for filing, 1305 Forms required, 1302 Time and place for filing, 1304 Foreign partnerships, Forms required, 1302 Forms, 72-74 Fraudulent, 109-127 Penalty for abetting, 133-138 Gross income, individual returns, 52 Guardians, 77 Holding companies, 99 Husband and wife (see "Husband and Wife") Retirns — {Cofitinued) Imperfect or incorrect not acceptable, 138 Inactive corporations, 95 Incompetents, 77 Incomplete corporations, 95 Individuals, 52, 75-129 Fiscal year basis for fractional part of year, 170 Gross income, 75 Last due date, 55 Partner as, 87 Who must make, 75 Inspection (see "Inspection of Returns") Instalment dealers, 488 Insurance companies, 100, 1405 Interest from tax-exempt securities need not be reported, 76 Internal Revenue Commissioner, 52-53 Mailed on time, penalties waived for, 149 Married persons, 52, 75 Military and naval forces, 78, 86 Minors, 77, 84, 1348 Emancipation of minor, 85 Former procedure, 84 Negligent, 109-127 Non-resident aliens, 1297 Beneficiaries, 1300 Extension of time for filing, 1305 Filing of for deductions and credits, 1295 Forms required, 1301 Required for sailing permit, 1297 Responsibility of agent for, 1299 Time and place for filing, 1304 Partnerships, 87 By receiver, 797 Former procedure, 53 Purposes, 798 Personal service corporations, 53, 90, 818- 819 What must be included, 714 Place for filing, 63 Receivers, 102, 797 Mortgage foreclosure, 103 Responsibility in filing, 1343 Re-examination of, 199 Amortization claim, 1150, 1165 Requirements, 52 Soldiers and sailors, 86 Special kinds, 54 Taxable year, 64 Tentative, 57-59, I39 Penalties waived for, 150 Time for filing, 54, 57 Former procedure, 54 Trustees, In bankruptcy, 102 In dissolution of corporations, 1341 Understatement, 135, 139-144 Unmarried persons, 52, 75 Who shall make, 52, 75 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX i88; Returns of Information at Source, Actual owner, 317 Alien employees, by foreign branches, need not be reported, 303 Aliens, non-resident, 299 Amount to be reported, 293 Annuities need not be reported, 303 Bills for professional services not re- ported, 303 Board and lodging of employees, 296 Bonds. 298 Sold between interest dates, 313 Sold between interest dates, former procedure, 314 Brokers, Payments to customers, 303 Returns on customers, 302 Returns on customers, former pro- cedure, 302 Calendar year, 294 Civil service employees, 303 Classes about which furnished, 292 Classification, 292 Commission on single transaction not to be reported, 295 Compensation for personal services, 295- 297 Compensation to employees for injuries or sickness need not be reported, 303 Corporations, 315 Must furnish, 292 Payments to, not to be reported, 303 Debtor corporation ownership certifi- cates, 299 Discussion, 291 Dividends, domestic or resident foreign corporations, 303 Dividends paid, 301 Former procedure, 301 Employers must furnish, 292 Examination of bank accounts, 1 1 s Extension of time for filing, 303 Failure to file, penalties, 134 Former procedure, 132 Fees for professional services to be re- ported, 29s Fiduciaries, 297, 314, 1344-1346 Fixed and determinable income, defined, 294 Foreign countries, bonds of, 298 Foreign dividends, 298 Foreign items. Defined, 300 Ownership certificates, 299 Form of certificate when withholding is required, 309 Forms of, 293, 305, 309. 1346 Former procedure, 293 Freight bills, 303 Individuals must furnish, 292 License for collection of foreign items, 1331 Merchandise bills, 303 Monthly and annual, by agent, 298 Former procedure, 298 Returns uf Information — (.Continued) Municipal government, 303 Non-resident aliens, 301 Non-resident corporations, source of in- formation, 300 Ownership certificates, 120 As returns, 299 Forms and uses, 304, 306-319 Necessity for, 1345 Shall constitute, 306 Partnerships, 297 Foreign, 301 Must furnish, 292 Payments, On which required, 293 Requiring no information, list of, 30J To agents of $1,000 or more to be reported, 293 Former procedure, 293 To employees must be reported, 295 To nonresident aliens, 1320 Penalties for refusal, 321 Personal service corporations, 297 Rent paid to real estate agents need not be reported, 303 Soldiers and sailors, payments to by gov- ernment need not be reported, 303 State or political subdivisions, 303 Storage bills, 303 Substitute certificate, 310 Telegram bills, 303 Telephone bills, 303 War Finance Corporation bonds, 318 Who must furnish, 292 Revaluation (See also "Appreciation," "Valuation"), As of Jan. i, 1909, applicable to cor- poration excise tax only, 1070 Gain or loss through, 582-586 How entered on books, 582 Mines, 1 1 76 Property, Losses deductible, 1002 Securities, Permitted dealers, 986 Surplus from, not taxable, 583 Roadway, Depreciation of railroad, 106 1 Royalties as Income, 640-649, 6»)(i, 1280 -Advance royalties, 1229 Basis of patent valuation, 655 Copyrights, 647 Depletion allowances, 1216 Depletion applicalile, 645 Depreciation charges, 660 Mines, oil wells, etc., 640 Depletion allowances, 641-647 Depletion allowances, former proced- ure, 642 Patents, 648660 Tax on payments withheld, 1310 Taxable, 31 Waived for several years, 647 Wells, gas and oil, 1198 [See also Estate, Capital Stock, and Excess Profits Indexes] 1 886 GENERAL INDEX Russian Investments, When worthless, 987 Russian Property, Deductions for bad debts, 1043 Sailing Permits, Non-resident aliens, returns required, 1297 Sailors, Board and lodging as compensation, not taxable income, 439 Compensation for active service during war exempt up to $3,500, 410 Items to be included in the $3,500 ex- emption of the 1918 law, 411 Payments to by government need not be reported, 303 Returns, 86 Special