mill. 4% $50,000 $1,750 2nd Liberty Bonds 4% 50,000 2,000 3rd Liberty Bonds 4j4% 50,000 2,125 4th Liberty Bonds 4>4% 50,000 2,125 1st Converted to 4th 414% 50,000 2,125 5th Liberty Bonds 4^% 50,000 2,375 $300,000 $12,500 Assuming the 4th and 5th Bonds to be original sub- scriptions, the exemptions would be applicable to the greatest advantage, as follows : First apply those exemptions which relate only to single Issues, thus : Exemption 3, 4th's $30,000.00 $1,275.00 Exemption 4, lst-4th's 30,000.00 1,275.00 Next, the exemption which Is applicable to 2nd's and 3rd's is to be used on the highest rates : Exemption 2, 3rd's $45,000.00 $1,912.50 16 INCOME AND PROFITS TAXES The remaining exemptions must be used to cover the highest rates possible : Exemption 1, 4th's $5,000.00 $212.50 Exemption 5, lst-4th's 20,000.00 850.00 4th's 5,000.00 212.50 Exemption 6, 4th's 10,000.00 425.00 3rd's 5,000.00 212.50 2nd's 10,000.00 400.00 $160,000.00 $6,775.00 The Ist's are entirely exempt. We have obtained the fullest exemption, $160,000, and have expended only $10,000 on 4% Bonds and obtained 4j4% exemptions on the entire remaining $150,000. Dividends are normally exempt from taxation, that is to say dividends from corporations which are subject to income taxes. This, of course, is a continuation of the principle laid down in the original 1913 law when cor- porations were subject to the same rate of normal tax as individuals and it was deemed double taxation to re-tax the dividends received from these corporations, except for surtaxes which were levied from a different view- point. We have above mentioned that the dividends and in- terest from certain institutions, including the Federal Re- serve Bank, are not subject to taxation. Care must be taken, however, not to confuse this provision with any thought that the dividends from banks which are mem- bers of the Federal Reserve System have any exemption. There is a distinction between a Federal Reserve Bank and a member of a Federal Reserve System. The point of interest in the discussion of dividend taxation arises mainly in the consideration of the profits from which these dividends are paid. In the first place, you will re- INCOME, PERIODICAL 17 call that income accrued prior to March 1, 1913, is nor- mally considered as belonging to the taxpayer free from income taxation under the later act. On the same prin- ciple, a dividend paid out of profit derived prior to that time by the corporation paying the dividend would not be subject to taxation if the fact could be demonstrated. On the same principle, personal service corporations which have not been subject to corporation taxes since January 1, 1918, would not find their dividends subject to taxation in the hands of the recipient because as the entire profits of the corporation are taxable on the basis of ratable interests whether actually distributed or not. It follows that a re-taxation of the same as dividends would be a pure case of double taxation. To acquire these distinctions for the benefit of a tax- payer, however, it must be clearly demonstrable that the profit from which these dividends have been paid are ab- solutely entirely earned during the exempted period. In the absence of such demonstration dividends are pre- sumed in all cases to have been paid out of the last earned profits. To understand the next differentiation with respect to dividends, it must be remembered that there are many distributions from corporations called dividends which are in no sense distributions of profits. For instance, a corporation closing its affairs would make what are called dividends to its stockholders in winding up the corpora- tion's business and in finally closing out and liquidating the assets. These, of course, are not dividends. They are the proceeds, to all intents and purposes, of a sale of the stock of the corporation by the stockholders back to the corporation and should be dealt with as sales and treated on a basis of the cost of the stock to the stock- holders as against the proceeds received from the llquida- 18 INCOME AND PROFITS TAXES tion. In this connection, it is provided, however, that if the property of the corporation is distributed in kind, which means if the property is distributed in its physical form without conversion to money, there results from the transaction neither gain nor loss until some later date when the property itself is sold. However, if the corpo- ration actually distributes property in payment of divi- dends taken from profits, the fair value of the property distributed would be the basis for the determination of the amount of the dividend. The principal reason for these distinctions is that the dividends which are not paid from profits are not exempt from normal taxation. Corporations frequently pay dividends in paper, that is to say in notes payable called script dividends. Where such is the case, the fair market value of the script con- stitutes a dividend the same as cash. If the script bears interest, the interest is not a part of the dividend and is subject to normal taxation. Among mining and other similar organizations, it is quite frequent to recover the cost of the capital assets from which the corporation de- rives its income by periodical charges called depletion. It is also quite a common practice to repay the cost of these assets to the stockholders, simultaneously, with the charging of these depletions. Where such is the case, it must be brought to mind, that these depletions constitute a return of capital and the dividends paid from the deple- tion reserve, if the same can be definitely allocated against them, are not profits at all but are, as has been said, re- turn of capital. While the subject of stock dividend is treated rather extensively in the Regulations, the recent Supreme Court decision makes this an entirely obsolete question. Stock dividends, economically considered, are neither a profit nor a loss, nor a return of capital to a stockholding in- INCOME, PERIODICAL 19 vestor, and for that reason the Supreme Court has de- cided that there is no income involved in a stock dividend transaction. Approximating dividends, we have mentioned under another heading the question of premiums paid for insur- ance and on the contrary premiums or savings returned by insurance companies to their policy holders. Where such returns are made on or in respect to a paid-up policy, the Regulations provide that such premiums shall be con- strued as dividends, consequently exempted from normal taxation and subject only to surtaxes. Aside from this, there is also the question, that where the proceeds of insurance come to a policy holder at its maturity, to the extent that they exceed the premiums he has paid without interest they constitute profits to him. Of course the March 1, 1913, value rule would apply in such a situa- tion, and those premiums which had been paid prior to March 1, 1913, would constitute capital at that date and apply also in reduction of the profits earned. The student will now read, in the order given. Regu- lations 45, Articles 21; 71; 72; 73; 31; 32; 33; 34; 37; 85; 86; 48; 74; 75; 77; 78; 79; 80; 76; 1541; 1543; 1544; 1545; 1546; 1548; 1549; 1642; 47. CHAPTER III INCOME, GAINS, AND PROFITS Taxable Income includes profits from the sale of prop- erty even where those sales are only occasional matters with the taxpayer. In such cases the cost of the property deducted from the net selling price is the profit to be re- turned as a part of the taxpayer's income. Where such property has been in the possession of the taxpayer since prior to the first of March, 1913, the taxpayer must use, instead of the said cost, the value of the said property on that date. Where a person has a large number of securities or indistinguishable properties acquired at dif- ferent times, the sale of a part of them must be construed as being from the longest owned of such property. This is particularly so in the case of securities. For example, if a taxpayer had a hundred shares of stock in a certain corporation which had been acquired at various times and sold twenty-five shares, such shares would be deemed to be the twenty-five which he had owned for the longest time and the cost or value March I, 1913, of those twenty-five shares first purchased would necessarily be used in determining his profit on the sale. The question of stock dividends affects the matter of selling stock so received. In such case, the cost per share of all the stock must be considered the cost of the stock purchased divided by the entire number of shares, includ- ing those received from the stock dividends. The aver- age thus established will be the average cost per share on which the question of profit against the selling price is to be determined. For example, if I have ten shares of stock, receive a dividend of five and sell five shares, the cost of the entire fifteen shares to me is only such 20 INCOME, GAINS, AND PROFITS 21 amount as I paid for the ten shares purchased. I can, therefore, charge against the sale of the five shares only one-third of the cost of the ten shares instead of one-half as would normally be the case. There are other items in the question of selling stock received as dividends in the Regulations but they are obsolete in view of the Supreme Court decision previously mentioned. The provision for profits on sales applies equally to such intangible properties as patents, copyrights, trade- marks, good will, franchises, concessions, and all those other rights which have a marketable value, but are not physically existent. In such case, it must be remembered that the determin- ation of profits is based again, as in all other cases, on the value March 1, 1913, or the cost if purchased since that date. The question of demonstrating the value of an intangible asset on March 1, 1913, is a difficult one to discuss. The question of the determination of the value of a good will or a patent right is always difficult. Whenever a sale of a patent or good will is involved in the question of income taxes, however, there must be, of course, some basis by which the selling price has been arrived at. Using such basis, one should follow the same principles in determining the value on March 1, 1913, if such good will or patent was in existence prior to that date. To illustrate this, suppose a good will is sold today on the basis of three years' profit to the business. Then three years' profit to the business to March 1, 1913, would be about the only possible value that could be reasonably established as a cost or value March 1, 1913. The fundamental basis for determining gain or loss from the sale of property is, as has been stated, (a) sell- ing price minus cost, or, (b) selling price minus value March 1, 1913, if owned prior to that date. If cost 22 INCOME AND PROFITS TAXES in (a) Is greater, or value March 1, 1913 in (b) is greater, there is naturally a loss. Where such property is of a depreciating or wasting character, the depreciation or waste from the time of its acquirement must be first deducted from cost (or value March 1, 1913). The effect, of course, is to increase the gain, if any. Where property is acquired by gift, or bequest, the value at the time of its coming into the ownership of the new seller must be used in lieu of cost. Where a person sells property on the instalment plan, it is permissible to consider if preferred that the profits on such sales are not realized except in proportion to the amount collected from time to time on account of the sales contract. For example, if the sales contract pro- vides that the selling price should be paid during a period of several years, the proportion of profit to be returned as income in each year is that proportion of the entire profit which the amount collected in such year bears to the entire selling price. It is, of course, optional with the vendor in such cases to trade the entire obligation to purchase as equivalent to cash and return the entire profit in the year of sale. Under the latter method any loss resulting from failure to complete the contract on the part of the vendee, would be claimable subsequently. Where instalment methods are to become available, the method is best described by a short example. Sup- pose we sell an article, costing $500 for $750 and that the sales agreement permits the purchaser to pay $25 per month. The following schedule will show the result. Selling Price $750 Cost " 500 Profit $250 or 33 1/3% of selling price. INCOME, GAINS, AND PROFITS 23 1st year — collected $300, profit $100 2nd year — collected 300, profit 100 3rd year — collected 150, profit 50 $750 $250 Now if the purchaser of the above article defaults in payment, say after having paid in $300, and the property is recovered, it is to be assumed that having his property returned to him, the seller has in reality made a gain of all that was paid on it, or $300. However, if the profit of $100 on the collected amount has been reported in a previous return, he would only report so much of the entire collection as had not been reported, or $200. This is further entangled, however, with the question of wear and tear. If the goods, when returned, are worth, for example, only $400 instead of $500, there is a loss permitted of the $100 wear and tear. In this case, therefore, we have : Sale Price $750 Cost Price 500 Profit $250 33 1/3% 1st year — collected $300, profit (returned) $100 2nd year — goods returned 750 Total collected $1,050 First selling 750 Gain $300 Reported 100 Balance $200 Less — Wear & Tear 100 To be reported $100 24 INCOME AND PROFITS TAXES Real estate transactions are generally considered a little differently from personal property when dealt with on the instalment plan. The regulations provide that where the initial payment is large and the risk of failure to consummate the purchase is small, the contract must be treated as equal to cash and the entire profit reported in the year of the sale. The adoption of this method, however, would be inadvisable in cases where the market value for real estate were liable to serious changes and the Department will fully recognize that a serious drop in the market value would heavily increase the proba- bility of default by the vendee. Analogous to the subject of sales is that of exchanges, or trades in property of one kind or another. The sale or exchange, to all intents and purposes, amounts to little more than the sale of one property and the purchase of another The party merely surrenders one property in order to acquire another, and in the last analysis the cost to him of the new property is nothing more or less than the original cost of the old, subject to such use or improvement as he may have obtained or given it. For simplicity of expression, in the following discussion of exchanges, we will eliminate the constant reference to cost or market value March 1, 1913, If owned prior to that time and reduce our expression to the word cost, which will be understood to mean the whole of the situa- tion as defined in the last expression. Broadly speaking, the basis of income determination from an exchange consists in the difference between the cost of the property surrendered and the fair market value of the property acquired. Where the properties exchanged are different in form merely and not in sub- stance, no such differences in values can be ascertained nor is deemed necessary of ascertainment. This rule INCOME, GAINS, AND PROFITS 25 would not apply generally to physical properties, how- ever, but only to those intangibles, such as securities of various sorts. Tangible properties usually can be reduced to a fair market appraisal. It follows, therefore, that fair valuations can be obtained to apply in determining a profit on an exchange of the same. In the case of securities, however, these differences are not so easily determined. For instance, where one kind of security is exchanged for another kind both having a fair market value or a quotation obtainable, the differ- ence in quotation measures the gain or loss as the case may be. If the value of one kind only can be obtained, this will measure the value of the other. If the value of neither kind is obtainable, the matter cannot be said to result in gain or loss, but such situations necessarily would be rare. Where, as a result of recognization or some other such transaction, stock in one company is exchanged for stock in another, either as a holding or a subsidiary, it is construed that there is no gain or loss in the transaction, if the par value of the two securities exchanged is equal. In cases where one kind of security is exchanged for two other kinds of securities, one of which has a fair market value and the other has not, the situation is a little more complicated. Here the cost of the property surrendered will be compared with the fair market value of the appraisable item received and the difference will result in the cost of the item on which the fair market value cannot be ascertained. There is neither gain nor loss to this point, but subsequently, on the sale of any of the newly acquired securities, the gain or loss will be predicated on the cost thus determined. Of course, if the determinable fair market value of one of the acquired securities exceeds the cost of the surrendered security, 26 INCOME AND PROFITS TAXES there would be a gain in the first instance, and the addi- tional unknown value of the second security would stand as zero, from which any subsequent sale would be all profit. In the case of the organization of corporations or of the sale of physical or tangible properties to corporations for stock, the manner of income is determined, first, by the cost of these tangible assets at the time of sale, or at the time of their purchase by the owner as against the fair market value received therefor. Where stock in one company is exchanged for stock in another, the par values exchanged being different, there arises the necessity of choice. First: The taxpayer may return as income the difference between the par value of the stock surrendered and the par value of the stock received, if the latter is greater; or, second, he may re- port the excess of the market value of the stock received over the market value of the stock surrendered. In either case, whichever method is used will be the one which shows the lesser profit. It will be seen fhat the general subject of exchanges is merely one of comparable values and a little common sense applied to any situation will easily determine the proper results. Where a partnership is dissolved and one of the part- ners receives a part or all of his interest in the partnership in property formerly belonging to the partnership as dif- ferentiated from money, the distribution in kind will result in neither gain or loss, as it is assumed that he was already the owner thereof at the time the partnership held the title. If, however, this distribution is made in cash, it must be remembered that the amount thus paid to him is the selling price of his interest, and the cost of the same, or the market value March 1, 1913, is his gain, minus. INCOME, GAINS, AND PROFITS 27 however, such profits as he has previously not withdrawn from the firm, but reported as income. We now come to the subject of income derived from business or trading in its broader sense, that is to say, from the operation of a business or trade. In the first place, the gross income from a business necessarily consists of its sales, or what stands in the place of sales, depending on the nature of the business. From these, primarily in the case of a trading concern, is to be deducted the cost of the goods sold. In deriving the cost of the goods sold, it is basically true that this cost cannot be determined accurately without the use of in- ventories. To apply the purchases during a given period against the sales would not suffice because the quantities bought and sold respectively would rarely be equal. The inventory in its increase or decrease adjusts this matter of inequality in the quantities purchased and sold. It also adjusts, to a certain extent, fluctuations in market values. On this score it is important to note that the time-honored rule among accountants of inventorying goods on hand at "cost or market, whichever is lower" is recognized in full by the Department, but the Depart- ment also permits the use of strict cost inventorying if desired. While there is no provision for the same and it would be rather foolish from the standpoint of taxa- tion, inventorying at a market price above cost would find no objections if used, unless it had a tendency improperly to deflect income from taxation. The cost of goods sold, therefore, is the amount ascertained by adding to the inventory at the beginning of the period, the pur- chases during the period and deducting what is left or the closing inventories. Let us mention here that, while a person, firm, or corporation owning securities either for speculation or 28 INCOME AND PROFITS TAXES investment cannot give any effect to the fluctuations of the market, but must deal strictly with cost and selling, a dealer in such securities treats them the same as mer- chandise by a merchant, and the "cost or market" rule is permissible. In the case of a manufacturing concern, the question of the cost of goods sold does not depend, however, on a purchasing account but on a cost of manufacture. The line of demarcation between what constitutes cost of goods sold and what constitutes cost of general operation or selling expense is not a part of this discussion. The best advice we can give the student at this point is to suggest that he use the manufacturing account as carried on the books of the taxpayer, and that any improper allocation will at least be substantiated by the record. It will make but little difference to the Bureau of Internal Revenue whether items be included under manufacturing costs or under operating costs so long as there is no im- propriety in their deduction. In addition to the simple question of sales and cost of sales, however, we find some other minor items about income and deduction which the Department seems to prefer to category as gross income. Income received for the amortization of plant or equipment where, under contract with the Government or other person, such allow- ances are made in respect to special manufactures, must be added to the gross income of the business. On the other hand, where a concern is in the habit of giving premiums or trading stamps as an inducement for sales, it is permissible to deduct the probable cost of redeeming these trading stamps from the gross sales, or, in the case of premiums, to deduct the probable value of the premiums which will be ultimately issued. The normal average experience of the business in the redemption of INCOME, GAINS, AND PROFITS 29 these articles will be used as a basis in determining the amount which can be deducted. By the normal average experience, we mean that there would be permissible as a deduction such a percentage of the total stamps issued in the taxable year as previous experience has demon- strated was usually redeemed, or, in the case of premiums, such an amount as the experience showed to be the prob- able liability for later claims of the same. There are some special provisions in the regulations with respect to income from farming. By Income from farming, we mean income derived from those occupations usually called farms, including stock farms, dairy farms, poultry farms, fruit farms, truck farms, plantations, ranches, and general agricultural land. In order to en- able a taxpayer to qualify as a farmer, however, it is necessary that he be engaged in farming as a livelihood or for the purpose of profit. This would apply whether the operator of the farm were an individual, a partner- ship, a corporation, an association, or a syndicate, or any other form of organization. It must be understood that the definition does not apply to those persons who have as a matter of taste or comfort, or for the purpose of providing themselves with a comfortable country home, entered into the operation of farms or tracts of land as a hobby. If, however, even In the case of a "hobby farm," or a "gentleman farmer," as he Is sometimes called, the Income from the farm being operated exceeds the expense In connection therewith, he is compelled to include the profits as income. The differentiation Is In- tended to cover those cases In which persons whose real business Is something else than farming are, as afore- said, engaged in operating tracts of ground incidentally to their enjoyment or maintenance of country residence. Farmers may make their return as any other person. 