exemption of 1918 law not re- enacted in 1 92 1, 410 Salaries (See also "Bonuses," "Compen- sation for Personal Services") Contingent, deductible in year paid, 884 Deductions for, 870-876 Deductions for annuities, civil service employees, 413 Definition of "Including a reasonable allowance for salaries," 871 Determined after close of fiscal year, 884 Fiduciaries, included in returns, 297 Fixed by contract, 877 Lump sum payment of, 878 Must not be unreasonable, 875-876 Paid by corporations, 874 Paid by exempt corporation. Taxable, 49, 51 Partners, Included in returns, 297 Taxable income, 805 Payment of tax at source, 1306 Personal service corporations, included in return, 297 Professors', in land-grant and states' colleges not taxable, 412 Received as income from professions or vocations, 401 Voted subsequent to close of books not deductible, 886 Sale and Exchange of Capital Assets (See "Capital Gain," "Exchange of Property," "Sale of Property") Sale of Ore, Lease as distinguished from, 1227 Sale of Property (See also "Exchange of Property," "Property") Acquired by gift, 619-625 Acquired by inheritance, Income only taxable, 355 Allocation of income, 1282-1284 Basis for determining gain or loss when appreciation is realized, 569-582 Sale of Property — {Continued) Capital assets of corporation, 554 Former procedure, 554 Deferred tax on instalment plan sales, 549 Expenses for sale of, by estate, when deductible, 1363 Fair market value. Defined, 539 Goodwill, 549, 602-612 Income from, 535-566 Market value at March i, 1913, 596 Mines, 159, 599 Obsolescence, 1130-1149 Options, 538 Profit realized from, taxable, 31 Vessels, Profits from under Merchant Marine Act, 1920, 369 Wells, 599 Sale of Rights, Stockholder's, to subscribe for new stock, taxable, 550 Sale of Securities (See also "Exchange of Securities") Acquired by inheritance, 625-627 Basis, when shares of same issue are bought and sold at different dates, 587 Income from, 535-566 Losses on, 989 Right to subscribe to stock, When taxable, 550 Tax exempt. When taxable, 554 To establish losses, 993-995 Former procedure, 993 Valuation of stock sold at varying prices, March i, 1913, 614-616 Sale of Stock Dividends, Taxability of income from, belonging to trust estates, 1361 Sales (See also "Closed Transactions"), Export business, unpaid drafts not in- cluded as profit, 377 Goodwill, proceeds taxable, 549 In escrow, 375 Instalment plan, 487-504, 548, 549 Of capital assets, partnership profits, law of 1921, 804 What constitutes closed transactions, 536 When taxable, 548 Salesmen, Advances to deductible, 878 Commissions received by, taxable, 420 Sanitarium, Not in personal service class, 834 School Officers, Compensation when not public employer, subject to tax, 407 Scientific Organizations, Gifts to, 1241 Scientific Societies, Exemptions, 39 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1887 Scrip Dividends, As cash dividends, taxable, 741 Interest on, 742 Deductible, 926 Not taxable, 779 Reaeemable in cash or stock, taxability questioned, 743 Seamen (See also "Sailors," "Ship Cap- tains") Alien, Proof of residence, 1373 Residence, how established, 1273 Non-resident, wages, when taxable, 1289 Seasonal Business, Reorganization of corporations doing. Returns, loi Securities (See also "Liberty Bonds," "Exchange of Securities," "Sale of Securities," "United States Bonds") Carried on margin with broker, Stock dividends, refunds, 781 Collateral, Depreciation of, 1043 Interest deductions, 930 Corporations, losses in issuance at re- demption, 1013 Dealers in, Defined, 481 Inventories, 481-489, 582, 985 Former procedure, 986 German, 987 Government, discount on bonds, ac- counting for proceeds, 741 Income from interest. Acquired between interest dates, 674 Losses, accrued, "Wash sales" to establish, 993-995 Former procedure, 993 Revaluation, Permitted to dealers only, 986 Russian, 987 Sold by estates, advantages to, of capi- tal gains provision, 1374 Tax-exempt, 378 Valuation, At date available, 626 When acquired by inheritance, 626 Services, Personal (See "Compensation for Personal Services") Shares (See also "Stock") Distributive, in partnerships, taxability, 790 Sheep (See "Live Stock") Shipping Industry, Depreciation, 11 17 Shipowners' Mutual Protection and In- demnity Associations, 363 Income of, 365, 1395 Ships (See "Vessels") Ships' Captains, Not subject to withholding, 131 1 Shipwreck, Loss by, S'Jo, 978 Sickness, Compensation to employees for sickness need not be reported, 303 Penalties waived for, 150 Silver Mines (See "Mines") Single Persons (See "Unmarried Per- sons") Sinking Funds, Interest or gain from, taxable, 670 Not established for mines, 11 79 Smith-Lever Act, 1914, Salaries in colleges under, 412 Soap Industry, Depreciation, 11 18 Society por the Prevention of Cruelty to Animals, Gifts deductible, 39, 1242 Society for the Prevention of Cruelty to Children, Former procedure, 39 Gifts deductible, 39, 1242 Soldiers, Compensation for active service during war exempt up to $3,500, 410 Items to be included in the $3,500 ex- emption of the 1918 law, 41: Payments to by government need not be reported, 303 Returns, 86 Special exemption of 1918 law not re- enacted in 1921, 410 Special Counsel, Compensation of. To city, not exempt from income tax, 408 To state comptroller, not exempt from income tax, 408 Specific Exemptions (See "Exempt In- come") Speculation, Losses, deductions, 996 Former procedure, 996 Speculation in "Futures," Taxable, 448 Stamp Taxes, Deductible only by person levied upon, 959 Deductible on sale of property by execu- tor, 1363 State, Community property of husband and wife as defined in, 395 Interest on obligations of political sub- divisions of, tax-exempt, 664 Public service corporation, Fiscal year fixed, Cg State Bonds, Interest, On loans secured for purchase of, not deductible, 929 When distributed as dividends, taxable, 740 State Courts (See "Courts, State") State Income Tax, 6 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX State Officers and Employees, Exempt, 366, 403 Former procedure, 403 Right to inspect returns, 118, 121 Salaries exempt, 33 Special counsel for state comptroller, 408 State Securities, Exempt, 360 State Witness (See "Witnesses, State") States of the U. S., Deductions, Taxes paid to, under secured debts laws, 957 Defined, 368 Former procedure, 368 Exemptions, income from public serv- ice corporations, 50 Gifts to. Deductible, 1242 Returns of information at the source, 303 State Taxes, Deductions for, 927 Statistical Information, Income tax, publication of, 126-127 Steamship Companies, Foreign, Income, Sources within United States, 1290 Steamships (See "Vessels") Stock (See also "Bank Stock," "No Par Value Stock," "Sale of Stock") Building and loan associations, 673 Capital, Certificates must be canceled or stamped for payments required by reduction of, 747 Exchange for cash considered as pur- chase of old stock, 735 Proper procedure in reduction of capi- tal stock, 747 Reduction of, 747 Determination of value of stock received as compensation, 431-434 Former procedure, 431 Joint subscription not partnership, 785 Received as bonus, 533 Record owner responsible for return, 1301 Retirement of common, with surplus earn- ings, when taxable, 1264 Sale on instalment plan. Closed or continuing transactions, 549 Sale or retirement by corporation, 523 Self-purchase by corporation, 524 Stamp taxes on, should be treated as taxes, 960 Former procedure, 960 Stockholding taxes paid by corporations. Not deductible, 938, 939 Subscription rights, when taxable, 530 Taxes paid by corporation not deductible by shareholders, 957 Treasury, accounting procedure, 523-527 Stock — iContinned) Valuation, 543 Worthless, deductible, 988 Former procedure, 9*89 Stock Brokers, Interest derived from accounts of, 670 Stock Dividends, Allocation to, Different years, 728 Earliest purchaser, 775 Periods when accumulated, 728 Amount received in redemption of can- cellation, taxabje, 764 Appreciation of assets as source of, 780 Cancellation of, taxable, 764 Carried two years, taxable as capital gains, 770 Cash dividends, 764 Corporations, Domestic, 705-706 Resident, foreign, 705-706 Credits, 780 Declared by national banks, 766 Defined, 764, 765 Effect on surplus at March i, 1913, 732 Excise tax, 783 Fractional shares received as dividend, 779 Goodwill as source of, 780 Guaranteed, as rental equivalent, by corporations, 699 History of taxable question (see book, "Income Tax Procedure") National banks may not lawfully declare, 766 Not a distribution, 768 Not taxable, 763 Paid in stock of another corporation, not, 730, 769 Personal service corporations. Supreme court decision, 814 Preferred stock, not deductible, 932 Preferred stock not taxable, 768 Property of life tenant or remainder- man, 782 Reappraisal as source of, 780 Redemption of, taxable, 764 Refunds, 780 Refusable, 708, 782 Retroactive tax, 783 Sale by trust estate, Taxability of income from, 1361 Sale of Basis for determining gain or loss, 771 Computation of profit or loss, 770-780 Computation, shares of different char- acter, 774 Computation, shares of same character, 7TI-773 Computation, shares purchased at dif- ferent times and prices, 774 Shares carried on margin with broker, Refunds, 781- [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1889 Stock Dividends — {Continued) Stockholders to be advised, 714 Subsidiary corporations, 768 Surplus, Accumulated prior to March i, 1913, 767 And undivided profits as source of, 711 As source of, 780 Capitalized by means of, 767 Taxable when set apart for stockholders, 388 Stockholders, "Bargain" purchase, capital assets, 989 Compensation of deductible, 877 Contributions to creditors, 990 Deductions on taxes paid by life in- surance company, 1384 Depletion claims, not allowed, 1216 Dividends in Liberty bonds. Losses on, 988 Dividends, owners of record liable, ex- ception, 70s Injunction not granted in suits to re- strain collection of taxes, 250 Inspection of returns, 119, 123 Liability of, Liquidating corporation, 222 Personal service corporations. Changes in, 837 Exemptions, 690 Income to be reported, 822 Returns, 155, 819 Service must be principally rendered by, 829-833 Status of, 840 Taxed as individuals, 784, 814 Profits on sale of rights 10 subscribe to stock, taxable, 550 Taxable for sale of corporation's capi- tal assets, 554 Former procedure, 554 Taxable for undistributed dividends, when, 706 Taxable for undistributed profits, 706, 1359 Former procedure, 1259 Taxable on distributive shares, if so elected, 1268 Voluntary assessments, tax-exempt, 520 Stock of Other Companies, Dividends paid in, not considered a stock dividend, 730 Redemption of, 755 At substantial premiums, is a dis- tribution of surplus, 758 Stock Preferred, Retirement of. Contractual, 747 Retirement of preferred, with surplus earnings, not taxable, 1264 Former procedure, 1264 Stock dividends in, not taxable, 768 Storage Bills, Need not be reported, 303 Storm Losses, 978, 1415 Deductions for, 860, 978, 141 5 Street Railway Companies, Donations to induce to extend tracks, not deductible, 1250 Stumpage, Revaluation in depletion not allowed, 1335 Styles, Depreciation and, 11 14 Subscriptions (See "Gifts") Subscription Rights, Stock, when taxable, 550 Subsidiary Corporations (See "Affiliated Corporations") Substitute Certificates, For ownership, 310 Suits at Law, Certified copies of returns for use as evidence, 120 Claims for refund, procedure, 252-277 Collection of taxes by suit, 231 Compromise of penalties bars, 153 Criminal proceedings, 152 Income assessments, 236 Injunctions to restrain collection of tax, 250 Must be brought against collector who collected tax, 267 Recovery of penalties, foundation for, 149 Recovery of taxes wrongfully collected, 373 Specific penalties not subject of, 149 Time limit for action by government, 153 Where collector dead, 268 "Supper Money," As compensation for personal services, 440 Surplus (See also "Profits, Undis- tributed"), Arising from reappraisals not taxable, 582 Capitalized by means of stock dividend, 767 Dissolved limited partnerships. Disposition of surplus. 