30 INCOME AND PROFITS TAXES either on the basis of an accrued system or on a receipts and disbursements principle of accounting. Of course, a large majority of the average farmers do not keep books at all and in such instances the receipts and disbursements method is about the only basis that would be possible. If the farmer uses an accrual method accompanied by the usual system of inventories, his inventories must be based on the same general principles as in the case of a merchant. In any event, the gross income of a farmer includes all of the produce of the farm sold or exchanged and also all sales or exchanges of produce purchased for sale. If the produce is sold for cash, cash is the basis; but if it is sold for something else, that is to say, if it is bartered or exchanged for other commodities needed by the farmer for one purpose or another, it is the market value of the commodities received that determines the selling price of the produce given in exchange therefor. There is a peculiar exception from the general rule as to income in the case of a farmer, in that he is not re- quired to include in his income the value of such farm products as are consumed on the premises or elsewhere by himself and family. While this is unquestionably a discrimination in favor of the farmer, in that it permits him in this wise virtually to cover his living expenses without having to pay taxes on the income consumed in paying for them, yet it is impractical to do otherwise as can be readily understood. Where a farmer is raising crops which require more than the ordinary twelve months to mature, it is possible for him to make his returns in respect to such crops on either one of two bases. He may accumulate without deducting in his Income tax return all of the expenses incurred in respect to such crop and use them as a deduc- INCOME, GAINS, AND PROFITS 31 tion from the gross selling price when the crop is finally matured and disposed of. On the other hand, he may charge the expenses of carrying these crops from year to year and in that Instance will have the entire selling price against only one year's expenses when the crop is actually matured and sold. If such crops are raised so as to alternate, it would make but little difference In which way the accounting was kept, but where such crops only occur once every two or three years, the net result would be an excess of expenses in the years when no Income was received and the payment of a large Income tax in the second or third year when the crops matured, because the expenses had been carried Into previous years' returns. The method of deferring these expenses until the sale of the crop would therefore be much better in the latter instance. Farmers dealing in live stock must deal with their live stock on the basis of purchases or cost of raising. Where live stock Is sold, which was originally purchased for sale, the cost of the stock is deducted from the selling price similarly to the cost of goods in the case of a merchant, but in such case, it Is to be understood that If the cost of this stock was Included In expenses In prior years' returns, it does not constitute a deduction at the time of the sale. Otherwise there would be a duplication of deduction. When live stock is raised on the farm and sold, there is no deduction except the ordinary expenses of operating the farm. In any case where live stock has been held since March 1, 1913, or before, its value on that date may be used in place of the cost, or in place of the cost of raising prior to that time as the value on that date is assumed to be the property of the farmer. A farmer Is entitled to depreciation on his equipment under the same general rule as depreciation Is computed in any other busi- 32 INCOME AND PROFITS TAXES ness. Depreciation would also apply in the case of live stock purchased simply for use in the operations. In such case the cost of the live stock may be charged off over a period of years representing the life, as well as the same can be estimated. In dealing with live stock the question of reinventory is particularly applicable. The inventory value of the stock from year to year may be used in determining the cost of that which has been sold. Such reinventory method may also be used in the case of stock held for use on the premises. This is rather different, of course, from the ordinary method of calculating depreciation in the case of physical property. Having discussed the various elements of Income, it is necessary to consider the basis on which the same must be computed. Any standard method of accounting which clearly and uniformly reflects income from year to year will be ac- ceptable to the Department. In dealing therewith, how- ever, all matters treated on the basis of accrual must be consistently so treated in successive periods. Thus one could not divert from the basis of receipts and disburse- ments to a basis of accruals, if in doing so his income was so modified as to alter his taxability. In the use of such methods of accounting as are above described, there are three principal essentials: first, that in dealing with any sort of business in which the sale and purchase of merchandise or property constitute an In- come producing factor, a proper determination of Income Is not possible without the use of Inventories at the suc- cessive closing periods; second, that It is not permissible to include in expenses, the cost of property bought for the use of a business and having a probable life exceeding one year, but in such cases the value of the property must INCOME, GAINS, AND PROFITS 33 be treated as a capital investment and depreciated at such rate as will correspond to the number of years during which its usefulness will continue ; third, and as a corol- lary of the above, those expenditures made to prolong the life of such property are not legitimately expenses but amount to additional capital disbursements affecting di- rectly or indirectly the rate of depreciation used for the property. Income must be computed with respect to a fiscal period ordinarily of twelve months, and known as the taxable year. Such a period is assumed to be the calendar year except in those cases where a systematic method of ac- counting makes use of another definite annual period. Under such cases the taxpayer is required to make his returns as of his own fiscal period and not by the calendar year. This requirement is new to the present law, the previous laws making it optional in the case of corpora- tions and partnerships and prohibiting it In the case of individuals. A fiscal year in all cases must end on the last day of a month. That Is to say, notwithstanding the conditions in the business might make it advisable or de- sirable to close the books on some other than the last day of the month, that Is prohibited for the purposes of In- come tax returns. Where a business or an individual desires to change a fiscal year or where previous returns have been made on a calendar year basis, there arises a situation where the period differs from twelve months. It is particularly provided in the Regulations that no return shall be made for a period exceeding twelve months. Therefore, In any case where a change in fiscal basis Is made. It is neces- sary to fix the new date and make a return for that period of time lying between the last previous return and the first date corresponding to the close of the new 34 INCOME AND PROFITS TAXES fiscal period. For illustration, assume that a business previously reported on a calendar year basis, that is to say December 31st. It now desires to change its period to March 31st. As a result, it is necessary that it should first make a return for the three months from January 1st to March 31st, and thereafter it will make its returns annually as of March 31st of each year. In order to establish this new year, it is necessary to do two things: First, to notify the Collector of the de- sire to change the date of return, and second, to so notify him not less than thirty days prior both to the due date of the return for the new year and the due date of the return for the old year. Where such a change is to be made the Commissioner has the authority to refuse permission if it will result in a diversion of taxability. In case a person is engaged in such business as con- tracting, so that income is actually received with great irregularity, depending upon the occasional completion of long contracts, there are two methods possible for mak- ing the return of income, but whichever is used must be consistently followed. It is permissible, on the one hand, to consider for the purpose of income tax, only those gains comprehended in such contracts as have been closed during the taxable year; the unfinished contracts, and the cost and expense in connection therewith to be carried forward from year to year until completion. On the other hand, it would be allowed to consider in each re- spective year such a proportion of the estimated gain on the pending contracts as the amount of the work com- pleted bore to the entire amount. It must be understood that this second method, however, which is merely an adaptation of the inventory principle in merchandise ac- counting, is dependent for its efficiency upon the accuracy INCOME, GAINS, AND PROFITS 35 of the estimated profits, and serious errors in such esti- mates would necessarily mean the over or under reporting of income in the years prior to the close of the contract. As an objection to the first method in this case, however, it must be noted that if profits are to be determined only on those contracts which had actually reached completion, it may result in large gains in one year as against small gains in another, thus causing such fluctuations in the sur- tax as to amount to a considerable loss in taxes. The Regulations provide that money or property recov- ered on a judgment should be considered income in the year of its receipt, assuming it would have been income in the earlier year when the obligation accrued. This of course would not apply to any case in which the matter involving litigation was merely a return of capital in the first instance. But, where the subject of litigation is pre- viously unreported income, or litigation has arisen under circumstances where the obligation has been construed and claimed as a bad debt or loss in any prior year, the recovery of any part or all of the amount Involved con- stitutes income when received. To complete the question of what is and what is not a method of accounting for income, let us remind the student that cash is not the only basis for determining receipts ; for instance, there Is such a thing as constructive receipts, so-called, which would include such matters as interest coupons uncashed, and dividends or profits cred- ited to the account of a person but not actually paid, and similar developments of that sort. In addition to this, there is a distinction to be made which is very important at this point. The first Income tax law affecting indi- viduals took effect March 1, 1913, and, so far as the present practices are concerned, that date is also the basis for corporations. All income earned or accrued prior to 36 INCOME AND PROFITS TAXES that time, therefore, is not subject to taxation. For this reason, where indebtedness to a taxpayer accrued prior to that time or where the values of property or the values of any income or increment can be ascertained as having been existent prior to that time, such date determines the value for all purposes under the present law. Income of any sort which actually accrued so as to be really due and collectable prior to March 1, 1913, is therefore not subject to taxation, regardless of the date of its receipt. The student will now read, in the order given, Regu- lations 45, Articles 39; 1547; 40; 41; 1561; 1562; 42; 43; 44; 45; 46; 1563; 1564; 1565; 1566; 1567; 1568; 1569; 1570; 35; 1581; 1582; 1583; 1584; 1585; 88; 38; 22; 23; 24; 25; 26; 36; 52; 53; 54; 87. CHAPTER IV INCOME, DEDUCTIONS Having discussed the inclusions and exclusions which constitute gross income, we now come to those deductions which reduce gross income to net income. The first and broadest of these is styled "ordinary and necessary ex- penses." Under the heading of ordinary and necessary ex- penses, we find that usual group of items constituting the cost of operating the business which may be recovered without any particular explanation under the heading of selling and administration expenses. This list would nat- urally include salaries and other compensations paid to employes, rents, taxes (except federal income taxes), Interest on capital, advertising, office and store supplies and expenses, and all of the other matters usually found in one or another branch of the accounts of an operating concern. In dealing with the question of supplies or materials, as in the case of a manufacturer, with raw materials used in producing his output or, in the case of a merchant, the tangible supplies which are necessary to the conduct of his business, the inventorying principle previously de- scribed should also be used unless these matters are of so small moment as to make the cash receipts and dis- bursements basis a reasonable average. For example, in the case of a store, its fuel account for heating might be adjusted by periodical inventory for unconsumed coal and wood, but, as the practice of stocking heavily in ad- vance would be rather unusual, the cash paid or indebt- edness incurred would probably be in most Instances an entirely satisfactory measure of the expense. 37 38 INCOME AND PROFITS TAXES In most business a certain amount of wear and tear on the equipment and possibly the building occupied in- volve a need from time to time of repairs. In so far as these repairs are merely incidental to the maintenance of the efficiency of the property, they are admissible as an expense, but when they become a matter of improving the condition or enlarging the capacity of the equip- ment, care must be taken to differentiate between the part of the expenditure which is mere maintenance and that which covers the betterment. The betterment would necessarily be a capital expenditure. These theories, except as they relate strictly to the stock-in-trade, are equally applicable in the case of a pro- fessional taxpayer, and his supplies, wages for help, ex- penses for maintaining his practice or his office, in general are all within the scope of admissible deductions. The ex- penses for additions to or the improving of furniture or professional implements or equipment, or for a library, or for other matters of a permanent nature would not, of course, be reasonably termed expenses. Under the previous discussion of compensation, we have touched broadly on the question of salaries or wages paid in other than cash. It is, of course, equally true from the standpoint of the employer that if compensation is paid in something other than cash the market value of the commodity or property becomes a part of the cost and expenses to the business for the services thus pro- cured. The question of the reasonableness of compensation is also of some importance, especially where the recipient is a stockholder or partner. In instances of remuneration in amounts in excess of normal standards, the Bureau will investigate closely to ascertain whether in fact these pay- ments are attempts to disguise payments for property or INCOME, DEDUCTIONS 39 Interests sold the employing firm or company, or distri- butions of profits so covered In order to divert taxation. Much discussion has arisen over the question of dis- tinguishing between fixed and resulting compensations, and those unusual expenditures which of recent years have become common, called "bonuses." If those bonuses are in reality payment for services rendered, constituting a part of the earnings which the employe is by the usual practice of the business entitled to expect, even though not definitely fixed In advance, the same is compensation. Where, however, the employer gratuitously pays addi- tional sums to his employes in the nature of presents, they must not be considered an expense of the business but come more logically under the heading of gifts which are not deductible. Of course, in the case of the employe such gifts would not 'be taxable as income. Compensation to constitute a deductible expense need not necessarily be fixed in advance. It may be by way of a commission which would be based on the amount of the sales or services of the employe, or it may be by way of a share or proportion of the earnings of the business which is a very common method for the measuring of com- pensation of persons In responsible positions. In the case of employes whose work is of a specialized or profes- sional nature, it very frequently happens that the com- pensation is measured by the Importance of the services rendered and varies considerably from time to time, but this does not take it out of the class of compensation. In addition to the above, compensation may be con- tinued for the benefit of an employe or his family after his retirement from the business or because of injuries received while in the service. These payments would be none the less legitimate so long as they were not compen- sated by insurance. In a large measure the true admissi- 40 INCOME AND PROFITS TAXES bllity of such payments, however, would depend on the right of the employe or his dependents to receive the same. That is to say, if as an inducement to his continued services, the employer agrees to provide a retirement pen- sion or a pension to his dependents, there could be no question as to the admissibility of the expense but if it were done voluntarily and out of the good nature of the employer, it is extremely doubtful whether it should be construed as named. We have also discussed in a previous chapter the ques- tion of rents, particularly emphasizing that the annual payment of cash might not always be the entire rent. A lease for instance might readily require the tenant to pay the taxes, interest on the mortgage, or other incidentals. In such cases these payments are quasi-rents and equally deductible with the regular monthly or annual payments. In addition to this, however, if a tenant pays a fixed sum in advance for the executing of the lease in his favor, this amount averaged over the term of the lease becomes an additional renting expense. So also the cost of repairs or improvements added to the property rented, which by law or contract would revert to the landlord on construc- tion or termination of the tenancy, are rent. Interest on indebtedness either paid or accrued within the taxable year is a deductible expense, with the excep- tion of such interest as is paid or incurred for the purpose of carrying securities, the income from which is not tax- able. The reason for this is apparent in that the ex- penses of procuring exempt income should necessarily be offset against the same and not permitted to reduce the general income. There is, however, an exception to this general rule in favor of obligations of the United States issued after September 24, 1917. Like many other spe- cial provisions of the tax acts, the preference in favor INCOME, DEDUCTIONS 41 of these obligations is an intentional effort to popularize Liberty Bonds and other securities issued during the war, and constitute a part of the advantages attaching to the purchase of these securities. While the Regulations provide that so-called interest on capital is not a deductible expense, the accountant will recognize that this restriction will be nullified in effect by the non-inclusion of such interest in .the income of the tax- payer. Interest on capital as it is known, is largely a matter of adjustment between partners or a matter of statistical treatment, and while carried as an expense in one department of the business, of course, inures as a profit either to the proprietor or another department. It follows, therefore, that the provision, that interest on capital is not deductible, becomes a nullity by reason of its being also not a part of the true income. Taxes of all sorts, if taxes in the strict sense, are de- ductible expenses with exception of Federal income and profits taxes. It will be recognized that so-called taxes for local improvements such as street paving, sewers, etc., are in reality not taxes at all but merely a distribution of expenses of these improvements against the properties benefited. Such, of course, should not be deductible. The Regulations also provide that inheritance taxes are not a deductible expense on the theory that they are virtually a charge against the capital or corpus of the estate and as such amount merely to a government charge for the transfer of the property. On the subject of losses, the general proposition is that losses are broadly deductible under the present condition of the law. They must, however, constitute real losses and not voluntary surrenders of property or other rights such as the destruction of buildings for the improvement of newly purchased land, which amount to capital ex- 42 INCOME AND PROFITS TAXES penditures under most conditions, constituting a part of the cost of the new structures. Where the loss in value of property arises from unusual conditions such as the invention of new equipment which renders the old equip- ment valueless in a competitive field, we find a loss which would be entirely within the provisions of this subsection of the law, but such matters being more naturally a phase of obsolescence would seem to relate more particularly to the subject of depreciation and will be extensively dis- cussed under that heading. Losses to be claimed must be actually sustained by the taxpayer. Those losses resulting from mere changes in value, therefore, are not a part of the deductions per- missible. This applies particularly to stocks and bonds which undergo a constant change in value by reason of market conditions. Such changes are ordinarily not a part of an income calculated either as an addition or deduction except where the said change has been liquidat- ed as a result of actual sale of the property. It must be understood, however, that this does not preclude the use of inventories on stocks in trade of merchants, and that a broker dealing in such securities would be permitted to treat the same as stock in trade subject to inventory valu- ations according to the market. We have discussed this previously. Again, losses to be claimed must have been incurred either in the pursuit of a trade or business, in matters entered into for the sake of possible profit, or as a result of fire, storm, or other casualty, or theft. Thus, a loss in the sale of one's residence property is distinctly men- tioned as non-deductible. A special note is made in the law and the Regulations of those losses which are commonly called bad debts. The same are admissible as a deduction from income but there INCOME, DEDUCTIONS 43 must be a legitimate and reasonable determination of their worthlcssness. Such determination may be based on the expiration of a statute of limitations, or on the bank- ruptcy of the debtor, or on the death of a debtor leaving an insolvent estate. But these extreme conditions need not always be present in order to justify the claim of loss. Nor is it necessary that actual efforts to collect by legal means be resorted to. Any reasonable method of ad- justment will be recognized provided the claim for de- duction is contemporaneous with the actual determination of the fact of worthlcssness. Of course, where a debt is claimed to be bad it would be deducted and any subse- quent recoveries on account of the same constitute income. A peculiar condition arises In the case of indebtedness secured by mortgages, or, as In the District of Columbia, deeds of trust. Where such deeds are defaulted so as to necessitate a sale of the property and the holder of the mortgage recovers or obtains the title to the property, it is assumed In all cases that the mortgage Is paid with the property and aside from other conditions or incidents there would be neither gain nor loss from such transac- tion. Where securities have become worthless, they are in the nature of a bad debt. The limit on the losses Is either the cost of the security or its fair value, March 1, 1913, if owned prior to that date. All of the aforegoing losses are subject to the provision that it Is the time of the incurrence of the loss, not the time of the discovery, which determines the point or time of its deductibility. Where losses arise from matters of litigation such as a judgment, the time of the judgment is the time of the loss. The important phase of this question of time lies in the necessity frequently for amend- ing former returns In order to exclude losses which oc- curred in prior years but were not discovered until later. 