563 Distribution of, when necessary, 1266 Dividend distributions made from, 746, 780 Effect of stock dividend on surplus at March i, 1913, 746 Personal service corporations. Accumulated prior and subsequent to January i, 1918, 840 Taxation of undistributed profits, 1259- 1335 Undistributed, not (Icduclible, 071 Surtax, Computation of, i s^' Corporations not liable lo, /u.i Kvasion of on iniilislributcd pidfil. by corporations, 12^10 [See also Estate, Capital Stock, and Excess Profits Indexes] 1890 GENERAL INDEX S u RTAX — (Continued) Husband and wife, 79, 80 Former procedure, 79 Imposed on net income, 377 Individuals, 31, 155, 156 Individuals of partnerships. Avoidable by retroactive incorporation, 796 Law of 1931, 18, 683 Mineral deposits, sale of, 159 1921 rates, 156 1 93 1 rates on cash dividends as taxable income, 732 1922 rates, 156 On interest on certain U. S. bonds, 680, 682 Partnership profits, 803 Payable when normal tax exempt, 156 Personal service corporations, 819 Rate of, 156 Former procedure, 156 Non-resident aliens, 1297 Sale of mineral deposits, 159 Tax on, for individuals exempt under normal tax, 344 Undistributed profits, payable by corpora- tion, 1259 Former procedure, 1259 Wisconsin, 974 Syndicates, Not associations, 91 Tables, Amortization, 11 80 Decisions, ix Present worth of each dollar of operat- ing profit, Hoskold's formula, 600 Tables of Depreciation Rates, 1123-1128 Tax Collectors (See "Collectors of Taxes") Tax Paid, Refundable, 972 Tax Payment (See "Payment of Tax") Additional (See "Additional Tax Pay- ments") Tax Rates, 154-172 (See also "Computa- tion of Tax," "Net Income," "Sur- taxes") Corporations, 160 Outlawed accounts subject to, 520 Prorated for fraction of year, 167 Estates and trusts, 1329 Foreign corporations, 1297 Gross income of individual, 1330 Individuals, 155 (See "Individuals, Tax on") Insurance companies, 1379, 1387 1 91 7 laws, 13 1921 law, changes summarized, 154 Non-resident aliens, 1297 Repeal of profits tax, 531 Tax Simplification Board, Organized under 1921 law, 21, 179 Taxable Year, Change in, 163-171 [See also Estate, Capital Stock Taxable Year — (Continued) Changes in, 1027 Defined, 64 Different tax rates, 733 Returns on basis of, 63-72 Status at end of determines exemption, 343 Uncompleted for corporations in dissolu- tion, 55 Taxation, British practice in betting, 447 French practice in gambling, 447-44S Tax-Exempt Securities (See "Exempt Securities") Tax-Free Covenant Bonds (See also "Ex- empt Bonds," "Ownership Certificates," "Payment of Tax at Source," "Re- turns of Information at Source") Corporations issuing, 931 Deductions for, 677 Former procedure, 678 Defined, 323 Due prior March i, 1913, 330 Federal tax paid, not deductible, 928, 971 Former procedure, 972 Form for personal exemption claimed by non-resident alien on interest from, 1313 From whom withheld, 327 Legal theory of deduction, 324 Limitation of debtor corporation's lia- bility, 335 ^ Ownership certificates, 306-319 Taxpayers, list posted, 126 Withholding provisions apply to, 1306 Taxes, (See also "Computation of Taxes" and special subjects in body of index) Adjustment of taxes of prior years, 966 Bank stock, paid by bank not deductible by shareholders, 957 Claims for credit. Applied against income, war profits, or excess profits tax, 278 Corporations, Deductions, 939 Former procedure, 939 Credit for payment, 1368 Customs duties deductible, 959 Deductions, 937-974 Accrual method permitted, 973 Former procedure, 973 Criticism of law, 963 Excise taxes, 960 Former procedure, 960 For interest on overdue federal, 927 For taxes paid for another person, 963 Former procedure, 974 Luxury taxes, 960 Former procedure, 960 Not allowed, 931 Real estate owned by life insurance company, 1384 Foreign, Credits for domestic corporation con- trolling foreign subsidiary, 948-951 Former procedure, 948, 951 and Excess Profits Indexes] GENERAL INDEX 1891 Taxes — (.Caniinucd) Foreign — iCo-ntinucd) Credit for, under fiscal year basis, 954 Former procedure, 954 Deductions, 937, 942-944 Forms to be used for credits, 956 Limitation of credit, 943, 948 Massachusetts trust, 956 Procedure for securing credit, 953 Foreign dividends, Deductions, 944 Individuals, Deductions, 938 Former procedure, 939 Inheritance taxes deductible, 961 Local improvement assessments not de- ductible, 966-968 Former procedure, 966 Local improvement assessments not in- creasing value of property, deductible, 968 Paid by tenant, deductible, 903 Paid by vendee for vendor, taxable to vendor, 521 Paid for another person, deductions, 963 Paid or accrued by insurance companies not deductible, 1391 Paid states under secured debt laws, Deductible, 957 Payable by manufacturer, not deductible by consumer, 960 Penalty additions to may or may not be deductible, 966 Stamp taxes. Deductible only by person levied upon, 9S9 On stock, 960 Former procedure, 960 State, Deductions for, 927 Undistributed surplus, tax on not de- ductible, 971 Teachers, Deductions for courses, 863 Hawaii not exempt, 410 Telegram Bills, Need not be reported, 303 Telephone, As compensation for personal services, 440 Bills, need not be reported, 303 Territories of the U. S., Compensation of government employees not exempt, 410 Exemptions for citizens residing in, 368 Former procedure, 368 Interest on obligations of political sub- divisions of, tax-exempt, 664 Securities exempt, 360 Texas, Community property of husband and wife as defined by Texan law, 400 Textile Industry, Depreciation, 11 18 Theft or Embezzlement, Loss by, 860, 978, 1 008-1 01 1 Former procedure, 1008, loii Timber, Depletion, 1234 Basis of, 1 167 Computation, 1234 Determination of quantity, i.'38 Market value, 1237 Depreciation, 1079, 1119 Improvements, 1334 Lease as distinguished from sale, 1227 Valuation, Located in Canada, 1338 Tips and Gratuities, Taxable, 420 Title Abstract Companies, Maintenance of records deductible, 914 Title to Property, Cost of defending or perfecting, not de- ductible, 913 Tobacco Industry, Inventories, 461 Tools, Depreciation, 1121 Farmers, 1413 "Trading as a Principal," Defined, 827 Trading Stamps, Expenditures on, deductible, 916 Former procedure, 916 Transfer of Property (See "Exchange of Property," "Royalties") Traveling Expenses, Deductions for, 851, 853, 856, 864-867 Of commuter, 855, 856 Travel by automobile, 868, 869 Treasury Certificates of Indebtedness (See also "United States Bonds") Exemptions, 688 Treasury Notes, No cxeu'iptions, 683 Payment of tax by, 223 Treasury Stock, Accounting Procedure, 525-527 Treasury of the United States (See "United States Treasury") "Treating Money," Deductible, 1254 Trees (See "Orchards," "Timber") Trust Companies, Contributions to, for charitable purposes, not deductible, 1245 Use of stamps and facsimile signatures, 3'9 Trust Estates, Depreciation not deductible from indi- vidual's tax, 1072 Trustees, Compensation over period of years tax- able as of wliat year, 416 In bankruptcy, returns by, loa, 1341 In dissolution of corporafioii. Compensation of, fixed by court, 408 [See also Estate, Capital Stock, and Excess Profits Indexes] 1892 GENERAL INDEX Trustees — (Continued) In Dissolution of Corporation — (Con- tinued) Definition of term, 408 In returns by, 1341 Income of discretionary trust taxable to, 1351 Liquidating corporation, 221 Payments to trustee for ultimate benefit of taxpayer not deductible, 921 Remuneration provided by will, taxable, 421 Trusts (See also "Estates and Trusts," "Fiduciaries") Irrevocable, defined under Kentucky state laws, 1350 Law of 1916, 1329 Revocable, 1340 Grantor taxable, 1352-1354 Several trusts, separate returns, 1340 Typewriters, Depreciation, 1121 u Understatements (See also "Additional Tax Payments") Claim by government, refund, 276 Made in good faith, 140, 141, 217 Former procedure, 140 Made through negligence, 140 Notice from collector, 143 Penalties, 135, 139-144 Underwriting Income, Insurance companies, 138S Undistributed Profits (See "Profits, Un- distributed") Undrilled Acreage of Wells, Valuation, 1203 Unearned Income, Insufficiently taxed, 859 Unearned Increment, Earnings and profits do not include, 721 Uniforms (See also "Clothing") Depreciation. 11 22 United States, Defined, 1271 Gifts to, deductible, 1242 Possessions, citizens of, 13J2 United States Bonds, Accepted as security, 247 Capitalization of interest received, aban- doned, 684 Exemptions, 350, 680-691 Interest, Need not be reported, 303 On loans secured for purchase of, not deductible, 929 • On loans secured to purchase or carry, not deductible. 924 Former procedure, 934 Non-resident aliens, owned by. 1285 Ownership certificates not required. 318 Undistributed profits, investment of, un- taxable, 1364 United States General Appraisers, Board of (See "Board of United States Gen- eral Appraisers") United States Treasury, Decisions merely interpretations, 238 Interpretations of statutes, 188-191 Regulations governing practice before, 180-182, 238, 239 Taxpayer's appeals from decisions of, 239 Taxpayer's notice of inventory, method adopted, 480 University Stores, Not exempt, 46 Unmarried Persons, ."Vs head of family, 341 Exemptions, 341 Returns by, 75 L'nworkable Resources (See "Resources, Unworkable") "Useful Life," Defined, 1055, 1090 War property, 1079, 1082 Valuation (See also "Cost or Market Value," "Market Value," "Revalua- tion") Assets of old partnership taken over, 809 Book, excessive, 1053 Book value, 810 Capital assets. Adjustments of appraisals of various dates, 612 Fixed by appraisers of state court may be rebutted, 616 Capital stock, 614-616 Claims, 602 Dividends paid in, Liberty bonds and other government securities, 740 Property, 735 Stock, 735 Gifts, 1243, 1247 Former procedure, 1247 Goodwill, 602-612, 807 Homesteads acquired from government, 624 Infringements, 602 Inventories, General basis for, 456-459 Judgments, 603 Land with crops growing thereon, 614 Market, to lessee, 1224- 1226 Market value of stock received by way of compensation, 431 Mineral deposits, 1181 Mineral properties, 1217-1221 Mines, 1174-1196 As of March t. 1913, 599 For depletion allowance, 1168, 1171 Revaluation after March i, 1913, 1329 Tables, 600 [See also Estate, Capital Stock, and Excess Profits Indexes] GENERAL INDEX 1893 \"all"atio.