44 INCOME AND PROFITS TAXES The filing of such amended return is always permissible under a proper state of circumstances. That is to say, if an actual loss occurred in the one year but is not dis- covered until later, it is, barring the statute of limita- tions as provided in the Act, possible to amend the earlier return at the later period, when the loss has been dis- covered. In the case of losses occurring as a result of casualty such as fire or storm, or where losses are incurred by reason of any exercise of the right of eminent domain on the part of the Government, or where a surrender of property is made in contemplation of the exercise of the right of eminent domain at some price less than its true value, the loss thus involved is subject to a peculiar pro- vision for protection against the same in respect to any damages which may be recovered. Such damages might be the compensation paid for the property under the con- demnation proceedings or the insurance in the case of a casualty. In effect, the provision is this : In the event of such a loss and the recovery of the insurance or damages, the taxpayer, even though such insurance or damages may exceed the cost of the property is not compelled to in- clude the excess as an income item, but may, with the per- mission of the Commissioner, establish what is known as a replacement fund. This replacement fund he may use at his reasonable leisure to replace the property thus damaged, destroyed, or taken. After the replacement of the property, the net results of the transaction as a whole will constitute a gain or loss as the facts may disclose. Of course, by replacement, it must be understood that what is meant is replacement in equality of capacity, style, value, material, or other elements entering into the de- termination of the real value of the property. A tax- INCOME, DEDUCTIONS 45 payer for instance would not be permitted to replace a destroyed building with a better one and charge the dif- ference against the so established replacement fund. If in the process of restoring the building, the taxpayer deems it advisable to enlarge or improve the damaged property, the procedure is to determine what would have been the cost of replacement in its original capacity, style, and material. Having determined this, that much only of the cost of replacement is used as the basis for deter- mining the net result of the loss offsetting damages re- covered. There is a provision in the Regulations to the effect that a forgiveness of indebtedness amounts to a gift or a capital transaction, unless supported by a consideration. This means that as a gift or capital transaction, if the same be so construed, it is not subject to taxation, but if the forgiveness of indebtedness amounts to a means of com- pensating or a means of paying for property or other services rendered, it amounts to both expense for the creditor and income for the debtor on the indebtedness thus canceled. Between a stockholder and his corpora- tion such transactions would amount either to a contribu- tion to surplus or a dividend and unless they could be construed as compensation or payment for property or special privileges they amount to capital matters, not in- come or expense. Charitable contributions are merely gifts and in no sense an expense. Under the provision of the law, how- ever, where these gifts are made to duly organized and incorporated societies or institutions conducted for re- ligious, scientific, or educational purposes, and certain con- cerns specially enumerated in the law, they are deductible, but only to an amount not in excess of fifteen per centum of the net income of the taxpayer before the deduction 46 INCOME AND PROFITS TAXES of any such contributions. I hese deductions are not lim- ited to payments in cash, but may be deductible if made in property. Of course, this provision is not intended to include those gifts which are made to individuals or to institutions which have a profit earning capacity. To illustrate the fifteen per centum provision above, assume : Gross income $10,000 Expenses $3,000 Contributions _ 2,000 5,000 Net Income $5,000 The limit on the deductibility of contribution would be fifteen per centum of the gross income ($10,000) minus expenses only ($3,000), or ($7,000), and the re- sult would be : Gross Income $10,000 Expenses 3,000 Net Income $7,000 Charities Deductible 1,050 Taxable Income $5,950 Chanties Not Deductible 950 True Net Income $5,000 The personal living and family expenses of a taxpayer very naturally do not enter into the computation of his income, but are, on the other hand, a use of the income after he has earned or received the same. It follows that such expenses are in no sense applicable as deductions in the case of income taxes. Besides the ordinary living expenses for food, clothing, shelter, amusement, etc., there is included under this category such items as insur- INCOME, DEDUCTIONS 47 ance on one's house or his life, both of which must be considered as personal matters and in no wise affecting his income. Where a person makes use of a part of his dwelling for business premises, it is permissible to appor- tion the cost of maintenance of these premises in respect to the area or some other basis which is fair and reason- able. If, however, the use of the premises occupied mainly as a dwelling for occasional business purposes is merely an incident and he really has a business office else- where, the matter does not permit such adjustment. Alimony, in the case of divorced persons, is neither expense nor income. It amounts, in the last analysis, to a substitute for the living expenses which would be in- curred if the parties were living together. In the case of army and navy officers special mention should be made of the differentiation between those items of special ex- pense which constitute substitutes for his ordinary per- sonal and living expenses and those which would not con- stitute such substitutes. To illustrate this : An army officer would be permitted to deduct the cost of such articles as special accouterments, but not the cost of his uniforms which are merely a substitute for his clothing if he were a private citizen. It is well at this point to mention traveling expenses again. They are, as has been said, a business expense when paid to an employe, but where a party pays his own traveling expenses the situation is a little more compli- cated. Business trips on one's own affairs are expense in so far as the railroad and other transportation items are concerned, but no further. His board and lodging under such circumstances do not constitute expenses which are deductible, being construed mere substitutes for his living expenses at home. In our first chapter we discussed to some extent the 48 INCOME AND PROFITS TAXES difference between income and the return of capital. It is necessary, on the other hand, to bear in mind the dif- ference between expense and the disbursement of capital. In this sense we mean by the disbursement of capital, dis- bursements of cash or other assets for other property. Where disbursements are made to increase the value of property or for the purchase of the property itself, it follows that they do not constitute expense as the increase in value or the property acquired makes a complete and perfect substitute for the cash or other assets given for the same. Under this heading we find such peculiar items as the cost of perfecting title, the architect's fees in con- nection with the erection of a building, commissions on the sale of property which constitute a deduction from the sale price, or commission on the purchase of a prop- erty which constitutes an addition to the cost thereof. Premiums on business insurance deserve some little especial mention. Where a corporation or employer pays insurance on the life of an officer or employe, and the beneficiary of such insurance is the employe or officer him- self, the amount thus paid is additional compensation to that person. Where the employer or corporation is the beneficiary under the insurance contract, however, it con- stitutes a matter of protection against future possible losses by reason of the death of the party involved. Under these circumstances we are told by the Regula- tions that the premiums are not a deductible expense but that the same may be capitalized to the extent of their cash surrender value and its periodical increase. The author is of the opinion that if the amount involved is large, it would be well to discuss with the Department whether it is not reasonable to capitalize the whole of the premium. The logic of this is that an expenditure for the purposes of a business, if it is not permitted to INCOME, DEDUCTIONS 49 be an expense, should be capitalized under the general meaning and intent of the law. The expenses of a farmer need hardly be enumerated and the same general principles would naturally apply as in the case of any other business activities. Those expenditures made for services or supplies or other things which are consumed in the use of them in operations and are not of a permanent nature would be strictly within the limits of the definition of expenses. While those ex- penditures which were for property of any nature having a prolonged life of not less than a year would be in the nature of investments or capital expenditures, and would not be deductible although subject to the allowance for depreciation which will be hereinafter discussed. All of the foregoing must be considered strictly in the light of their relationship to the activities of the period of the return. It is perfectly logical to demand that expendi- tures or disbursements which relate strictly to the business of one period should not be availed of in another. This, however, is subject to the general provision that where accounts are not kept and returns are made on the cash receipts and disbursements basis, the law of averaging will probably rectify any errors in the strict relationship of these expenditures to the periods under consideration. That is to say that in many cases it will answer all prac- tical purposes to treat the expenses as belonging to the year as in which paid, the theory being that in the long run no serious differences could possibly result. This, of course, does not apply to those matters which we have mentioned as constituting capital expenditures or matters extending over more than a year in their value to the business. In the case of losses by a farmer, their deductibility depends on the circumstances. Losses of property which 50 INCOME AND PROFITS TAXES has been actually purchased, of course, may be deducted at the cost minus such depreciation as should have been claimed since the purchase. Where property raised on the farm has been lost, however, unless the method of accounting reflect this loss in the inventorying of the pro- duce or stock, there is virtually no relief for the farmer. A reason for this is that his cost of operation when de- ducted from his gross sales determines his profits, and if he has not the produce or stock to sell, his income is simply so much less. The student will now read, in the order given, Regu- lations 45, Articles 101; 102; 103; 104; 105; 106; 107 108; 109; 121; 122; 131; 132; 133; 134; 141; 142 143; 144; 151; 152; 153; 154; 111; 49; 50; 51; 251 291; 292; 293; 294; 110; 145. CHAPTER V DEPRECIATION AND DEPLETION Wc have deemed It well to make a special chapter of these two subjects as they involve a great deal of tech- nical and academic discussion, and are too lengthy and too involved to be included under the general heading "deductions." Depreciation, as a matter of general business interest, has occupied the attention of accountants and economists for many years and in the many and various theories and solutions of the problems involved has become a subject in itself of considerable importance. Theoretically, depreciation, as the term is used in accountancy, is an attempt to provide in advance for that wastage in value or shrinkage in efficiency which neces- sarily follows the use of property, or which results from the mere lapse of time. The fundamental equation on which depreciation is based presupposes an estimate of the length of time over which the usefulness of the prop- erty will continue and attempts to divide its cost over the years of its useful life as estimated in the effort to pro- vide in advance for the necessity of replacement. The most commonly used methods of depreciation are the "straight line," which takes each year an aliquot part of the cost to be depreciated; the "diminishing balance," which applies a percentage in each successive year to the residuum after having deducted the previous deprecia- tion; the "sinking fund," which attempts by annual pay- ments, bearing compound interest, to meet the anticipated Anal loss. For the purpose of income tax returns the selection of a principle is not important, but there are certain modifi- 51 52 INCOME AND PROFITS TAXES cations of the general rules which it is well to discuss. The property which is depreciable under the Regulations and Act is that class of property, generally speaking, which, having a life in excess of a year, does not become in its original purchase a deductible current expense but which, because of its ultimate exhaustion may be pro- portionately charged off according to the estimated life. These remarks apply, of course, to physical or tangible properties but are strictly limited to such properties as directly relate to the operation of the business. It is permissible, however, as In the case of automobiles used by a business man partly for his trade and partly for personal purposes, to apportion such depreciation as would legitimately attach to the property against the business on the one hand and his personal affairs on the other in the ratio of the respective use of the equipment for the two purposes. Intangible property may also be the subject of depre- ciation where the condition justifies such treatment. Of course, leases, licenses, franchises, patents, and other rights or other privileges which expire by lapse of time can be apportioned on the basis of their cost value, as here- inafter defined, over the time involved. There is a spe- cial restriction, however, against the application of such depreciation in the case of those intangibles which in the last analysis do not represent rights or privileges so much as assumed values on existing conditions. Such, for instance, would be good will, trade-names, trade-marks, secret formulae, etc. In determining the amount to be used as a basis for the depreciation, recourse must be had to the cost of the asset or, if owned prior to that date. Its value on March 1, 1913, provided that value is other than cost less de- preciation accrued prior to that time. To illustrate : A DEPRECIATION AND DEPLETION 53 property whose cost on March 1, 1910, was $10,000 and which had an estimated life of twenty years would have been naturally subject to three years' depreciation on March 1,1913. Its normal value, therefore, at that time would be seventeen-twentieths of its cost (assuming for this example the straight line method). If, therefore, the property is to be depreciated on the basis of cost, the con- tinued annual charge would be one-twentieth of cost or $500 per annum. If the value as of March 1, 1913, is to be used, it must be correspondingly recognized that the remaining life is only seventeen years, with a result that the annual depreciation becomes one-seventeenth of seventeen-twentieths of the cost. So far the two methods produce the same ultimate result. If, however, it can be demonstrated successfully that, notwithstanding the three years' usage and previous depreciation, this prop- erty had a value on March 1, 1913, which was different from $8,500, the result in the use of a depreciation rate properly ascertained would be of possible advantage. As to the matter of computing depreciations no fixed standard is demanded. Any method in reasonably com- mon use and logically demonstrable will be permitted. A method once adopted must be adhered to in the absence of grounds for a change. Such grounds would lie, for instance, in a discovery of error in the original life esti- mate, but a change of method should never be attempted merely to meet changes in market value. Where the error in the original method has been an overestimate of the possible life, so that as a matter of fact the de- preciation averaged according to the estimate does not meet the exhaustion, we find a condition which may come within the purview of the provisions for obsolescence. Patents and copyrights are depreciable on the actual cost only, and not on any basis predicated on the value 54 INCOME AND PROFITS TAXES to the business aside from such cost. On the same prin- ciple drawings, models, and similar contrivances must be dealt with at actual cost. Both of these classes of assets may come into the equipment of a business either by con- struction or production as a part of the business opera- tions, or, in the case of rights, by acquisition through in- vention, design, and the customary legal formalities, or they may be purchased from other persons who have so produced or obtained them. In either case it is, and must be remembered to be, the actual cost in cash or its equiva- lent which determines the value. A patent which in its relationship to the output of a manufacturing concern may be worth thousands of dollars may have cost noth- ing but a small legal expense and a small item for devel- opment, but it could not be dealt with on the basis of its true value ; only on the actual cost. Depreciation to be claimed must be "charged off." The exact meaning of this is not defined in the Regulations. The exact effect is that such depreciation to be claimed must in any event be reflected in the balance sheet values or ultimate disposition of the property. A taxpayer might claim depreciation even though his books made no record of the method, but he must always recognize this depreciation claimed in dealing with the assets at any later date so far as his later tax returns are concerned. Of course, the complete discontinuance of the use of the property depreciated removes any possibility of further depreciation claims in respect thereto, but at such time the remaining value after deducting all previous claimed depreciation may give rise to a loss or gain as against the scrap value of the article. Notwithstanding our remarks in the last paragraph, we deem it well to remind the student of the general account- ing necessity for a proper record of depreciation. The DEPRECIATION AND DEPLETION 55 logical and most intelligent method of carrying such mat- ters in your books is to keep a record of the basic valua- tion of your property, and to enter the depreciation either in separate reserve or in some other account separate from the value of the property. This preserves intact the record of the cost and the accrued depreciation to any given date, and the residual value as shown by the books can always be computed by comparing the two accounts. The subject of depletion is one of a very technical character, and we do not deem it well to burden the stu- dent with a long and detailed discussion of all the neces- sary factors in respect to this subject as provided in the Regulations. Some presentation of the general aspect of the matter is necessary because it is a subject which can be understood in the broad theory if not in detail. Depletion is that provision which is made by charging against the Income of a property a sufficient amount to cover the exhaustion of the assets themselves. It is used most extensively and almost exclusively In the case of mines, wells, and timber forests. It would also apply to clay deposits used by brick and pottery manufacturers, to sand banks where the same were being withdrawn from year to year by a dredging company, to quarries and in fact to any of those natural resources which in their ex- traction and conversion to commercial uses are gradually exhausted from the original natural supply. The basis on which the depletion Is to be computed is, as In any other case, the cost of the property or its value March 1, 1913, if owned prior to that date. In addition to this, however, there is a provision that where the mine, or deposit, or well has been discovered by a taxpayer who is himself the owner of the same, he, for the purposes of the tax return, may use the value of the property at any time within tlilrty days after the discovery of the valuable 56 INCOME AND PROFITS TAXES deposit which constitutes its earning power. While pro- vision is made in the Regulations for the addition of plant and developing costs, these are more naturally the sub- ject of depreciation rather than depletion. Where such properties are being returned, so far as the income from them is concerned, by a taxpayer who is a lessee, the basic value from which the depletion must be deducted is the cost of the lease. Should such taxpayer hold a lease which dated prior to the discovery of the valuable deposit and the discovery has inured to his bene- fit as such lessee, the value to be used as the basis is the lease value as of not more than thirty days from the date of the discovery. In such cases, that is to say, when the property is under lease, and whether or not the discovery of the deposit has occurred subsequently to the lease or before, there arises the necessity for apportionment of the depletion between the lessor and the lessee. Of course, funda- mentally, the lessee's charge for depletion would be the amount which he pays the lessor, and which the lessor must include as income against which he may charge de- pletion on the basis of the value of the property. The most particular point under this heading is the fact that the total depletion charged by both the lessor and the lessee in any case must not exceed what would be a proper depletion charge if the property were operated by the owner himself. In determining the valuation of property within thirty days after the discovery for the purpose of this provision, fictitious transfers must be, of course, excluded from the consideration. By fictitious transfers are meant those transfers which occur between persons organizing a cor- poration and itself as such, and which are frequently based on valuation far from real, either greater or less. DEPRECIATION AND DEPLETION 57 The mineral deposit or the value of the same on which the depletion is to be made must be supported by a proper intelligent, scientific estimate of such value. Such an ap- praisal would be based on proper engineering estimates of the quantity of the ore in the mine, or of the oil or gas in a well, or of the timber in a forest. The general prin- ciple would be the same in any case but the appraisement must be made by those persons who are competent to make it. In many cases the owner or operator of a mine under a lease is compelled by his lease to pay royalties in excess of his actual extraction of minerals. Such contract usually provides for the payment of minimum royalties whether the equivalent amount of mineral be extracted or not. In such case, while the minimum royalties naturally con- stitute a proper expense for the lessee, in the case of the lessor the amount of those minimums over and above a proper royalty based on extraction or a proper depletion constitutes additional income to him for the time being. Where, however, such minimum royalties are subject to accumulative recovery by later extraction, on the part of the lessee the situation would be one for a case of reserve, the reserve being the amount which would necessarily be recoverable by the lessee if he extracted the proper amount of the minerals at some later date. In the case of any such properties, there is a point prior to which all of the expenses incurred in respect to the property are not for the production of income. This means those expenses which occur prior to actual extrac- tion of any salable material from the mine. On the same principle as that under which organization expenses in the case of a corporation are usually construed to be capital items and not expense, those expenses in the case of a mine or well that occur prior to the beginning of 58 INCOME AND PROFITS TAXES actual production may be capital items and should be so construed in future accounting. As a modification of the general rules of depreciation, it is provided that in the case of mines, wells, or timber forests, the depreciation of the plant and equipment con- nected therewith may be charged on a unit basis com- puted on the extraction, instead of on an annual basis as is customary in other businesses. To give a general idea of the theory underlying the use of depletion, it becomes necessary to explain particularly the method of computing the same. This method is the method based on a unit. Having as a base the cost of the property or its value under the conditions provided, and knowing from the estimates obtained the real quantity of ore, oil, timber, or other resources to be extracted from the property, we find the unit cost of that produce by dividing the cost of the whole property by the number of units in the same. Now having computed the unit cost for the product to be extracted from the property, the amount extracted in any one year in similar units multi- plied by this unit cost constitutes the deduction for that year. This is a broad statement of the principle, but will answer all practical purposes. For the remainder of the provision covering this sub- ject it is necessary to refer to the Regulations in any spe- cial case. It is the scientific and prescribed method of determining unit cost and determining quantity, and other technical matters that constitute that part of the discussion of the subject in the Regulations, which the author does not feel justified in taking the time of the student in re- hearsing. The student will now read, in the order given. Regula- tions 45, Articles 161; 162; 163; 164; 165; 166; 167; 168; 171; 169; 170; 216; 217-; 203; 202; 201; 204; DEPRECIATION AND DEPLETION 59 205; 206; 207; 208; 210; 215; 216; 217; 219; 222; 224; 209; 211; 212; 213; 214; 218; 220; 221; 223; 225 to 233, inclusive; 216; 234; 235. CHAPTER VI NET INCOME OF CORPORATIONS Generally speaking, the net income of corporations is broadly figured on the same lines as in the case of in- dividuals. There are some differences, however, which it is absolutely necessary to consider in detail and which it is absolutely necessary to bear in mind in attempting to make a corporation's income tax return. So far as the gross income is concerned, it includes with few exceptions just as broadly as in the case of individuals all increments from all sources whatsoever except such as can be con- sistently claimed to be capital returns or payment of con- tributions to the capital of the company. In addition to this general statement, however, it must be added that in the case of a corporation which insures the life of an officer or an employe so that at his death it receives the proceeds of the policy, the amount of the proceeds minus the premium paid constitutes addition to the income of the corporation for the year in which received. To distinguish more particularly for corporate affairs, between income and return of capital or increment of capital as such, let us consider a few of the items. If the stock is sold for more or less than the par value, the difference results in a surplus or deficit, whichever the case may be, paid in or created at the time of the sale and does not affect income. The same would be true of contributions by the stockholders of the company in any form or manner whatsoever, not resulting in the delivery to them of additional capital stock. Illustrations of this class might be cited as assessments by the stockholders, duly paid in to cover perhaps deficits already created or for creating additional surplus. 