\ — I Continued) Mining claims, 6s7 Obsolescence, 1134 Patents, Application for, 659 Capital value on or after March i, 1913, 648 Damages for infringements, 649 Intangible property, 651 Method of, 433 Method of valuing, 651, 654-659 Readjustment permitted on accounts prior to 1917, 653 Pro rata method, 616-619 Property, Acquired by inheritance, 625-627 Determination of losses, 982-985 Leased, prior to March i, 191 3, 694 Prorating replacements, 512 Replaced in kind, 508 Requisitioned or destroyed, 504-508 Real estate, Cost of development work, 503 Sold or exchanged, 569-582 Sale of a business, 602-612 Securities, Acquired by inheritance, 626 Revaluation permitted dealers, 986 Shrinkage of, in securities, "Wash sales" to establish, 993 Former procedure, 993 Similar property, 614 Tables for mines, 600 Used automobiles as instalment payments, 502 Value or cost basis by discoverer of mine', 1228 Wells, oil and gas. For depletion allowance, 1171 Method of determining, 1197 Risks affecting rate of return, 1202- I.!03 Undrilled acreage, 1203 Vessels. Bonus for earlv delivery of, deductible, 918 Depreciation, 11 17 Exemption of profits from sale of, 369 Former procedure, 369 Victory Notes, Exempt interest on, 350 Interest, Accrued upon conversion of, 685 On loans secured for purchase of, when deductible, 939 Paid to buy or carry deductible only when in hands of original subscrib- ers, 925 Paid to carry, 923, 934 Payment of tax by, 226 \'1NE YARDS. Obsolescence not allowed unless aban- doned, 1 146 Virginia, Partnershii)«, Status of, 8i2 Virgin Islands, Taxation of citizen of, 1322 Vocational Rehabilitation, Fund for, Gifts to, 1242 Vocational Rehabilitation Act, Payments received by military and naval forces of the United States under, tax- exempt, 411 Former procedure, 411 Vocations (See "Professions") Voluntary Assessment of Stock, 520 w Wages fSee also "Compensation for Per- sonal Servfce," "Salaries") Alien (See "Payment of Tax at Source — non-resident aliens") Deductions for, 870-876 Included in gross income, 1280 Paid to children, 861 Payment of tax at source, 1306 Received as income from professions or vocations, 401 Wagons, Depreciation, i i 22 War. 1 1 Termination, 61-63, 411 For amortization purposes, 11 50 War Facilities (See "Amortization of War Facilities") War Camp Community Funds, Gifts to, deductible, 1243 War Chest Funds, (Jifts to, deductible, 1243 War Finance Corporation Bonds, Exemptions. 350, 680, 681, 685 Ownership certificates must be filed, 318 War Industries Board, Industries regvilated by, can secure evidence for amortization claims, 11 57 War Profits Tax (See also "Excess Profits Tax") Exemptions, law of 1921. 683 On United States bonds, 680 War Property, Depreciation, 1079, 1082 Warrants Received for Public Work Done, Face value is taxable income, 411 War Risk Insurance Act. Pavments received by military and naval forces of the United .States under, tax-exempt. 41 i War Service. Bonus for. not taxable. 363 Excmp'.ion expired, 362 Wards, l-'xcniplions. 345 [See, also Estate, Capital Stock, and Excess Profits Indexes] 1 894 GENERAL INDEX "Wash Sales," 20 Basis when loss on is denied, 591 Collateral securities, 1043 Partnerships, Computation of net income, 794 To establish losses, 993-995 Former procedure, 993 Not deductible, 977 Welfare Work, Deductions for, 887 Wells, Oil and Gas, Depletion, 1202, 1210-11 Allowance, 1216 Basis of, 1 167 "Discovery value" of mines and oil basis for, 160 Development costs, how accounted, 1228 Discoveries (See "Discoveries of Mines and Wells") Economic limit, deiined, 1200 Inventories of raw products, cost or market value, 1213 Participating lease, 643 Present value method, 1201 Prices for the oil or gas unit, How estimated, 1200 Production costs, 1201 Production decline curves, 1197 Royalties and depletion charges, 640-647 Sale of, limitation of surtax, 159 Valuation, As of March r, 19 13, 599, 642 Method of determining, 1197 Risks affecting rate of return, 1202- 1203 Undrilled acreage, 1203 Widows, Pension received from United States, not taxable, 421 Wife (See "Husband and Wife") WiSCOiN'SI.N, Interest on tax certificates issued for land sold for non-payment of taxes, exempt, 665 Surtax, 974 Withholding (See "Payment of Tax at Source") WiTHHOLDixG AoENT (See also "Owner- ship Certificates") Defined, 324, 1309 Fiduciaries, 1356 Former procedure, 1356 Filing of exemption certificate with, 1314 Liability of, 328 Monthly and annual returns, 298 Former procedure, 298 Non-resident aliens. Claims, 299 Returns, 301 Owners not known to, 1307 Return of tax withheld, 13 18 Former procedure, 1318 Withholding returns, owner unknown to agent, Form used, 310 Tax paid by, 328 Withholding of Tax at Source (See "Payment of Tax at Source") "Within the Taxable Year," Defined, 1049 Witnesses, State, Fees paid to are taxable, 412 Wood-Working Industry, Depreciation, 1122 Workmen's Compensation, Insurance premiums deductible, 898 Workmen's Compensation Insurance, State funds exempt, 51 Worthless Debts (See "Bad Debts") [See also Estate, Capital Stock, and Excess Profits Indexes] INDEX— FEDERAL ESTATE TAX [See also General, Capital Stock, and Excess Profits Indexes] INDEX— FEDERAL ESTATE TAX Accounts Receivable, Valuation, 1446-1447 Administration-, Expenses allowed resident estates, 1471 Annuities, Computation, 1455-1456 Valuation, 1452-1454 Appointment, Property passing under power of, 1462- 1464 Appr.\isals, Household goods and personal effects, 1449-1450 Assessments, Additional, Interest on, 1520, 1521 Determined within one year, 1521 Attorney's Fees Allowed from Resident Estate, 1472 B Bank Deposits, As cash, in valuation pf property, 1437 Bonds, Valuation of property, 1439 Broker, Indebtedness to, deductible from gross estate, 1440 Business, Valuation of interest in, 1444-1445 Close Corporation, Valuation of securities, 1440-14. C'OLLECTION of TaX, I 532 Collectors, Returns made by, 1503 Community Property, Valuation, 1450-1452 Courtesy Valuation, 1454, 1456 Crops, Valuation, 1447 D Deductions, Gifts, non-resident estate, 1487 Gross estate, Indebtedness to broker, 1440 If decedent died prior to Feb. 25, 1919, 1469 Losses from casualty or theft, 1474 Miscellaneous administration expenses allowed resident estate, 1473 Xon-resident estates, 1486-1488 Property acquired in exchange, 1479 Property previously taxed, 1476-1479 Resident estates, 1468-1476 Specific exemption, resident estates, 14S4 Support of dependents, 1475 / Taxes upon resident estates, 1473 Unpaid mortgages on resident estate, 1474 Dividends, When not included in gross estate, 1434 Dower, Valuation, 1454, 1456 Cash, Accounting for in valuation of property, 1437 Cemetery Lot, Included in gross estate, 1434 Cheques, In payment of tax, 1506 China, Proceedings for United States Court for China, 1516 Citizens, Coming under extra-territorial court, 1516 Claims for Abatement, 1511 Filed after 30 days, 1437 Interest accrued on, 15 12 Limitation period, 15 12 Claims for Rekund, 1512 Filed after 30 days. 1437 Military exemption, procedure, 1431-1432 Transfer of estate exempt, 1431 Estate (See also "Gross Estate," "Net Estate," "Non-Resident Estate," "Resi- dent Estate") Deductions allowed residents, i468-i476 Description of taxable, 1429 Status of certain property of non-resi- dent, 1485 Examination qf Kfturn, 149R, 1514 Executor. Appraisal of household goods and per- sonal effects by, 1448-1440 Commission allowed for resident estates 1471-1472 Commission not entitled to, 1472 Duly to keep record.s, 1514 Duly to render statements, 1514 Liability of, IJM. 'S'8 Payment nf fax by, 1518 [See also General, Capital Stock, and Excess Profits Indexes] 1898 INDEX— FEDERAL ESTATE TAX Executor — {Continued) Sixty day notice, 1489 When not yet appointed, 1490 Exemptions, Military exemption, 1430, 1492 Failure to Exhibit Records on Prop- erty, 1511 Failure to File Notice, 1510 Failure to File Return, 1510 Federal Estate Tax, How computed, 1424, 1426 Law, definitions in, 1425 Law, summary, 1424-1425 Rates, 1425-1427 Fraudulent Returns, 1510 Gift, , Transfer of property by way of, taxable, 1457 _ Goodwill, How computed, Treasury decision, 1446 Valuation, 1445 Gross Estate, Amount of filed within 60 days, 1489 Cemetery lot part of, 1434 Deductions, 1468-1488 Indebtedness to broker, 1440 Dividends, when not included, i434 Interest on notes included in, 1443 Life insurance, when included in, 1468 Market value of, 1434 Real property included in, 1433 Transfer of property, when included in return of, 1423 Valuation, 1432, 1437-1468 H Household Effects, Valuation, 1447 Insurance, Life, Partially exempt from tax, 1 465-1 46S Payment of non-resident estate, 1495 Insurance Companies, Sixty day notice, 1491. M94 Interest, Accrual of, as affected by abatement claim, 1 512 In additional tax payments, 1520, 1521 Notes, how computed, 1443 Urtder Act of 1916, 1515 Unpaid taxes, 1520 Jewels, Valuation, 1447 Joint Property, Taxable, 1460-1462 Former procedure, 1461 Liability, Of executors, 1514, 1518 Of transferee and insurance beneficiary, 1507 Liberty Bonds, In payment of tax, 1505 Lien, Amount limited, 1507 For unpaid taxes, 1508 Release of, 1509 M Market Value, Gross estate, 1434 Property, real, 1437 Stocks and bonds, 1439 Military and Naval Forces, Claims for refund, 1431-1432 Defined, 1430 Exemptions, 1430, 1492 Missionaries, As residents, 1485 N Net Estate, Determining non-residents', 1484, 1488 Military and naval forces, exempt, 1430 Rates of tax, 1425-1427 Tax computed on value of, 1424 Non-Combatants, Taxable, 1430 Non-Residents, Deductions allowed estates of, i486 Determining net estate of, 1484, 1488 Payment of tax, 1489 Status of certain property of, 1485 Non-Resident Estate, Claims and expenses allowed, 1487 Insurance payments, 1495 Public, cliaritable or similar gifts al- lowed, 1487 Return form, 1501 Sixty day notices, 1493-1496 Transfer agents' sixty day notice, 1493 Transfer of stock, 1494 Notes, Valuation, 1443- 1444 Notice to be Filed, By others than executor or administrator, 1490 Executors of exempt estates, 1492 Executor's 60 day, 1489 Failure to, 1510 Insurance company's sixty day notice, 1492. 1494 Non-resident estate, 1493 Transfer agent, i493 When no executor appointed, 1491 When property not within" executor's control, 1491 [See also General, Capital Stock, and Excess Profits Indexes] INDEX— FEDERAL ESTATE TAX 1899 Patents, Valuation, 1445 Payment of Tax, By executor, 's 1 8 Extension of time for, T-09 Interest on additional payinents, 1520, l.i2I Liability of transferee and insurance beneficiary, 1507 Liberty bonds as, 1505 Xon-residents, 1489 Payable in full within one year, 1504 Receipts in duplicate, 1521 Reimbursements, right to, 1506, 1523 Uncertified checks, 1506 Unpaid tax a lien on estate, 1508 Penalties, 1510 Compromise or remittance, 1512 Interest on unpaid taxes, 1520 Personal Effects, Valuation, 1447-1448 Property, Acquired in exchange, deductible, 1479 Held jointly (See "Joint Property") Passing under power of appointment (See "Appointment") Previously taxed, deductible, 1476-1479 Real, Included in gross estate, 1433 Valuation, 1437 Transfer of (See "Transfer of Property") Valuation of (See "Valuation") Real Estate (See "Property, Real") Receipts, For payment of tax, issued in duplicate, 1521 Records, Kept by executor, 1514 KEFfNDS, I 51 2 Reimbursement, For tax payment, 1506, 1523 Repeal of Act, 151 5 Resident, Defined, 1429 Resident Estates, Amount of gross estate filed within 60 days, 1489 Deductions allowed, 1469-1488 (For com- plete list of subjects, see "Dciiuc- tions") Executor's 60 day notice, 1489 Insurance companies' notice, 1492 Not subject to estate tax, 1424 Sixty-day notices, 1 489-1492 Residents, Missionaries as, 1485 