60 NET INCOME OF CORPORATIONS 61 In the case of corporate bonds, the question is not so simple and yet is not so very difficult if you bear in mind that the face of the bond, in its last analysis, represents a liability of the corporation which must sooner or later be met. If then the corporation issues bonds at less than their face value, it follows that it must create on its books a liability which is in excess of the amount of assets received at the time of the issue. The difference is usually called discount on the sale of bonds or some simi- lar title. At this point the corporation has on its books a liability of one amount, it has received assets of another and smaller amount, and the difference lies on the debit side under the name of a discount. It is clear that in the last analysis this discount is an asset which must be retired or as it is generally termed amortized. The process of amortization is to divide the amount of the discount by the number of the years ex- tending over the life of the bond, and to construe the amount of this discount assigned to each year as being in the nature of additional interest on the obligation in- curred. Where the bonds are sold for more than their face value, the situation would be exactly the reverse. The corporation would have received assets in excess of the liabilities incurred. The difference must necessarily be- come therefore a premium, on the credit side of this ac- count. This difference, however, is subject to the same method of treatment, to wit : It is either credited off over the life of the bonds by periodical subordinate credit to the interest paid out or to the loss and gain account di- rectly or indirectly. This is sufficient for the question up to the point of the issuance of the bonds. At this point let us inject into our discussion a little talk on the subject of amortization. The word as here 62 INCOME AND PROFITS TAXES used must not be confused with the word as used in a later chapter with respect to the covering of the cost of plant expenditures made for war purposes and provided in a special section of the law. The two things are in no sense the same. Amortization comes from the Latin root meaning death. Similar words derived from the same source will be found in mortuary, etc. The word literally means the killing of an item of expenditure, or of receipt by periodi- cal charge or credit away from the same. In other words, it is nearly parallel to depreciation but is distin- guished from depreciation principally by the fact that that item refers to the wastage or exhaustion of assets. The methods for computing and charging amortization are as complex as those for depreciation. Many such methods are in use, the most common being, of course, as in the case of depreciation, the "straight line" method, this being that the amount to be amortized is merely di- vided by the number of years covering the life over which it is to be spread and the result is used as an annual in- stalment. Sinking fund and annuity methods are also frequently found in large cases although in small ones it makes too little difference to justify the enormous amount of calculation necessary to set up the sinking fund instal- ment or the annuity basis. The method to be adopted is not important so far as we are concerned. Any method which clearly and logically carries the necessary facts to a proper conclusion will serve the purpose for income tax returns. In our explanation, we have reached the point where the bonds have been sold for the premium or discount, and subsequently the same premium or discount is to be amortized over a period of years representing the life of the bonds. This, however, does not complete the subject. NET INCOME OF CORPORATIONS 63 Corporations very frequently find it advantageous to buy up their own bonds when funds are plentiful and retire the same. It is particularly so when they can buy them at less than the reasonable present worth value of the ultimate obligation. In such cases, the transaction is exactly parallel with the purchase or sale of any other property. Let us illustrate. The corporation has issued a large number of bonds which have yet several years to run. Finding the market favorable, it determines to buy these bonds in and retire the same in advance of their maturity. Of course, when the corporation sold the bonds it received certain assets for them, either more, less, or the same as their face value. The process of computing a selling profit is chronologi- cally backwards, the selling price occurring first as will be readily seen by the student. The selling price is the amount which the corporation received for the bonds in the first instance. The amount at which it now purchases the bonds Is the cost, and the difference is the profit or loss as the case may be. So far we have a simple proposition, but suppose, in the first instance, the bonds were not sold for face value but were sold subject to a premium or a discount. In that case the selling price of the bonds at the present day is not what was realized for them in the first instance, but it is what was realized for them minus or plus such amortized premium or discount as has accrued to the date when they are repurchased. To put this case more clearly, let us use the condition of the books as a method of illustration. The corpora- tion at this time has on its books a liability representing the face of the outstanding bonds. It also has thereon an asset representing the unamortized portion of the dis- count originally granted. If, therefore, these bonds can 64 INCOME AND PROFITS TAXES be repurchased for less than the mathematical liability or the difference between the unamortized discounts and the face of the bonds, there is necessarily a profit at the time. On the other hand, if the bonds are repurchased for more than the difference between the unamortized discount and the face of the bonds, there is a loss at the time of the transaction. Now to carry this principle further, if the face of the bond, which is a credit on the books, must be increased by an unamortized credit for a premium realized at the time the bonds were sold, it fol- lows that the liability to be retired mathematically is the sum of the two. The purchase of the bonds, there- fore, will make a gain if less than the sum of the two, or a loss if greater. As the repurchasing of bonds de- pends on market conditions and not on book records, it follows that either of the four possibilities may readily develop. Where a corporation sells its assets, the matter is merely one of profit and loss as determined by the differ- ence between the cost and the selling price, the cost, of course, being subject to such depreciation or other dimi- nutions as may have been found necessary or utilized in previous income tax returns. Income from property leased to others by a corpora- tion is income, to all intents and purposes, and where the tenant in addition to paying a rent also assumes such unusual liabilities as interest on a mortgage, taxes on the property, repairs and maintenance, or, as is the case in some instances, assumes to pay a given dividend to the stockholders of the corporation, all of this must be in- cluded as a part of the rent by the corporation reporting. The dividend in this case would of course be subsequently charged out as dividends to the stockholders and the stockholders would not pay normal tax thereon. NET INCOME OF CORPORATIONS 65 The corporation in liquidation is one which has wound up the purposes for which organized and is now engaged in the business of liquidating or cashing its assets and distributing the same, or the proceeds thereof, to the stockholders in order that the corporation itself may cease active business. If during the course of such liquida- tion, the corporation should earn an income such as rent or interest from its assets, this is, of course, income for the time being. In addition to that, it is to be noted that the distribution of these assets if in kind, that is to say the division of the assets among the stockholders and not a conversion to cash for this division, there results neither gain nor loss to the stockholder from the surrender of stock for the same. But where the assets are liquidated in cash and the cash is delivered to the stockholders for the surrender of their holdings, it follows that the amount that they receive constitutes a gain or loss depending upon the purchase price they have paid for the stock. On the question of deduction, the difference between corporations and individuals is more marked than in the case of computation of gross income. In the first place, dividends received by one corporation from another are not subject to tax at all. In the case of individuals, you will recall, such dividends are subject to surtaxes and are exempt from normal taxes but in the case of corporations there is no tax whatsoever on the same. So much for the gross income of corporations. In the first place, a corporation is not granted any allowances whatsoever for donations, however made. It is necessary to distinguish, however, between those things which are donations and those things which constitute expenditures from which a return is to be reasonably ex- pected whether as income or capital. Donations, for in- stance, made to a public enterprise which is expected to 66 INCOME AND PROFITS TAXES inure directly or indirectly to the benefit of the corpora- tion in the way of increased business, would constitute a virtual expenditure to obtain income. Similarly, where a corporation made donations to an institution either inde- pendent of itself or a part of its operation, which insti- tution was designed and intended as a benefit to its em- ployes, such as hospitals, clubs, etc., these also would be deductible as they can be construed to be a part of the expense of the corporation, in maintaining the morale or good will of the employes. In a previous chapter we have made mention of script dividends. These, as we explained, are dividends paid in notes or other obligations of the corporation and not in cash. Although these, being dividends, do not affect the income or expense of the corporation, it frequently happens that such notes or obligations bear interest, and in that event amount to borrowed money to pay the dividend. Consequently the interest on the obli- gations is a deductible expense and the Regulations so provide. The question of interest on preferred stock is a matter to be determined from all the facts of the case. It is difficult to lay down a rule. Broadly speaking, if the preferred stock amounts to an interest in the business, subordinated in every respect to the general creditors and having priority of lien or interest only over the common stock, it amounts to invested capital and the interest or dividends on this stock are dividends for the purposes of this Act, and do not affect income. Where the circum- stances surrounding the case, however, show a condition which in reality means that the preferred stock is a dis- guised bond issue or other obligation of the corporation, it follows that the interest on the obligation is an expense, but it must be borne in mind that under such circumstances NET INCOME OF CORPORATIONS 67 the preferred stock cannot be included as a part of the invested capital in computing excess profits credits. Where a corporation's bonds contain a tax-free cov- enant clause, which means a clause guaranteeing the holder of the bond against any loss of face Interest by reason of taxes on the same, the corporation is neces- sarily compelled to pay the taxes. The income tax law provides that, in such cases, the corporation must with- hold and pay two per centum of this tax. The two per centum is an arbitrarily selected amount. To all intents and purposes, the payment of this tax is additional income to the holder of the bonds, being in effect an additional amount added to the interest he receives in order to pro- tect it from this liability. In respect to the holder's in- come, we have already learned that he is obliged to include it in his income return but may apply payment as a payment of taxes on his behalf. Notwithstanding this provision, the corporation under the Regulations is denied the privilege of considering the payment of this tax as additional interest on the bonds. A similar situation de- velops in states where there is a tax on the stock of a corporation held by the sundry and various stockholders. This happens most frequently in the case of banks under state law. Where such are paid to the state by the bank on behalf of the stockholders, they are construed to be in addition to his dividends, and in no sense the obliga- tions for tax liability of the bank. In other words, the bank cannot deduct these taxes as an expense but the stockholder after adding them to his dividend can deduct them as a tax expense. In those states where banks are required to deposit with a state officer a guarantee fund for the benefit of its depositors, such deposits are a permissible expense under the income tax law, unless it is a part of the law provided 68 INCOME AND PROFITS TAXES for the deposits that the bank itself shall receive the unused portion of any such guarantee. If the guarantee fund, in other words, remains permanently the property of the state or public as a permanent guarantee against losses In general and is never recoverable by the bank in any part. It Is an expense. If any part of the same be re- turned to the bank after having proved to be unused then the bank must not claim the amount deposited with the state as an expense but can only claim so much of these guarantee funds as is not returned to it. We believe we have sufficiently explained that capital disbursements or capital expenditures are in no sense de- ductible expenses. Especially to be noted is the fact that restorations of property must In no wise duplicate the allowances made for depreciation. That is to say, the depreciation allowance having been based on an estimated price of the property it follows that when the property is replaced, the amount of the replacement should be charged against this depreciation reserve, and not as an additional expense nor in fact as an additional capital item for increasing the plant or other asset value. At this point let us again remind the student that among capital disbursements, so construed, are premiums paid on the insurance of an employe or officer of a corporation in a case where a policy is payable to the corporation as beneficiary. Among other common expenditures are what are known as organization expenditures. These usually com- prehend the legal and state costs for Incorporating a company, together with those expenses known as pro- moting expenses. Where a parent corporation guaran- tees dividends on the stock of its subsidiaries, these guar- antees constitute a part of the cost of this stock. Such a situation arises principally where the holding or parent NET INCOME OF CORPORATIONS 69 company, in order to induce the capital to become invested in its subsidiaries, guarantees to pay these investors a given minimum dividend. For the purposes of income taxes which correspond to normal taxes in the case of an individual, a corpora- tion is allowed certain credits paralleling in a sense a credit allowed individuals for conjugal status and de- pendency. These credits consist, firstly, of the war and excess profits taxes payable in respect to the same year's income. That is to say, this credit is amount of the war or excess profits taxes computed on the same year's in- come as shown by the return. Secondly, a specific credit of two thousand dollars is allowed domestic corporations. Thirdly, credit is allowed for the interest on those United States obligations not entirely exempted from tax. This is merely equivalent to saying that the interest on such obligations is exempt from normal taxes but not from the excess profits tax. Under the general head of corporations it is well to consider the class of corporations known as Insurance companies. Insurance companies, as these words are in- tended in the law and the Regulations, include the com- panies organized as corporations with capital stock and also companies organized on a mutual or non-stock plan. It would also include voluntary associations of persons for the purpose of protecting members or their depend- ents from loss by death, illness, and Infirmity. In addition to the usual items of income and expense, the gross income of Insurance companies includes its net premiums. By net premiums we mean, of course, the gross premiums collected by the company minus such return of premium, or return of savings or so-called dividends as are returned to the policy holders, either in refund of their Interest or as paid-up additions or in 70 INCOME AND PROFITS TAXES abatement of premiums to be paid. Excluded or de- ducted from these gross premiums are such reinsurance premiums as are paid by the company in order to dis- tribute its risk. In the case of mutual fire insurance companies, those premiums that are paid in as deposits or guaranties of the liability of the members are neither income nor are they reserve under such provisions con- cerning reserves as will be presented later. In cases where the dividends or returns above men- tioned exceed the amount of the premium chargeable against, or to be paid by the policy holder, the excess is not deductible but must be construed as a corporate dividend. After the usual deductions, as in the case of computing other net income, such as expenses of operation, etc., the Insurance company is allowed to deduct additions to its reserves as required by state or other government power. To consolidate our remark about these reserves, if the reserves are increased it is expense; if decreased, income. These reserves, as will be known by the average student, are reserves computed under certain provided averages based on the American Experience Tables of Mortality, and calculated to protect the policies provided the holder pays his premiums in due course for his usual expectation of life. Payments by an insurance company on account of policy or annuity contracts are cited as deductible. To reduce this to simpler language it may be stated that the payment by the insurance company on its policies where death has occurred or, if not a life insurance company, where the casualty or contingency for which the policy was issued has occurred, constitutes an expense or a loss, and in the case of annuity contracts or policies payable in NET INCOME OF CORPORATIONS 71 instalment the annual payments are also an expense on account of the policy contract. The required additions to the reserve funds of an insurance company must not, in any sense, be made to include any reservations set aside for known claims against the company such as cases where the insured is deceased but the claim has not been actually paid. Because of the fact that there is frequently no par- ticular requirement in respect to reserves of the life, health, and accident companies, it is provided in the Regulations that reasonable additions to the reserve not required by the law may be computed as an expense. In such case a proper explanation of the method of setting aside these reserves must be sent with the return. In the case of fire insurance companies, the only reserves usually recognized in accounting are the unearned por- tions of the premiums collected. Where mutual marine insurance companies refund premiums with interest in a case of losses or for other reasons, interest added may be included as a part of the refunded premium. It is well to add that in the case of mutual insurance companies whose members pay their premiums, as it were, tentatively or in estimated deposits in advance with the understanding that the losses and expenses of the year after computation will be taken out of these deposits and the balance returned to them, the amount returned is parallel to the case of a dividend paid back on its premium in any other insurance company. The amount retained, therefore, or the net premium, is the income. Out of this amount retained, however, the ex- penses and losses must be paid. Retention in this sense means strictly the amount of the net premium charged to the policy holder, and must not be confused with the 72 INCOME AND PROFITS TAXES retention of any sum out of the gross collection of pre- mium, which is in reality retained as provision for further contingencies. To express this differently, we might put it thus: That the premium collected being the gross income, the amount returned to the policy holder is the deduction therefrom to make the net re- ceipt or gross income from which is to be deducted the expenses and losses. If the amount returned to the policy holder is not the entire gross collected premium minus actual expenses and losses, but in addition there is withheld an amount for estimated expenses and losses of the future and, as it were, retained for contingencies, this amount is also deductible but in such cases the actual expenses and losses when incurred cannot be deducted in addition to this retained amount. Furthermore, if the retained amount proves excessive or if it proves more than is necessary for the actual losses and expenses, it must be understood that the retained amount must be re-added to the income in later years or when the actual result is determined. Losses and expenses, as defined in the last sentence, include reinsurance reserves. Of course where any part of these retained amounts is in- vested in interest bearing assets or income producing assets, the income therefrom must be reported and can- not be considered as an exclusion from the income because of the fact that it was derived from an excludable prin- cipal amount. The student will now read, in the order given. Regu- lations 45, Articles 531; 541; 542; 543; 544; 545; 546; 547; 561; 562; 563; 564; 565; 566; 567; 581; 582; 591; 1508; 548; 549; 568; 569; 570; 571; 572. CHAPTER VII PERSONS (NOT INCORPORATED) The word person as used In this text Is Intended to Include not only individuals but also organizations such as firms, partnerships, associations, joint stock companies, and all Incorporated bodies. In differentiating between the different classes of persons, however, we are obliged to add a few more kinds to the terms covered by the definition. We must Include trustees, receivers, admin- istrators, executors, partners (that Is to say the members of the firm), and the stockholders of personal service corporations. This also includes such organizations as associations of business men or other classes of persons, and clubs or societies In general. The law makes a great many distinctions between the methods of taxing these various kinds of persons. The taxability of persons or corporations not resident within the United States Is somewhat different from that of residents of the United States. For the purposes of the income tax law, the United States, as a definition. Includes the several states, the District of Columbia, and the territories of Hawaii and Alaska. It does not Include the Philippine Islands or Porto Rico. Primarily a domestic corporation Is one which Is or- ganized within the United States. A foreign corpora- tion Is one which Is organized outside of the United States. Partnerships are domestic or foreign accord- ing to the place of their organization. As regards individuals, persons born or naturalized in the United States are American citizens and fully amenable and liable for the purposes of an Income tax. However, a naturalized person, that Is to say a foreigner 73 74 INCOME AND PROFITS TAXES naturalized as a citizen of the United States, who sub- sequently returns to his former country and remains there two years is presumed to have lost his citizenship. If a foreigner naturalized in the United States leaves the United States and resides for five years in a country other than his native country, he also loses his citizen- ship. A person born in the United States, however, never loses his citizenship, that is, without voluntary surrender by naturalization in some other country. Let us not be misled by this discussion, however, into