Returns, 1496-1503 Adjustment, 1520 Date of filing, i497 Examination of, 1498, i5'4 Extension of time for filing, 1500 Failure to file, 1510 False or fraudulent, 1510 Forms, 1500 Non-resident estate, 1501 Investigations of, 1498, 1514 Made by collector, 1503 Right of disclosure, 1502 When no return has been made, 1497 Who shall make, 1499 Securities, Valuation, 1440 Statements, Executor's duty to render, 15 14 Stock, Transfer of, non-resident decedent, 1494 Valuation, 1439 Tables, Computation of annuities, i455-i45( Federal estate tax rates, 1425-1427 Transfer Agents, Sixty-day notice, 1493 Transfer of Property, By gift, I4S7 In lifetime of decedent, 1456-1460 Taxable, 1459 Two years prior to death, to avoid taXi . '423 Valuation, 1460 • Trustees, ' As executor, not entitled to commission, 1473 u United States 'Court for China, Proceedings, 1516 Valuation, -Accounts receivable, 1446-1447 Annuities, 1452-1454 Bonds, 1439 Community property, 1450-1452 Crops, 1447-1448 Dower and courtesy, 1454, 1456 Coodwill, 1445 Cross estate, 1433 Household effects, 1447 Interest in business, 1444-1445 Jewels, 1447 Notes. 1443-1444 Returns, 1424 Securities, 1440 In close corporation. 1440-1443 Stocks, 1439 Transfer of property, 1460 X'ali'e. Dffined, 143s [See also General, Capital Stock, and Excess Profits Indexes] INDEX— FEDERAL CAPITAL STOCK TAX [See also General, Estate, and Excess Profits Indexes] INDEX- FEDERAL CAPITAL STOCK TAX Additional Tax Payments, Limitations on, 1563 Affiliated Corporations, Returns, 1549 Assessments, 1553 Final, 1562 Associations, Xot exempt, 1531 Capital, Employed in the U. S. by foreign cor- poration, 1555 Claims for Abatement, 1559 Claims for Refund, 1559 Limitation of interest on, 1564 Limitations on, 1563 Computation of Tax, Domestic corporations, rate and, 1537 Former procedure, 1537 Consolidated Returns. Not permitted, 1549 Corporations, "Doing business" as basis for, 1533 Election to be taxed as, 1561 Former procedure, 1561 Exemptions, 1533, 1536 D Deductions, 1348 Domestic corporations, $5,000 permitted, J 524 Former procedure, 1324 Foreign corporations, no deductions per- mitted, 1324 "Doing Business," Basis for taxing domestic corporations under, 1533 Defined, 1355 Illustrations of not, 1534. '535 Former procedure, 1535 Period of, determines tax liability, 1536 Former procedure, 1336 Domestic Corporations, Deduction of $3,000 permitted, 1524 Defined, 1329 Effective date, 1528 Fair value, methods of ascertaining. 1338- IS47 Former procelure, 1344 Rate and computatinn of tax. 133; ■ Former procedure, 1337 Scope of taxj 1328 Former procedure, 1524 "Doing business" illustrated, 1334 Effective date, 1528 Scope of tax, 152S E Examination of Books, Papers and Per- sons, Unnecessary, 1564 Exemptions, Associations not exempt, 1331 Corporations, 1336 Corporations exempt under income tax law also exempt under, 1323 Corporations, listed, 1535 Corporations not "doing business" cer- tain, 1526 Individuals, 1523 Insurance companies, 1524, 1333 Former procedure, 1324 Joint stock companies not exempt, 1531 I^imited partnerships, 1332 Limited partnerships not exempt, 1331, ■53a Massachusetts trusts, 1331 Partnership banks, 1532 Partnerships, 1523 Personal service corporations, 1329 Former procedure, 1329 Returns of corporations claiming exemp- tion, 1337 Extension of Time for Filing Returns, None granted, 1333 Failure to Make Return, 1534 "Fair Value," Methods of ascertaining, 1338, 1347 Former procedure, 1344 Foreign Corporations, isss-issq Deductions not permitted to, 1324 Returns, 1358 Fr/M'dim.ent Returns, 1334 Income Capitalized, Issuance of new stock i.';47 Individuals. Exemptions, 132; mil .illc-rl. [See also General, Estate, and Excess Profits Indexes] 1903 1904 INDEX— FEDERAL CAPITAL STOCK TAX Inspection of Returns, 1559 Insurance Companies, Exempt, 1524, 1533 Former procedure, 1524 Interest, Limit on refunds and judgments, 1564 Former procedure, 1553 Medium of, 1560 Penalties, 1554 Personal Service Corporations, Exemptions, 1329 No intention to tax, 1562 Joint . Stock Companies, Not exempt from, 1531 Judgments, Limitation of interest on, 1564 M Returns, 1536 Corporations claiming exemption, 1337 Former procedure, 1326 Tentative, 1349 Time for filing, 1348 Time of making, 1348 Massachusetts Trusts, Exempt, 1 53 1 Munition Manufacturers, Credit for tax, 1561 Former procedure, 1564 Partnership Banks, Exemptions, 1325 Limited, exempt, 1332 Limited, not exempt, 1331. When not exempt, 1332 Payment of Tax, 1353 Dishonored cheques, 1360 Stock, Calculation fair value, 1347 Income capitalized not affected by issu- ance of new, 1347 Preferred, Calculation of fair value, 1347 Suits at Law, Limitation on, 1563 Treasury Decisions not Necessarily Re- troactive, 1363 [See also General, Estate, and Excess Profits Indexes] INDEX— EXCESS PROFITS TAX [See also General, Estate, and Capital Stock Indexes] INDEX— EXCESS PROFITS TAX Accounting Procedtre (See "Computaticn of Tax") "Actual Value," Defined, 1600 Adjustments, Capital, surplus, reserves and liabilities, 1616-1620 Depreciation, 1600 Admissible Assets, Percentage of average, to total admis- sible and inadmissible, determines re- duction of invested capital, 1615 Reserves for bad debts, 16 14 Stocks of domestic so-called "foreign trade" corporations, 1613 Stock of foreign corporation of which dividends are not deductible, 1612 Affiliated Corporations, Consolidated returns, IS74, 1626-1637 (For full entries see "Consolidated returns"') Distribution of tax among, 1633 Pre-war period. Computation, former procedure, 1637 Computaticn of invested capital, 1633- 1637 Amended Returns (See "Returns, Amend- ed") Appeal to Courts. Right of, from Trea3ui>