placing the line of demarcation for purposes of taxability between citizenship and alienism. The true distinction is quite different. A citizen wheresoever he may reside is fully taxable. An alien if resident within the United States is fully taxable. An alien, if not resident in the United States, is taxable only on income derived from sources within the United States. Our present discussion is to be of the income of non- resident aliens In so far as the same is affected by the Income tax. The basic provision is that they are taxable on income derived from sources In the United States. This includes every form and variety of income so de- rived. For a proper limitation or better understanding of this Income, however, a few notes should be made of those kinds of income which could not come within this category. If an employer, being a United States citizen or corporation, in connection with his or its foreign busi- ness employes help whose work is performed entirely In foreign countries and whose wages are paid them there by branches or representatives of the establishment, this does not constitute income from sources within the United States. If a resident or corporation of the United States rents property in a foreign country, the income to the landlord of such property is not derived from sources PERSONS (NOT INCORPORATED) 75 within the United States. Dividends on the stock of a United States corporation and interest on bonds issued by a United States corporation are normally, of course, income derived from sources within the United States, but if paid to a non-resident alien individual and derived from income of said corporation not earned in the Uni- ted States (which is to say that said corporation is not doing business in the United States even though incor- porated here), such dividends and interest are not tax- able. This provision must be construed strictly to mean that the corporation paying the dividends or interest has no business whatsoever within the United States. In the case of hire for vessels or freight paid for trans- porting on vessels between the United States and for- eign ports. If such vessels are owned by persons who are not residents or citizens of the United States, the income derived from the operations is not taxable. If the own- er of the vessel in such case, however, maintains any form of agency in the United States, it must be under- stood that he is doing business therein and all income derived by or through said agency would be taxable. In the case of Liberty Bonds, there is a special pro- vision in the Fourth Liberty Bond Act by which the interest derived from United States obligations and bonds of the War Finance Corporation, while owned by a non-resident alien individual or foreign corpora- tion, is to be considered exempt from all income and excess profits taxes. This is limited to the cases, how- ever, where the foreign corporation or alien Individual Is not engaged in business In the United States. It is further limited to that interest received after March 1, 1919. The ordinary expenses of earning income are deducti- ble by an alien individual similarly to a citizen. With 76 INCOME AND PROFITS TAXES respect to general deductions, however, interest is lim- ited to so much of the entire payment of interest by a non-resident individual as is equal to the proportion of his income derived from within the United States to his entire income. In the case of losses, they are limited to losses arising from transactions in the United States only. If a non-resident alien makes contributions he is allowed to deduct the same under the same provisions as a citizen or resident, with the exception that the gift must be to a United States corporation and could not include any gift to a foreign corporation. For the purposes of the normal tax the non-resident alien individual is allowed the same deduction and ad- justment as are citizens and residents. That is to say, dividends from corporations in the United States are not subject to normal tax. The non-resident alien indi- vidual is also allowed a personal exemption and a two hundred dollar exemption for each dependent similarly to a citizen or resident provided that, if his own country imposes an income tax, the personal exemption and credit for dependents is allowed only in those cases where his country in imposing its income taxes allows a similar credit to citizens of the United States not residing in that country. Similar credit does not mean in this sense the same amount, it only means a credit paid on the same principle. To illustrate this, if a non-resident alien de- riving income from sources within the United States resides in a country which imposes no income taxes, he may claim a deduction for conjugal status and depend- ents. If he is a citizen of a country which imposes an income tax and allows personal exemption but no credit for dependents he may claim a personal exemption but no credits for dependents. It is useless to try to attempt to present in any text PERSONS (NOT INCORPORATED) 77 at any time a complete list of countries to which these provisions apply. The laws are subject to constant changes and the Treasury Department in issuing its Regulations declares its publications to be incomplete. An inquiry should be made in any case where doubt exists in the mind of the taxpayer. To claim these cred- its a non-resident alien individual must make the return in due course. In other words, if a non-resident alien individual deriving income from sources within the Uni- ted States does not make a return and the Bureau makes the return for him from information derived from other sources, he is not allowed to claim any of these credits. Nor can a withholding agent who deducts income taxes from income paid to such non-resident aliens be per- mitted to claim credit on behalf of the payee. To consider more at length what constitutes resi- dence, it must be understood that residence in this coun- try is predicated on reasonable permanency of presence here. A person who is merely passing through or is here on temporary business or for other purposes is not a resident and cannot be so construed. This is so even though the actual time of his return may be uncertain but the uncertainty of the time of return alone will not constitute a transitory status. Persons, for instance, who are in the country for such time as it requires to earn a sufficient fund to return to their own country and live there on the income from the amount so accumulated, cannot be construed to be transitory. On the other hand, a person whose presence in this country is primarily transitory does not forfeit that status by reason of the fact that his departure may be, for one reason or an- other, postponed from time to time, so long as he sin- cerely intends to return and not take up residence in this country. 78 INCOME AND PROFITS TAXES It is the status of the non-resident alien at the close of his taxable year which determines his taxability as a resident or non-resident as the case may be. An avowed and known intention to remove constitutes him a transitory resident. In view of the responsibilities of employers with re- spect to wages paid non-resident alien employes, certain facts should be mentioned concerning the basis on which they are to determine the status. A foreign or alien employe must be presumed to be a non-resident in the absence of evidence to the contrary. The burden is on the employer to obtain proof if he wishes to evade re- sponsibility of withholding the tax from the source. It is stated that a knowledge of residence one year prior to employment, or continuous employment by the particular employer for three months prior to the time for payment of the tax, will raise a presumption that he is a resident, but this may be nullified by any knowledge of the em- ployer to the contrary. Although a withholding agent cannot claim credit for a non-resident alien, a non-resident alien employe in this country may claim his credit through his employer. That is to say, he may use his credit in exempting himself from the withholding on the part of his employer. This provision only applies to the compensation paid for the services of a non-resident alien. It is also possible for a non-resident alien to claim his credit in so far as these credits may apply to interest derived from tax-free cove- nant bonds if he files a proper certificate with the debtor corporation. In connection with this, let us note that if a debtor corporation withholds the tax from a non- resident alien's income derived from the interest on its bonds and the tax so withheld exceeds the true liability of the non-resident alien for all taxes from income de- PERSONS (NOT INCORPORATED) 79 rived from all sources within the United States, it is necessary for the non-resident alien to make a formal claim for the refund. We have mentioned that a non-resident alien is com- pelled to make a return. If he has a fiscal agent in this country, the fiscal agent may make the return and must make the return in the absence of the non-resident alien himself. This return must include all income upon which tax was not withheld at the source. In the case mentioned in the last paragraph in which the amount withheld at the source exceeded the true tax liability of the non-resident alien, a return made on behalf of the non-resident alien, in order to demonstrate the amount due by way of a refund for overpayment must disclose completely all amounts withheld and persons withhold- ing them as a part of the return. There is a general provision in the law and the Regula- tions that the actual and record ownership of stock or other securities on which income is earned is presumed to be the same in the absence of evidence to the contrary. This means, that where the record owner of the stock or bonds is different from the true owner, the responsi- bility for the tax lies on the record owner until the true owner is disclosed either by such record owner or some other person. This is repeated here because it applies largely to non-resident aliens who may hold large quan- tities of securities by trustees or other representatives in the United States. There is some special mention of the case of alien seamen with respect to the income tax. It must be un- derstood that the wages of alien seamen sailing on for- eign vessels which are engaged in the United States coastwise traffic are to be construed as earned within the United States. The wages which such alien seamen 80 INCOME AND PROFITS TAXES receive from vessels engaged in foreign trade, however, even where the routes covered by such vessels may fly the United States flag, do not constitute wages received from within the United States. This, of course, is merely a continuation of the principle that transitory residence does not constitute a person subject to tax as a resident. We have stated that the possessions of the United States, that is to say the Philippine Islands and Porto Rico, are not to be construed as part of the United States. They are, for the purpose of income tax, for- eign countries. In both Porto Rico and the Philippine Islands, the 1916-17 tax laws are still in force. The effect of this provision is that in so far as dividends are concerned, when such dividends are derived from cor- porations doing business within Porto Rico or the Phil- ippine Islands, such dividends are not to be construed as dividends from a corporation taxable in the United States. As regards persons deriving income from sources within the United States and also within Porto Rico or the Philippine Islands or both, the question of credits for foreign taxes applies to the income from the Philippines and Porto Rico in the same manner as such cases of income derived from other foreign governments in imposing taxes. The next class which we will consider will be that known as fiduciaries. A fiduciary is one who exercises a position of trust in respect to the property or person of another. So far as the income tax is concerned, we principally deal with those fiduciaries who have charge of the property of others, although in some respects the law places burdens on those who have charge of the persons of others, such as a guardian. The responsi- bility of making a return in the case of a fiduciary lies PERSONS (NOT INCORPORATED) 81 primarily on the fiduciary and not on the person for whom he acts, or for whose behalf his activities as a fiduciary are conducted. It is necessary to distinguish, however, between a fiduciary and an agent. The Regulations provide that unless a legal trust actually exists the beneficiary or prin- cipal is not relieved from acting, but where such trust does exist, the duty is on the fiduciary to make the return. The most important phase of the subject of fiduciaries, however, lies in the question of estates and trusts. Es- tates and trusts are taxable. Returns must be made for these estates and trusts by the executors, administrators, trustees, or other fiduciaries having them in charge. The income of an estate or trust is figured on the same basis in practically every respect as in the case of an individual. The deductions for an estate or trust are the same, care being taken, however, to prescribe that where the expenditures relate to such matters as are chargeable against the body or corpus of the estate it constitutes capital disbursement and not a part of the deductible expense. In addition to this an estate is allowed to deduct only such contributions as are provided by the will or trust deed. Contributions in this sense are limited, of course, to those contributions ordinarily considered deductible charities. The provisions which permit these charities must be in accordance with the limitations on charitable deductions allowed individuals. The responsibility of the trustees to report is funda- mental but where the trust is a temporary one or is revocable by the donor or vendor, the property or in- come in custody remains the property and income of the 82 INCOME AND PROFITS TAXES original vendor or donor and such vendor or donor must report the same as his own. Where an estate is in process of settlement or, as it is commonly called, in process of administration, it must be dealt with as a unit. Where the beneficiaries of an estate or trust are unascertained or are contingent so far as their interests and rights are concerned, the estate must be also dealt with as a unit. In so far, however, as the estate or trust is merely an aggregation of inter- ests of known persons in whom these interests are actu- ally vested, so that the income of the estate is specifically distributable to known persons, the taxability lies on the persons entitled to receive such income. The estate in such case makes its return and must report these distri- butions as information concerning the income of the individuals. Following this principle, where the estate itself is normally taxed as a unit, if any portion of the income is specifically distributable by the terms of the trust or will to specific and known persons, so much of the income as is thus distributable need not be included in the income of the estate but is subject to tax as a part of such individual's income. Where such distributions are at the discretion of the trustee or other fiduciary, the provision for taxing the distributee does not apply. In such Instance the estate must still be dealt with as a unit. It matters not to what extent the ultimate beneficiaries of a trust may be exempt from tax, so long as the estate subsists as a unit, It is taxable and the exemption of the beneficiary does not relieve the estate. It should be understood broadly by the student that real property Is not usually a part of the estate held by an administrator or an executor. For that reason, the income from real estate of a deceased person must be PERSONS (NOT INCORPORATED) 83 reported by the individual heirs and has no bearing what- soever on the income of the estate and trust unless spe- cifically made a part thereof. Such statutory allowances as are made according to law to widows of deceased persons must not be misun- derstood to be expenses of an estate. They are merely distributions of income or capital as the case may be. As has been above said, the estate of a deceased per- son during the administration is taxable as a unit. "During the administration" means the time actually re- quired to administer the estate and settle its affairs not affected by any legal provisions or limits placed on this time. Upon the settlement of an estate a distribution of the property owned by the estate does not constitute income. The law, as will be recalled, exempts gifts, bequests, and legacies. So much of such distribution arising from accumulated income becomes capital at the time of the distribution, having been taxed itself during the period of the administration. There is just one exception to be noticed from the general condition which lies in the fact that where property of an estate is sold by an ex- ecutor or administrator at a value greater than the value of the property at the time of the death of the decedent, the difference constitutes a gain. On the other hand, a loss would be also claimable if the reverse were true. The responsibility for the return and for the tax is primarily the obligation of the trustee, executor, or ad- ministrator as such. This liability in so far as he indi- vidually is concerned is complete. His responsibility Is as great as If it were his own income with which he were dealing. The responsibility to see that the return is made and to see that the tax is paid, however. Is also a duty of the participants in the estate. Payment of the 84 INCOME AND PROFITS TAXES tax or rendering of the return by the trustee or the ex- ecutor therefore exempts the beneficiary, but the fidu- ciary's failure to do so may result in the following of the interests and the charging of the participants with the liability. Where the income of an estate or trust is distributable periodically or otherwise but is positively distributable, and where the estate or trust is distributable to guardians of minors who are entitled to the income for their sup- port and maintenance, and furthermore in respect to those specific allotments of income under the terms of the trust or will which are payable to particularly known and specific persons, the income is taxable against the beneficiary. An estate's returns are based on the calendar year unless it has a fiscal year. In the latter case, it must so report. As to those beneficiaries who are to report such part of the estate as they receive from it, the general rule applying to members of firms can be used in deter- mining the adjustments of periods with respect to their income in such a case. An estate when taxable as a unit is taxable as a single individual and is entitled to the same credit or exemp- tion as a single individual would be, with the exception that an estate is not entitled to any credit for dependents. This is perfectly logical, for an estate would not have dependents but beneficiaries. With respect to income distributable from an estate to a specific beneficiary dur- ing administration or after the administration, or during the time of the trust, the status of the beneficiary gov- erns the exemption of that portion of the income so far as personal credits are concerned, and the individual beneficiary in computing the income derived from the PERSONS (NOT INCORPORATED) 85 estate as his own claims his own exemptions according to his own condition. Liberty Bond exemptions in the case of an estate or trust must apply, so long as the estate is taxable as a unit, as the exemption of the estate and would be com- puted in the same manner as if the estate were an indi- vidual. For so much of the income from these Liberty Bonds, however, as is distributable to individual bene- ficiaries, the beneficiaries when including this Liberty Bond income in their own may then claim deduction for their proportion of the holding of the estate in accord- ance with income thus derived. To illustrate this, if an estate held twenty thousand dollars of bonds, fourth issue, which were exempt and the estate were taxable as a unit, it would claim the exemption on the basis of the provision for the exemption on fourth Liberty Loan bonds. If, however, this estate were distributable, as far as its income were concerned, to known beneficiaries equally, then each beneficiary would include five thou- sand dollars of the Liberty Bonds held by the estate among those on which he based his exemption. In those cases where the original subscription to the bonds deter- mined the amount or applicability of the exemption, the original subscription by the estate or by the decedent from whom the estate is descended, determines the status of the exemption and the beneficiaries can claim exemp- tions under such issue as if they were their own original subscriptions proportionately. A partnership is an organization or association of two or more individuals, not incorporated, for the pur- pose of conducting a business enterprise. Partnerships as such are not taxable but partnerships as such must make returns. The individual members of the firm are taxable on the income derived from the partnership. 86 INCOME AND PROFITS TAXES This Income, in accordance with their respective shares, is taxable as if received by them whether actually dis- tributed or not. The income of a partnership is computed broadly along the same lines as that of an individual, with the exception that a partnership may not claim contributions and charitable gifts, even within the provisions provided for individuals. To avoid this loss of deduction, the author offers the advice to all persons interested in part- nership income that contributions made by the firm be made as direct contributions of the individual members. In this way, the member may claim the contributions made as his own, within the statutory limits. A partnership return must be made as of the fiscal year. The distribution of the income whether actually made or not is presumed to have been made as of the close of such fiscal year. The member as an individual in reporting his own income must include his portion of the income of the partnership as determined by its clos- ing for the fiscal year ended during the taxable year of such individual member. To illustrate this let us consider the case of a firm closing its books as of September 30th. An individual member of the firm making his return on the calendar year basis for the year ending December 31, 1920, would include as his share of the profits in the partner- ship that amount which was determined by the partner- ship's fiscal closing as of September 30, 1920. If, how- ever, such individual made his return on the basis of a fiscal year of his own ending August 31st, his return for August 31, 1920, would include the distribution de- termined by the partnership's fiscal year ending Septem- ber 30, 1920. PERSONS (NOT INCORPORATED) 87 As dividends, Liberty Bond and municipal bond inter- est and some other forms of income have, as will be re- called, certain differentiation with respect to taxability. A partner should make his return, so far as the income from the firm is concerned, in such form as to segregate these portions of income derived through the firm from such dividends or other exempted income and claim the partial or complete exemption from taxability applica- ble to this proportion as if he had received it directly. To illustrate, if a firm holding stock in a corporation de- rives dividends from the corporation during the course of a year and a member of the firm in reporting, being entitled to one-half of the profits, is thereby actually receiving one-half of the dividends so earned by the partnership, it follows that he may claim exemption from normal tax with respect to the one-half of the dividends he thus receives. The same principle is applicable where a partnership pays foreign taxes which under the provisions of the statute are deductible from the liability for taxes. Where such foreign taxes are paid by the firm, the indi- vidual member may claim a deduction from his taxes for such proportion of these foreign taxes as his inter- est in the partnership entitles him. In claiming exemptions for Liberty Bond interest, the members of the firm in computing their exemption in- clude that part of the Liberty Bond holdings of the firm as is in proportion to their interests in the partner- ship. Thus the one-half partner of a firm owning a volume of Liberty Bonds would consider for the pur- poses of calculating his own exemptions from taxability on Liberty Bond interest owned by him, one-half of the bonds held by the firm, and in addition thereto the sub- scription by the firm, where subscription is necessary to 88 INCOME AND PROFITS TAXES determine the exemption, would be construed to be his own subscription in respect to his share. An association is an organization of persons not In- corporated but partaking of the nature of a corpora- tion in the operation of its affairs. Where such an asso- ciation Is organized for the purpose of earning a profit, it is under the income tax laws taxable as a partnership or as a corporation, according to circumstances. If the interests of the members of the association are transferable without the consent of the other parties interested, as In the case of stock held by the sundry stockholders of corporations, the association Is not a partnership and it must be taxed as a corporation. If the association acts by trustees and these trustees are not chosen periodically by the members of the associa- tion, it must be borne in mind that the members of the association are nothing more nor less than beneficiaries of a trust and all of the provisions for trusts and estates apply. The status of a trust Is particularly applicable to such an organization if the income is absolutely dis- tributable without the discretion of the trustees. Even if the income Is distributable at the discretion of the trustees, it does not necessarily establish a corporate status, but may be taxable as a unit trust. In the case of such association, however, if the right of periodical election of trustees to control the property and affairs subsists in the members thereof, it must be considered a corporation. Limited partnerships may sometimes be construed as corporations and taxable as such. Of course, where the general partners cannot be restricted or cannot obtain restriction as to their respective liabilities, the organiza- tion is a partnership and is taxable as such. But, where, as is the case under the statutes of some of the states, a PERSONS (NOT INCORPORATED) 89 limited partnership may be organized in which there are virtually no general partners but all of them have limited liabilities and interests may be transferred without re- striction depending upon the consent of the remaining members, the institution is taxable as a corporation. The association of two or more persons for a single venture such as a speculation or performance of a single contract does not constitute a partnership. Nor would the mere fact of common ownership of property either as joint tenants, tenants in common, or otherwise make the owners partners for the purpose of income taxation without other elements. The student will now read, in the order given. Regu- lations 45, Articles 1501; 1509; 4; 312; 312a; 313; 314; 91; 92; 93; 271; 306; 307; 311; 316; 92a; 315; 363a; 404; 405; 1121; 1131; 1132; 1521; 1522; 341 to 346 inclusive; 81; 321; 322; 323; 82; 1507; 1502; 1503; 1504; 1505; 1506. CHAPTER VIII CORPORATIONS Ordinary corporations, which means those not per- sonal service corporations, are subject to taxes. Some kinds of corporations are specifically exempted under the statute. A domestic corporation is taxable. It makes no difference that its income may not be derived at all from sources within the United States. On the other hand, a foreign corporation is necessarily only taxable for that proportion of its income which is derived within the United States. The important question with respect to corporations which are taxable lies in considering those for which specific exemption from taxation is provided. Let us first say that in the case of any corporation which claims exemption, it is required that it shall file with the De- partment such data as will enable the Department to decide upon its acceptability. This data will consist of a general statement, under oath, of the character and purpose of the business, the source and destiny of the income, and full and complete description and itemiza- tion of the private interests in the corporation. The corporations which are exempt are enumerated in Section 213 of the Act, and need not be specifically repeated here. In the case of the corporations enumer- ated in sub-section (1) "Labor, agricultural, or horti- cultural," (3) "Beneficial societies, orders, or associa- tions," (5) "cemetery companies," (6) "Religious, charitable, educational, or scientific corporations, or those organized for the prevention of cruelty to chil- dren or animals," (7) "Business leagues and similar organizations," (8) "Civic leagues," (9) "Clubs," 90 CORPORATIONS 91 (10) "Farmers' or other mutual hail, cyclone, or fire insurance companies, etc.," and (11) "Farmers', fruit growers', or like associations," all are exempted because and only if the profit derived from such organization, if any, does not inure to the benefit of private stockhold- ers. If, therefore, any private stockholders derive profit from such an organization, exclusive, of course, of compensation for service rendered or interest on money loaned, the said institution would thereby lose exemp- tion. These exemptions are provided solely because of their being entities of a mutual or non-earning nature as the case may be. The exemption of (2) "Mutual savings banks or building and loan associations," (13) "Federal land banks and national farmers' associations" is based strict- ly on the principle that the profits and earnings on such organizations inure not to investing stockholders so much as to contributing or depositing members of such or- ganizations, and in all such cases the net earnings of the organization are distributable to such members as their own respective individual earnings and fully taxable in their hands as such. Exemption (12) is based not on the status of the cor- poration exempted but on the status of the corporation beneficially interested in its affairs. This exemption must not, therefore, be understood to relate to all holding companies, but so far as this particular provision is con- cerned only to those holding companies in which holding is for the benefit of exempt organizations. The classi- fication (14) "Personal service corporations" will be discussed separately. In the case of these exempted corporations, it is nec- essary to consider some few instances in which these exemptions will not be held to apply. An agricultural 92 INCOME AND PROFITS TAXES and horticultural organization does not mean an Insti- tution or organization for the purposes of conducting an agricultural or horticultural business. It is limited to those societies which are organized for the purpose of promoting agricultural and horticultural information among its members, or to such institutions as are organ- ized for carrying on fairs or otherwise inducing com- petitive progress among those who are interested in such pursuits. It is the mutuality of interest of its members which constitutes the exemption allowed building and loan as- sociations. It follows, therefore, that where a building and loan association is in the habit of issuing paid-up stock which is to all intents and purposes a permanent investment in its business, no exemption can be claimed. The exemption for fraternal beneficiary societies is limited to those which are conducted on a lodge system or for the benefit of members of an organization which is conducted on a lodge system. It is required also that such societies shall have a regular system of payments to its members or their dependents of the benefits for which it is organized. This means that periodical or irregular practices of charity to its members or depend- ents does not constitute a beneficiary society. Cemetery companies are exempted because and if no private stockholder derives any profit therefrom, but where a corporation for this purpose is organized, and as a temporary financial expedient issues preferred stock pending the sale of its lots to a sufficient amount to cover its needs and retire said stock, this will not deny it the status desired. The provision for religious, charitable, scientific, and educational corporations is held to include trusts for such purposes. Collateral business enterprises con- CORPORATIONS 93 ducted by an institution otherwise within the scope of this definition will bar it from exemption even though there may be no private stockholders or other persons who participate in the gain. What we ordinarily understand as business leagues are such institutions as usually go by the name of boards of trade, chambers of commerce, or merchants' associa- tions. This class, however, may also include mutual business agencies such as bank clearing houses and ex- changes through which the persons engaged in a par- ticular line of business may buy or sell mutually with- out any profit being earned except by way of advanta- geous purchasing or selling. In other words where such an institution earns no profit for itself but is merely availed of by its members for the purpose of increasing their own income, it does not constitute a taxable cor- poration. Although social clubs are normally considered exempt from taxation, a club which engages in business enter- prises of any nature whatsoever would not be permitted exemption. An example of this would be where it main- tained for the purpose of earning profits, a traffic of any sort not within the scope of its ordinary presumed activ- ities. It does not mean that a club which maintains a cafe for the accommodation and use of its members would be barred from the exemption. Income of a mutual insurance company claiming ex- emption from taxation must consist solely of fees, dues, and assessments. But if, incidental to its operations as a mutual insurance company, it derives income collater- ally from such sources as interest on its bank balances or, in the case of organizations which handle or use paraphernalia, where the organization sells such para- 94 INCOME AND PROFITS TAXES phernalia to its members, the sale does not take it out of the status. Cooperative associations to be entitled to the exemp- tion must operate strictly on a cooperative basis and any tendency to accumulate profits or distribute the same on other than such basis will take it out of the exempted class. The basis of this exemption lies in the fact that its members must pay taxes on their share of the cooper- ative profits. Analogous, so far as income taxability is concerned, to a partnership is what is called a personal service cor- poration. The fundamental elements for the status of a personal service corporation may be roughly defined to be three in number, and as being an organization, although incorporated, (1) organized for the purpose of conducting a business of personal service, (2) which business is principally conducted by and with the activi- ties of the principal owners, and (3) in which capital is not a necessity or at least is merely an incidental neces- sity to the conduct of the business. There are three classes of corporations which are specifically prohibited from claiming the status of a personal service corpora- tion, to wit: foreign corporations; those which derive fifty per centum or more of their gross income from trading as a principal; and those which derive fifty per centum or more of their gross income from government contracts. It must not be assumed, however, that if less than fifty per centum of gross income of such corpora- tions is derived from trading as a principal, or from government contract, there is a negative presumption that they are not ordinary corporations. What constitutes trading as a principal may be gen- erally stated to be that character of business in which the party engages which involves buying at one price CORPORATIONS 95 and selling at a profit. Such buying would have to be in the name of the corporation or in its equitable right. A corporation which otherwise qualified as a personal service corporation could not be barred from the status if it traded in such matters purely as an agent and for the benefit of others. Elements which constitute buying and selling for a profit or principal trading including such items as assuming the responsibility for the collec- tion of debts, assuming the risk of market value, etc. Where principal trading occurs in the affairs of the cor- poration which is otherwise qualified to use the personal service status and this trading is merely incidental or negligible in quantity, the status of a personal service corporation need not necessarily be denied by reason of this trading, but this provision must be very strictly construed. By the activities of the stockholders of a personal ser- vice corporation, in so far as they are necessary to entitle it to the status desired, is meant that the principal own- ers of the stock in the corporation must be regularly engaged in the conduct of its affairs and the income of the corporation must be principally derived from their activities. This means that the conduct of the affairs of the corporation should be almost exclusively in the hands of these principal stockholders and not in a dele- gated manner, for that would constitute trading or oper- ating through the services of other persons. Such con- duct of the affairs of the corporation must be real and not merely a superficial authority. With regard to the interest in the corporation held by those stockholders who conduct its affairs, the mini- mum set down by the Regulations is eighty per centum, which means that the stockholders actually engaged in the business are normally required to own not less than 96 INCOME AND PROFITS TAXES eighty per centum of its capital stock. This must not be construed to be, however, a minimum which is in- tended as a fixed standard but it is merely the minimum on which the first return may be made and is subject to revision in cases where circumstances require or necessi- tate a departure from the particular standard. Changes in the ownership of the capital stock of a corporation must be watched with considerable care with respect to its status. Such changes do not raise any ir- rebuttable presumption that the corporation is not a per- sonal service corporation but where they are frequent it naturally follows that there is a strong indication that the interest of these changing partners is a matter of investment. Where changes of this character result from retirement, incapacity, or death of one of the prin- cipal owners, a reasonable time necessary for the substi- tution of another interested party who will be actively engaged in the business is permitted without destruction of the personal service status. It must be remembered, however, that if the retiring partner retains any interest in the business which is relatively large it amounts to an investment by him and therefore creates the status of invested capital with respect to the finances of the corpo- ration. The size of the capital of the corporation claimed to be a personal service corporation is not the basis on which the status is determined. It is the necessity for such capital from the nature of its business which is the determining factor. What constitutes the necessity for capital in a busi- ness is such a necessity from the nature of the business, involving such matters as inventory, the carrying of ac- counts of customers or clients, and the practice of loan- ing to customers for the retention of good will. Where CORPORATIONS 97 such practices prevail it is presumed that they are a necessity for the success of the business. The taxability of personal service corporations is ab- solutely the same as that of partnerships. In every respect stockholders of a personal service corporation must be dealt with as members of a firm. We believe it is unnecessary to repeat all these details. As corporations usually distribute their income by dividends, the question of distributing the shares to the various members of a personal service corporation Is not so simple as that of determining the distributive shares of a partnership, for the reason that the dividends them- selves are not the basis of taxation of the members. The stockholder In a personal service corporation, there- fore, must be careful to distinguish between the distribu- tive shares of the earnings of his corporation and the actual dividends received. Personal service corporations did not exist prior to January 1, 1918, but were taxed as corporations. Furthermore, we will recall that the taxation of indi- viduals begins as of March 1, 1913, and we have al- ready learned that where dividends are paid distinctly out of earnings accrued prior to that time, they are not subject to tax in the hands of the individual stockholders. A stockholder receiving dividends from a personal service corporation, therefore, must be very particular to consider the same from the standpoint of when the profits were earned out of which the dividends are paid. If the dividend is paid from profits earned by the cor- poration prior to March 1, 1913, they are not taxable. If it Is paid out of profits earned by the corporation between March 1, 1913, and December 30, 1917, both dates Inclusive, they are taxable as dividends, which is to say that they are not subject to normal taxes but only 98 INCOME AND PROFITS TAXES to surtaxes. Where they are paid out of earnings subse- quent to December 31, 1917, they are to be construed as payments on account of the distributive shares of the profits of the corporation, which is to say that they are virtually analogous to a drawing account of the mem- bers of a firm and are not income at all. It is provided, however, that where the fiscal year of a personal service corporation differs from the fiscal year of an individual and distribution out of profits earned since the last close of the fiscal year of the corporation is made to the indi- vidual prior to the close of his fiscal year, he is required to include these distributions. Observe that as these constitute nothing more or less than distributions of a part of the profits of the corporation which he will be under the necessity of reporting at his next succeeding personal fiscal year, these distributions should not be re- ported twice and should be deducted from the amount reported in the following return. To illustrate the whole matter let us take the case of a personal service corporation and utilize its dividends in respect to one of its stockholders. Assume that we are dealing with the affairs of the one-half owner of a per- sonal service corporation ; that the net income of this cor- poration as of February 28, 1913, was $50,000; that its earnings between March 1, 1913, and December 31, 1917, were $150,000; and that its earnings from De- cember 31, 1917, to December 31, 1919, were $100,000, making a total accumulation of earnings to December 31, 1919, of $300,000. Assume, of course, that no div- idends have as yet been paid out of these earnings. On May 31, 1920, the coi-poration declares a dividend of $325,000, which is based on the assumption that it has current earnings for the amount in excess of its surplus. We will now assume that the individual is necessitated CORPORATIONS 99 to make a return on June 30th by reason of his personal fiscal year. We find the following: In his return of June 30, 1920, he must report that he received $162,500 dividend, minus, however, $25,000, or one-half of the profits of the corporation earned prior to March 1, 1913. Of the remainder, $75,000 is taxable as dividends not subject to normal tax, being one-half of the earnings of the cor- poration for the period from March 1, 1913, to Decem- ber 31, 1917. With respect to his half of the earnings of the corporation for the period from January 1, 1918, to December 31, 1919, which is $50,000, he will have reported that portion of his earnings which occurred in his own fiscal return of June 30, 1919, and must now report the balance of that sum as shown by the closing of the corporation's books as of December 31, 1919, in making his own 1920 return. So far as the actual divi- dend represented by this half-interest is concerned it is not additionally taxable at all. It was taxable in the first instance as a distribution from the personal service corporation and the dividend is merely a withdrawal of his own capital. This leaves us $12,500, which is his share of the $25,000 paid on May 31, 1920, out of as- sumed profits since the last fiscal closing of the corpora- tion. As to this the Regulations provide that he must pay tax on it as distribution of a partnership. Now, furthermore, in the closing as of December 31, 1920, the personal service corporation shows a profit of $75,000. In the fiscal return of the individual for June 30, 1920, therefore, he must return $37,500, or one-half of the profits but at this time deduct from this amount $12,500 represented by his dividend in anticipa- tion of profit and reported in his 1920 return. June 30, 1921, therefore, irrespective of any possibility of fur- 100 INCOME AND PROFITS TAXES ther dividends between his last report and the one now considered, he would only report $25,000 as being the earnings of the corporation not previously distributed and reported by him. The student should work this out by tabulation for a better understanding. In the case of the stockholders of a personal service corporation, they are allowed to claim exemption as In the case of a partnership, which Is to say that when a personal service corporation derives Income from divi- dends on stock it holds, or derives Income from Liberty Bonds or from other Investment that proportion of those dividends and exempted Income due to the indi- vidual stockholders may be correspondingly exempted by them as If it had been received by them directly. In the same manner they may deduct from their own re- turns such taxes as have been paid foreign governments by the personal service corporation, meaning of course their proportionate shares. There Is a provision In the law for the taxation of corporations where a part of the income is derived from personal service. It must not be understood that, where such provision Is applicable to the corporation's affairs, It qualifies the corporation as a personal service corpo- ration. Such Is not the case. A corporation maintain- ing that status and successfully claiming the same is not a personal service corporation, but an ordinary corpo- ration with a special provision for avoiding overtaxation In Its favor. When a corporation is availed of by the stockholders as a means of avoiding individual taxation, the law pro- vides that the Commissioner may, if his judgment of the circumstances so warrants It, certify the unreasonable- ness of the accumulation of profits for this purpose and in such event the corporation Is not taxed as a corpora- CORPORATIONS 101 tion but shall be taxed as a personal service corporation. This means that the individual stockholders will have to pay taxes as individuals on their share of the profits from year to year. As a sort of penalty for this action it Is provided that In such cases, notwithstanding the taxabil- ity of the income of the corporation as a personal service corporation, the excess profits tax shall be computed against the corporation and It shall be compelled to pay the same and the stockholders who are compelled to report their shares of the accumulation of income may deduct a due proportion of the excess profits tax from the Income on which they compute their own respective individual taxes. What constitutes the status which subjects the cor- poration to this provision consists of two elements : first, an intent on the part of the stockholders to escape individual surtaxes, and second, an unreasonable accumu- lation of profits. The element which raises a presumption to escape sur- taxes consists principally of those instances in which the only purpose of the corporation is to hold securities or other property and collect Income therefrom, or where a corporation which Is not merely a holding company permits Its gains and profits to accumulate beyond the reasonable needs of the business. Holding companies are normally omitted from this classification because there is a further provision in the law under the head of affiliated corporations which is particularly directed to holding companies. What constitutes an unreasonable accumulation of gains and profits is that accumulation which is not neces- sitated for the ordinary purposes of the business of the corporation. This Is not limited, however, to the busi- ness which the corporation formerly conducted, as any 102 INCOME AND PROFITS TAXES businesses in which the corporation may legitimately en- gage would offer purposes justifying the accumulation of profits, If such funds were necessary for its conduct. Ordinarily, the necessity for increased Inventories or an accumulation of accounts receivable necessitating the re- tention of earnings so represented, constitutes the legiti- mate retention of profits. So, also, a corporation which makes a practice of investing its income in the stock of another company in order that the other may thereby become an affiliated subsidiary would be making legiti- mate use of its profits for the purposes of the business. Again if the corporation is compelled by reason of spe- cial contract with respect to its liabilities to maintain a sinking fund out of its earnings, the maintenance of this sinking fund cannot be held an unreasonable accumula- tion of profits. A change in the character of the business of the cor- poration will not necessarily raise a presumption of a purpose to evade surtaxes, but where such change is of a nature which indicates that the amount of capital re- quired will be less in the future or the income will be less so that the unused capital may lie idle for the time being, a strong evidence exists that the purpose is to escape surtaxatlon. We have defined a foreign corporation as one which has been Incorporated in some place outside of the United States. Such corporations are taxable on all income de- rived from sources In the United States. Where such corporations maintain branches or agencies within the United States such branches or agencies are responsible for the return and tax, and must report for information the entire income of the corporation on all transactions even though from business In foreign countries. This provision applies only to foreign Insurance companies. CORPORATIONS 103 With respect to the deductions from gross income, foreign corporations are treated in the same manner as domestic corporations, limited, however, to the expenses which are applicable to the income derived from sources within the United States. Such general and administra- trative expenses as the corporation incurs, including its interest, are to be apportioned over the entire income of the corporation, and only such portion of the same deducted for the purposes of United States income tax return as the income derived from sources within the United States bears to all of its income. Deductions of taxes are limited to taxes paid to the United States or subdivisions thereof. In computing excess profits taxes in the case of for- eign corporations the invested capital is not to be com- puted on the basis of actual invested capital at all. It is to be computed by the provisions which will be ex- plained later for the setting up of constructive capital, which is to say that it is to be assumed that the capital employed is that amount which bears the same ratio to the taxable income of the corporation as the average cap- ital of representative corporations, engaged in a like or similar trade or business, bears to their average net in- come. In each of such cases the basis is the net income before the deduction of the $3,000 specific exemption. The agent of a foreign corporation is responsible to make the return if the corporation has no office within the United States. Of course, it is not necessary for the person who is making the return for a foreign corpora- tion to make a statement of average invested capital required in the ordinary case. This is because the income tax and excess profits taxes are computed on the basis of constructive capital as just explained. The only in- formation needed, therefore, is the return as to income 104 INCOME AND PROFITS TAXES and the balance sheets of the corporation for the dem- onstration of the accuracy of the accounts. At the time of the enactment of this provision for the determination of the invested capital of foreign cor- porations on the average basis, no statistics were avail- able for the establishment of any averages for the dif- ferent classes of business. For this reason in determin- ing the first instalment of tax in the case of foreign corporations, it was provided that they might use as the tentative basis the invested capital as shown by the return for the year 1917. To this should be added or deducted such changes as had occurred in the said cap- ital. From this a tax would be computed, and then, if the same exceeded fifty per centum of the income of the corporation subject to the tax, the first instalment would be based on the fifty per centum as a maximum, other- wise the amount of the tax so computed would be the amount on which the first instalment was to be paid. United States corporations with income derived from sources within the Philippine Islands or Porto Rico are entitled to credit for taxes paid to such possessions in the same manner as income derived from sources within foreign countries. On the contrary, as before stated, the Revenue Act of 1918 is not in force in the Philippine Islands or Porto Rico. For this reason no credit for foreign taxes paid can be allowed the corporation in the Philippine Islands or Porto Rico with respect to income tax paid on income derived from sources within the United States. The income of foreign governments is entirely exempt from taxation. The income of representatives of for- eign governments is exempted from taxation so far as it is derived from such governments but not where de- rived from business conducted within the United States. CORPORATIONS 105 Of course, the fees of any sort of foreign representa- tive such as a consul, although earned in the United States cannot be taxed. Where, however, a citizen of the United States acts as an agent or employe of a for- eign government, his income has no exemption whatever as he is a citizen. The income of a state of the Union is necessarily not taxable. This applies also to the subdivisions of a state, such as counties and towns. Where towns operate public utilities, the income from these public utilities is never- theless exempt. To follow this to its logical conclusion, if a public utility is operated by private management but under a contract with a governmental agency, such as a town or a county, which receives a part of the profit from the utility, the amount of the profit going to the munici- pality or county government Is not taxable, but it may be deducted by the private management in determining the income of such management. In other words, it amounts to an expense, it being a compensation paid to the state or municipality for the exercise of the franchise of oper- ating the public utility. The student will now read, in the order given, Regu- lations 45, Articles 503; 511 to 522 inclusive; 1523 to 1532 inclusive; 328; 331 ; 330; 82; 741 ; 742; 743 ; 351 ; 352; 353; 550; 573; 871; 625; 913; 1133; 83; 84. CHAPTER IX THE TAX The tax consists of four elements. Two of them are taxes on individuals. They are known as the normal tax and the surtax. In the case of corporations we have the income tax and the excess profits tax. As will be recalled from the previous text, certain of the exemp- tions and credits which apply to both corporations and individuals relate particularly to the normal tax of the individual or to the Income tax In the case of corpora- tions. From this you will gather that the normal tax in the case of individuals corresponds broadly to the Income tax in the case of corporations, and the surtax for Individuals to the excess profits tax of a corporation. In this chapter we will consider the four taxes; first, for individuals and second, for corporations. The normal tax is at the rate of eight per centum on the net income after the deduction of the personal credits hereinafter described, but the first four thousand dollars of the net taxable income over and above the personal credits Is subject to only four per centum normal tax. To illustrate this more clearly consider a net taxable income of $10,000 and a personal credit of $2,400. This leaves an income subject to normal tax of $7,600, of which $4,000, called the first $4,000, is taxable at four per centum and the remaining $3,600 at eight per centum. To express It In another manner we might say the In- come is taxed at four per centum for the first $4,000 above the personal credits, and the remainder at eight per centum. The result is the same, of course. A student should not abuse this method of computa- tion with any suggestion that the first four thousand 106 THE TAX 107 dollars of net income bears a tax of four per centum and the credits ought to be deducted from this amount for such is not the case. We compute normal tax on the amount of the income in excess of the personal credits. For the information of the student it is well to men- tion that in 1918 the rates were twelve per centum and six per centum respectively, the method of calculation being exactly the same. As stated before, every citizen of the United States, wheresoever residing, every alien resident of the United States, and every non-resident alien deriving income from sources within the United States is subject to the tax. You will also recall that the tax applies to estates and trusts, and to members of partnerships and associations not taxed as corporations. It applies to stockholders of personal service corporations and to the beneficiaries of estates and trusts where the income of the same is dis- tributed or distributable. The personal credits deductible from net income, as those terms are used in this discussion, must be under- stood in every respect to apply to only the normal tax and not to the surtax. In other words, if an income is $20,000 and the credits are $2,400, the net taxable in- come for the normal tax is $17,600. But for the surtax the taxable income is $20,000. There is neither credit nor exemption applicable thereto. The principal element of the exemption to be claimed is in the dividends from corporations. Dividends from United States corporations or from foreign corporations subject to tax in the United States are not subject to normal taxation. To continue the practice of illustrat- ing these points, let us suppose the case of a man with $20,000 net income and $2,400 personal credit, and $5,000 of his net income is from dividends. In such 108 INCOME AND PROFITS TAXES case, the amount of the income for the normal tax would be $15,000 minus his $2,400 personal credit. But for the surtax, it would remain at $20,000. We have discussed the question of exemption of the income from United States obligations and the peculiar methods of computing these exemptions in the cases of those obligations issued after September 24, 1917. The application of these exemptions is only for purposes of the surtax. We do not mean by this that these ex- emptions do not apply in the normal taxes, but, on the contrary, interest of United States obligations is never subject to normal tax. Again using the illustration, let us state that $2,000 of the income of the above-named taxpayer were from interest on Liberty Bonds. In that case his normal taxable income is reduced now to $13,000 minus the personal credit of $2,400 and his surtax is still on $20,000. For this illustration we assume, of course, that the $2,000 interest from Liberty Bonds does not come within the exemptions. What are called personal credits to the taxpayer are based on his domestic circumstances. The first and larg- est of these is the credit of two thousand dollars in the case of a married person, which means a man or woman living with wife or husband, as the case may be. This two thousand dollar credit also applies to what is called the head of a family. To define the head of a family it is necessary to con- sider first, what constitutes the family and second, what qualifies the taxpayer to be the head of a family. The family for this purpose is a group of two or more persons living together in one household and receiving actual support and maintenance from the taxpayer. The said taxpayer must be related to them by blood, marriage, or adoption, and the relationship, in addition to this, must THE TAX 109 be such as to give him a moral or legal right to exercise authority as head of the family. On the question of actual maintenance in one house- hold there are some minor exceptions. In the first place, the temporary absence of one or more members from the household does not preclude the availability of the credits. When such absence becomes permanent, how- ever, the credit no longer applies in so far as that indi- vidual is concerned. Where the bread-winner of a family for business rea- sons is necessarily obliged to absent himself from the family headquarters for a long period, this in itself does not remove him from the status of being the head of a family, and he is still entitled to the credit. In cases where his absence is more or less permanent, the circum- stances alone can govern the status. It is recognized that in some instances the head of a family may from necessity in obtaining employment, or necessity from the nature of his employment, be obliged to be away from his household for very long periods. It may also be true that it is more economical or more productive, or in other respects more desirable that his family remain in one place and he in another. These must not be con- fused, however, with cases where the separation is in- tentional and is based on reasons amounting to a perma- nent separation, as in the case of divorced or legally separated persons. Broadly speaking, if one person is maintaining in one household a person or persons en- titled to his or her support, this may be considered a household, and he or she considered the head unless the circumstances contradict such a presumption. These general remarks apply whether the persons de- pendent and standing as head of the family respectively are related by marriage, kinship, or otherwise. no INCOME AND PROFITS TAXES The next item is that of credits for dependents. Two hundred dollars is the deduction allowed for each person under eighteen years of age, or incapable of self-support because of mental or physical infirmities. The relation- ship which originates the dependency must be such as to imply moral or legal responsibility for support. How- ever, parents whose children receive fifty per centum or more of their support from other sources can not claim credit under this provision. The question of credits for conjugal status or for dependents depends upon the status or condition at the close of the taxable year being reported. For instance, a man whose wife died on the 29th of December would be unable to claim a married man's exemption of two thousand dollars on the 31st of December. On the other hand, if a taxpayer were married on the 29th of Decem- ber he could claim the full marital exemption on the 31st of December. The same rule applies to dependency credit. For all those Individuals except married persons and heads of families, the personal credit Is one thousand dollars with such additional credit for dependents as applies In each particular case. It is possible for a per- son to have dependents and claim credit in respect thereto even though not qualifying as head of a family. Such would be the case If a single man were supporting a close relative who was confined In an infirmary, for example. The rule as to the last day of the taxable year governs the status for these credits and Is absolutely a fixed rule. Even In cases where the taxpayer is deceased and his executor or administrator makes the return, it is the status at the date of his death which governs. The claim In such case, however, even though his death may have occurred but a short while after his previous income tax THE TAX 111 return would be for the full personal credit to which he was entitled. The same rule would apply to any return made for less than a year. It is the last day of the por- tion of the year being reported that governs the credit allowed. The surtax is a sliding scale tax. It applies to the entire net income irrespective of credits or exemptions unless specifically made to apply to surtaxes. Of course, this does not mean that the expense deductions are not applicable. The difference between gross income and net income must be borne in mind, but the entire net income after deducting such expenses as are allowed by the statute becomes taxable for the purposes of surtaxes. The surtax calculation is based on a sliding scale rate. It applies with rising proportion to each higher portion of income. The first five thousand dollars of net income bears no surtax. The next one thousand dollars bears a tax of one per centum. To express this in the language of the statute, on the income in excess of five thousand dollars and not in excess of six thousand dollars, there is a surtax of one per centum. Above six thousand dol- lars and not in excess of eight thousand dollars, the sur- tax is two per centum. Above eight thousand and not in excess of ten thousand dollars, the surtax is three per centum. This ratio of increase continues until an income of one hundred thousand dollars is reached. The tax on the last two thousand dollars of this hundred thousand dollar income, or the surtax on the income above ninety- eight thousand dollars and not in excess of one hundred thousand, is forty-eight per centum. While a table of all these surtaxes is not extremely difficult to memorize, it is somewhat useless and im- practical to do so. The amount of computation neces- sary in applying the scale step by step may be entirely 112 INCOME AND PROFITS TAXES saved by the use of the table supplied with the return blank, or that set forth in Regulations 45. The most simple method of computing the total surtax is to follow such a table. It is urged, however, that the student completely understand the scale system. It is as follows: Income up to $5,000 No surtax Income over $5,000 up to 6,000 1% Income over 6,000 up to 8,000 2% Each additional $2,000 at 1% increase in rate over the next preceding $2,000, until an income of $100,000 is reached, the last $2,000 being at the rate of 48%. After this point the scale must be committed to memory, thus : Income over $100,000 up to $150,000 52% Income over 150,000 up to 200,000 56% Income over 200,000 up to 300,000 60% Income over 300,000 up to 500,000 63% Income over 500,000 up to 1,000,000 64% Income over 1,000,000 6S% The use of the table may be briefly explained as fol- lows : If the income is ten thousand five hundred dollars subject to surtax, we first find the amount ten thousand dollars in the table, setting down the amount of the sur- tax indicated at that point. The remaining five hundred dollars of this income is then taxable at the rate applicable to income in excess of ten and not exceeding twelve thou- sand dollars, which is four per centum. There is a modification of the general surtax provision in the case of a sale of property containing mineral de- posits, that is to say mines, and oil or gas wells. If the seller of such property is the discoverer of the deposits, that is to say if he purchased the land without knowledge of the deposits therein, it is provided that the selling price minus the actual cost of the property to him, or its value THE TAX 113 March 1, 1913, shall be used In determining the profit on the sale, and that the surtax on this profit shall not ex- ceed twenty per centum of the selling price of the prop- erty. In applying this principle, we first compute the surtax on the entire income from all sources, including the profit from such sale. We then apportion the surtax thus deter- mined between the income from the profit on the sale and other income. The surtax thus allocated against such sale may now be reduced to twenty per centum of the selling price of the property if It Is in excess of that amount. This is the method of computation provided by the Bu- reau of Internal Revenue, and although there are critics of the formula it must be followed until altered. The effect of this method, of course, Is to apply the tax on the other Income at the rate computed for the whole In- come by the surtax schedule, which critics claim unfair. In case of such sales. It is very necessary to bear In mind that all expense deductible by the taxpayer must be allocated where possible against those portions of the in- come to which they apply. In other words, if any ex- penses were Incurred in connection with the discovery or sale of the mine, not previously claimed in Income tax returns, these expenses would have to be deducted from the gross profit on the sale before computing the surtax. They could not be deducted from the other income as that would effect an Improper relationship. The present rate for surtaxes has been in effect only since January 1, 1918. The rates in previous years were different. Each successive year has had its own new table of rates for surtaxation. Where income received in the current year or due to be reported for the current year has accrued in prior years, it is taxable at the rates for those prior years. While this provision has lost some of its 114 INCOME AND PROFITS TAXES importance by lapse of time, it is well to understand it. It is stipulated in all such cases that the income taxable at the current year rates shall be used In the lower brackets of the surtax table and the income taxable at prior year rates shall be used in the next higher brackets of the sur- tax table. This effectuates a considerable saving of sur- taxes in such cases as the use of the current rate first and the older and lesser rates on the higher portion of the income naturally results in a lower average. We will revert to the subject of normal taxes for a moment to explain that this difference in rate also occurs In the case of the normal tax. In the case of a return by a member of a firm with a fiscal year ending In 1919 and containing a portion of the calendar year 1918, the deduction of credits by the member must be made first to that portion of his Income which Is taxable at the 1919 rates. By application of this rule the amount taxable at the 1919 rate may differ from the amount taxable at 1918 rates. In such case the lower bracket must be used for the 1919 return and the higher bracket for the 1918 return. This is consistent with the former rule, although In this case the occurrence of such difference would effectu- ate an increase in tax. These principles apply also to income from personal service corporations. It must be remembered that per- sonal service corporations were unknown to any law prior to January 1, 1918. It follows, therefore, that if any taxpayer is reporting income from a personal service cor- poration In respect to its fiscal year including any portion of 1917, that portion of net income which was earned in 1917 is not taxable unless distributed and then taxable as dividends exempt from normal tax. The income tax on corporations Is at the present time at the rate of ten per centum on the net income. In 1918 THE TAX 115 the rate was twelve per centum. Where a corporation closes its books on a fiscal year basis and such fiscal year contains months of a calendar year with different rates, the tax to be determined is the tax based on the fiscal year apportioned according to the number of months in such year. To illustrate, assume a corporation having a fiscal year ending on August 31st. In making its return for August 31, 1919, it would close its fiscal year for a period covering four months of the calendar year 1918 and eight months of the calendar year 1919. The tax, therefore, would be four twelfths of a tax computed at twelve per centum, and eight twelfths of a tax at ten per centum. Income tax in the case of corporations is computed on the entire net income in excess of two thousand dollars. That is to say, there is a credit of two thousand dollars allowed domestic corporations. In addition to this any Liberty Bond interest subject to surtaxes in the case of individuals and to excess profits taxes in the case of cor- porations, being exempt from normal taxation may be deducted from the income subject to the corporation in- come tax. In addition to these deductions from income in connec- tion with the normal or income taxes in the case of a cor- poration, it is also allowed to deduct the entire amount of the excess profits tax computed against the same year's income. More briefly, the credits against income tax in the case of corporations are three: First, the excess profits tax computed on the same income; second. Liberty Bond in- terest not exempt from excess profit tax; and third, a spe- cific credit of two thousand dollars for domestic corpora- tions. The war and excess profits tax on corporations is the most complicated element of the entire income tax prob- 116 INCOME AND PROFITS TAXES lem. This tax is levied upon the entire net income of the corporation in excess of three thousand dollars. In other words, there is a credit for excess profits tax purposes of three thousand dollars which must not be confused with the credit of two thousand dollars for income tax pur- poses. The tax is based on the proportion of income to invest- ment, or, as expressed in the law and the Regulations, income to invested capital. Eliminating the question of 1918 rates from present consideration, we find the tax of 1919 and thereafter to be twenty per centum on so much of the net income of the corporation as is in excess of the excess profits credit, to be hereinafter explained, and not in excess of twenty per centum of the invested capital of the corporation. In other words, a corporation having an invested capital of $100,- 000 and deriving an income from its business of $30,000 would pay twenty per centum on its income in excess of the credit, $1 1,000 in this case, and not in excess of twenty per centum of its invested capital or $20,000. For all income of a corporation in excess of twenty per centum of its invested capital, the rate of taxation is forty per centum, provided that in the case of any corporation whose excess profits credit exceeds twenty per centum of its invested capital the amount of such credit in excess of said twenty per centum may be used as a credit deduction from the income subject to taxation at forty per centum. For instance, a corporation earning $6,000 subject to an excess profits credit of $4,600 on an invested capital of $20,000 would have a credit in excess of twenty per centum of its capital. It would, therefore, pay no taxes on that portion of its income which did not exceed twenty per centum of its invested capital. On the remaining $2,000, however, the tax would be forty per centum after THE TAX 117 deduction of the unused portion of the credit, or $600. The forty per centum tax would be computed solely on the remaining $1,400. We have mentioned the matter of an excess profits credit. This credit is an amount equal to eight per centum of the average invested capital of the corporation plus three thousand dollars. Invested capital will be discussed in a later chapter. The steps of the computation method are commonly styled brackets. By brackets, we mean those places in the schedule of computation to which we apply the differ- ent rates. The first bracket is that in which is placed the income of the corporation not in excess of twenty per centum of its invested capital. From that bracket we deduct the credit composed of eight per centum of the invested capital plus three thousand dollars. This is the bracket taxable at twenty per centum. The second bracket is that portion of the income which exceeds twenty per centum of the invested capital of the corporation. From this there Is no deduction unless eight per centum of the invested capital plus three thousand dollars, that is the excess profits credit as previously explained, exceeds the amount of the first bracket, or twenty per centum of the invested capital. If the credit does exceed the first bracket, the excess may be used in reducing the amount taxable under the second bracket. The tax on the second bracket is at the rate of forty per centum. In the year 1918 the rate for the first bracket was thirty per centum and the rate for the second was sixty-five per centum. In addition there was a third bracket which will be explained in a later chapter, and which is called the war profits tax. The most important necessity for referring to the rates for 1918 lies in the fact that corporations deriving Income 118 INCOME AND PROFITS TAXES from government contracts in excess of ten thousand dol- lars are taxable on such income at the 1918 rates. In such case the expenses applicable to the government contract must be deducted from that income and the expenses not applicable must be deducted from the remainder of the income in computing the tax at the true rate. Where a corporation makes a return for less than twelve months, that is where a corporation is making its first return since commencing business or is changing its previous fiscal year basis, the excess profits credit ex- plained must be such portion of credit computed for twelve months as the number of months covered by the return bears to an entire year. The proportion of income tax- able in the two brackets is also to be adjusted in this case. By way of illustration take the case of a corporation hav- ing an invested capital of $100,000, and an income of $20,000, which income is earned during a period of only eight months now being returned. The application of the amounts would be as follows : Capital, $100,000.00 Income, $20,000.00 Exemption, 8%... $8,000.00 Exemption, specific 3,000.00 Total exemption based on twelve months $11,000.00 Adjusted exemption, 8/ 12th of above 7,133.33 Calculation of Tax 1st bracket, 8/ 12th of 20% of capital $13,333.33 Less excess profits credit as above 7,133.33 Amount taxable at 20% $6,200.00 2nd bracket, all income in excess of above bracket taxable at 40% $6,666.67 For the specific protection of corporations having small THE TAX 119 capital, there is a provision in the law that in no case shall the excess profits tax be permitted to exceed twenty per centum of the amount of income in excess of three thousand dollars and not in excess of twenty thousand dollars plus forty per centum on the remainder of the income. A short form of this is the statement that the tax on the income of a corporation must not exceed forty per centum of the amount by which the net income ex- ceeds twenty thousand dollars, plus thirty-four hundred dollars. In the same manner, if the income is less than twenty thousand dollars, the tax is twenty per centum on the entire income over three thousand dollars. The tax on twenty thousand dollars will not exceed thirty-four hundred dollars, of course, when we consider the specific credit of three thousand dollars, leaving seventeen thou- sand dollars not taxable income as a maximum to that point. Again in the case of a return for less than twelve months, the twenty thousand dollar limitation and the three thousand dollar credit are to be proportionately divided into twelfths, and the number of twelfths taken equal to the number of months covered by the return. Those corporations which are exempt from income taxes under Section 23 1 are also exempt from excess profits tax. In addition to that it is, of course, logical to say that any corporation whose net income for the taxable year is less than $3,000 would be automatically exempt. As a special provision, the law contains an exception in the case of corporations engaged in the business of mining gold. In these cases that portion of the net income derived from the mining of gold is exempt from taxation so far as excess profits are concerned. The tax on the remainder of the income, however, is not com- puted separately but the tax on the entire income must be computed in the usual manner, and then so much of the 120 INCOME AND PROFITS TAXES tax as is equal to the proportion of the net income from the mining of gold to the net income from all sources is eliminated from the result. In such cases in computing the entire net income and the net income from gold min- ing respectively, the same general rules must be followed with respect to the apportionment of income in all other cases, to wit, those expenses which can be directly allo- cated to either branch of the business must be so applied and the remainder of the expenses must be apportioned in respect to the gross income from each source. To illustrate this, a corporation having an entire net income of $50,000 of which $20,000 is derived from the mining of gold would be allowed sixty per centum of the excess profits tax computed on the entire net income as its entire excess profits tax liability. We have above mentioned that where returns are made for a shorter period than twelve months a specific ex- emption is to be apportioned and only so many twelfths of such exemption used as an exemption as the number of months in the return. For this and other credit and bracket apportionments, the general rule does not recognize a fraction of a year less than a month. There is an exception to this in the case of a corporation com- mencing business during a calendar month. In such an event the number of days in the incomplete month must be used as a fraction of a twelfth. A corporation starting business on the twentieth of July would use five-twelfths as representing the number of months remaining in the year, and twelve thirty-firsts of a twelfth as representing the portion of the month of July covered by the return. We have explained that the excess profits credit is eight per centum of the invested capital of the corpora- tion plus three thousand dollars. In the case of affiliated corporations making a consolidated return only one credit THE TAX 121 of three thousand dollars is allowed notwithstanding the number of corporations in the group. In the case of individuals there is a special provision that surtax on an income part of which is derived from the sale of mineral deposits discovered by the taxpayer shall not exceed twenty per centum of the selling price of such mineral deposits. A similar provision is made for corporation excess profits taxes in a like situation. The excess profits tax on that portion of the net income shall not exceed twenty per centum of the selling price. In such case the discovery of the minerals must be during the ownership of the corporation and cannot apply in any case where the corporation purchased or acquired the property subsequent to or as a result of anticipation of the discovery of these deposits. The exemption of personal service corporations from taxation under the corporation tax provisions has been explained. Where a corporation is engaged in two kinds of business, one of which is a personal service business and the income from the personal service business is not less than thirty per centum of its entire Income, the cor- poration has a special provision In Its favor. In the first case, that part of the Income attributable to personal ser- vice business Is to be deducted from the entire net Income and a tax computed on the remainder, using only that part of the Invested capital of the business, however, which Is employed in the non-personal service part of the business and using only such portion of the specific credits as the net Income of the non-personal service business bears to the entire net income. Having computed the tax in this manner, a percentage of the income from personal service equal to the per- centage of the tax on the other business Is of the net In- come therefrom shall be considered the tax on the per- 122 INCOME AND PROFITS TAXES sonal service branch of the business, the addition of these two forming the total tax. Where as a result of such method of computation, the tax is less than twenty per centum of the income, however, the rule will not apply and the corporation must figure its taxes in the regular manner. In all such cases, allocation must be made as to the capital used in each branch of the business, as well as the expenses incurred in each. It is further provided that a reasonable amount of capital must be allotted to the personal service branch of the business in such an amount as a corporation engaged entirely in that kind of business, and with about the same volume, would be required to maintain. There is a class of cases in which the excess profits tax is computed by special provisions. These are known as special cases and may be broadly enumerated: first, those cases in which the invested capital cannot be satisfactorily determined; second, in the case of a foreign corporation; third, where a corporation has purchased assets with stock and bonds collectively and the amount purchased with each class of security cannot be segregated, or where tangible and intangible property has been purchased for stock or bonds and the amount paid for each class of property cannot be properly segregated; and fourth, where the Commissioner by application finds and declares that owing to abnormal conditions affecting the capital or income of the corporation a tax computed by the ordinary method would be a case of exceptional hardship. This last provision is absolutely prohibited in any case in which fifty per centum of the income is derived from government contracts on a cost plus basis, or where the tax computed by the ordinary method is high merely because the cor- poration earned an abnormal rate of profit. THE TAX 123 In all of these cases, the tax of the corporation qualify- ing for this special provision shall be the same proportion of its net income as the tax of similar corporations is of their respective net Incomes. Both as to the corporations used for the example or standard, and the corporation whose tax Is to be computed by this method, the net in- come on which the computation shall be made shall be the net income after the deduction of the three thousand dollar exemption. This would not apply, however. In the case of foreign corporations, because no specific exemp- tion would be applicable and In that case those domestic corporations used as a standard would be figured without the deduction of the three thousand dollars. Where this method of determining the tax is used, a tax in the first instance must be computed by the ordinary method using such invested capital and Income as can be ascertained. If such tax exceeds fifty per centum of the net income of the corporation, the first payment to be made and the estimated tax for the tentative return shall be fifty per centum of the income. If however, the tax is less than fifty per centum of the income, the amount shall be computed and the first payment made on the basis of the tax as actually figured. As the maximum rate for 1919 is only forty per centum, this provision is obsolete, being useful only In respect to the 1918 rates. The student will now read, in the order given. Regula- tions 45, Articles 1533; 1 ; 2; 3; 301 ; 302; 303; 304 305; 11; 12; 13; 715; 1624; 1625; 324; 325; 326 327; 329; 332; 333; 334; 335; 1641; 501; 502; 951 952; 953; 954; 955; 1621; 1622; 1623 ; 720; 761 ; 701 711; 713; 791; 716; 718; 731; 732; 733; 714; 719 751; 752; 753; 971; 972; 741; 742; 743; 901; 911 912; 914. CHAPTER X INVESTED CAPITAL The credit for excess profits taxes (also for war profits taxes which will be discussed later) is based on the in- vested capital of a corporation. It is necessary for us to consider, therefore, the invested capital as defined by the law and the Regulations. Ordinarily speaking the calculation of the invested capital of a corporation be- gins with those accounts commonly classified in balance sheet preparation as the proprietorship group. This group includes capital stock outstanding, whether com- mon or preferred; all surplus whether paid-in or earned, including so-called undivided profits; and those reserves which are mere segregations of the surplus account and not statistical records of accrued expenses or deprecia- tion, or, in the language of the Regulations, "reserves, the additions to which are not deductible in computing net income." Besides this we are obliged to consider certain of the assets under special conditions provided for them. These provisions relate to the admissibility as invested capital of a business of certain of the assets under qualifi- cations predicated on the circumstances surrounding their acquisition by the corporation or the nature and char- acter of the assets themselves or the taxability of the in- come derived therefrom. The first account to be considered for this purpose is the capital stock account. Associated with this, however, are such accounts as treasury stock, donated capital, dis- count and premium on stock sold, etc. The accountant will realize that the capital stock account when considered in conjunction with these relative accounts mentioned above determines In the last analysis the actual amount 124 INVESTED CAPITAL 125 of capital paid in. The actual amount of capital paid in is, therefore, the first item in the determination of in- vested capital. If this has been paid in with cash there is no question as to its admissibility. If it has been paid in with other properties, the equivalent of cash, or having an actual tangible cash value, there is also no question of the admissibility other than such questions as may be raised in respect to the value. If such value is greater or less than the par value of the stock issued for the said property it is necessary to adjust the capital stock account by the amount represent- ing the difference at the time of its issue. This situation arises principally where stock has been paid out or issued for property in excess of its par value, a practice some- times indulged in by corporations. In such case, in order to demonstrate the actual value of the property, the tax- payer is required to prove by disinterested appraisal or other reasonable evidence, the true value of the property so paid in before he can add the difference to his invested capital. Where the amount of stock issued is greater than the value of the assets paid in, it will usually be found that the difference has been set up as an additional asset usually called good will or some equivalent title. The discussion of good will and franchise will be de- ferred until later in the chapter. We have mentioned that some assets are classified as inadmissible for the purpose of invested capital. In such case, the admissibility of items does not affect the capital statement but the adjustment for inadmissibility is made under a different heading. If the property paid in is a mixture of tangible and intangible property not segregated in the accounting, the burden is upon the taxpayer to establish the values of the various elements entering into the transaction. Thus for 126 INCOME AND PROFITS TAXES example, if the stock of the corporation were issued en bloc for a stock in trade, furniture, and fixtures, and an assumed good will of no stated value, the fair appraised value of the actual physical properties would be used as the basis for determining by deduction from the total and capital stock issued, the assumed value of the good will. In such case, however, the value of this good will would still be inconclusive as stated and it would be subject to further demonstration as will be discussed under the head of intangibles. Subscribers to the stock of a new corporation fre- quently purchase the same with their notes or other obli- gations or on open account. The admissibility of such transactions for the purpose of determining the cash or equivalent paid in depends on the legality of the contract on which the transaction was based. It depends also on the collectability of the account and in some respects must be determined with reference to the intent of the parties with respect to actual payment, so far as the same can be ascertained. It sometimes happens that a corporation will issue stock as a bonus or premium for other stock or bonds pur- chased by the person accepting the stock. In such case, It is necessary to bear in mind that if the bonds, having the stock as a premium, sold for a price which could not have been realized without such inducement it is fair to claim that the value of the stock was the better price ob- tained. Under such circumstances the question of the amortization of the premium paid on the bonds, or more likely the discount allowed on the bonds, is necessarily to be considered. Where such bonds and stock are issued conjunctively for assets other than cash, a question always arises as to which of the securities paid for which asset. In the ab- INVESTED CAPITAL 127 sence of evidence to the contrary In such case, It will be assumed that the bonds were issued for the tangible prop- erty and the stock for the intangible. If In such case the fair value of the bonds is not sufficient to pay entirely for the tangible property, the difference must be added to the intangibles in estimating the selling price of the stock. Stock returned to the corporation as a gift, donation to working capital, or under any other method by which corporations are financed, must be excluded from paid In stock. If, however, such stock Is resold, the proceeds of the sale are paid in stock to the extent of the amount realized. Where its own stock is acquired by a corporation through open purchase. It must be deducted from the stock outstanding at its par value. The difference be- tween the price paid and the par value constitutes a neces- sary adjustment of the company surplus. The net result of this provision is that the actual cost of the stock pur- chased is effective as a deduction from the invested capi- tal. Where such a transaction occurs during a taxable year of a corporation, the amount paid for the stock must be deducted as of the date of its payment, and If any part of the amount so paid is from current earnings, only so much as was not so paid out of current earnings must be considered In the adjustment. Where stock thus bought is resold the resulting gain or loss, although not affecting income, must be considered in adjusting the surplus and undivided profits of the cor- poration when setting up invested capital. If both the purchase and sale occur in the taxable year and any part of the purchase price Is out of current earnings, the In- clusion of this much of the selling price is prohibited. The next usual account is the surplus and undivided 128 INCOME AND PROFITS TAXES profits account whether carried in one or more accounts. As a matter of fact this element of the proprietorship may be represented in numerous accounts in some cor- porations. In that event all of them should be considered a part of one surplus account. The first and more com- mon separate account is found where there is a paid-in surplus or amount originally paid in for stock in excess of the actual par value thereof. This paid-in surplus has been discussed previously but is mentioned again because it usually appears as a part of the surplus and undivided profits group of accounts. It is admissible. Next, we find the earned surplus, in reality the accumu- lation of undivided or undistributed profits. This por- tion of the capital is admissible but some remarks are necessary to explain the care which must be exercised in using it. This care is necessitated by reason of fre- quent misapplication of expenditures and receipts result- ing in a situation where so-called undivided profits are a misstatement of the facts. The most glaring violation of correct accounting prin- ciples in connection with the undivided profits account is usually found in a misapplication of depreciation. Either the annual adjustments have not included a proper allow- ance for depreciation actually occurring, or on the other hand the depreciation charges have been made excessive in an effort to avoid overstating income. In either case an adjustment or correction must be made, not necessarily on the books, but for the purposes of a return. That is to say that if excessive depreciation has been charged in previous years, the matter should be adjusted in order to correct the undivided profits account to its true status. Likewise, insufficient depreciation charges in previous years must be recognized by a proper reduction of the undivided profits account. It is usually a necessary inci- INVESTED CAPITAL 129 dent to revise previous tax returns in making such adjust- ments, and this is permitted by the Department. Where the accounting includes proper deductions for depreciation, but the classification or arrangement of the accounting does not disclose that fact, it will become necessary to demonstrate to the Bureau, or its representa- tive, that the amount charged as expense from year to year has Included a proper allowance for depreciation. Similar adjustments are required where expenditures are made and charged to expense which should be in- cluded as capital Items. This very frequently occurs in businesses conservatively managed where administrative officers will buy small or large equipment, or other per- manent assets, having a life of more than the normal one year period, and charge these articles to expense rather than overstate the income. In former years, it was quite the practice among conservative business men to consider as actually gone from all further valuation all small articles of plant and equipment which could possibly be so construed, preferring not to "fool themselves." As a matter of fact, fooling oneself by overburdening a busi- ness Is as bad as the opposite case, although It has some justification in conservatism. When such cases exist the amount can be restored to the surplus or undivided profits by capitalizing them, but this will necessitate the revision of the tax returns for those years during which they were charged as expenses. The general principle is laid down that where such errors are errors of fact based on actual occurrences, the correction of the previous returns and the correction of the capital of the company Is permissible. Where, however, the allocation of the items forming the basis of the claim for the increase In capital is a matter of judgment, discretion, or optional business policy. It follows that they must remain as already determined and 130 INCOME AND PROFITS TAXES charged since the corporation will be conclusively pre- sumed to have selected its method. To carry this discussion on this particular point a little further, we may cite as illustrations, cases where the en- tire value of tangible or intangible assets has been written off the books in the effort to avoid an overestimation of income. Even where such is the case, the valuation sub- ject to reasonable depreciation on the date of the return may be restored by a proper revision of previous account- ing and tax returns. Among those items, charged to expense and not to capi- tal, constituting an election method which prevents the restoration of the items to invested capital, we may men- tion that intangible assets are particularly considered in this light. Patents, drawings, models, etc., if once charged to expense cannot be restored by a revision, the election already made binding the corporation. Draw- ings and models although tangible are intangible when considering values. With regard to all of this general subject of restitution of depreciation or depletion charges in excess of the actual facts, let us say a word concerning the matter of valua- tion at March 1, 1913. While this date may be used as a basis for determining the value of an asset, either for the purpose of calculating a profit on a sale or for the pur- poses of determining what is a proper depreciation rate for the remaining life of the asset, let it be distinctly borne in mind, that values at March 1, 1913, have no bearing on invested capital. To illustrate this we will assume the asset a machine which cost $20,000 in 1910, on which depreciation has been charged at the rate of five per centum per annum. On March 1, 1913, the resi- dual value of this machine was the original cost or $20,000 minus three years' depreciation of fifteen per INVESTED CAPITAL 131 centum, leaving a then value of $17,000. Now the re- maining estimated life of this machine is seventeen years and under normal conditions it would be assumed that five per centum continued for the remaining seventeen years would provide a fund sufficient to replace the ma- chine. As a matter of fact the machine was really worth more than $17,000 on March 1, 1913, owing to differing conditions surrounding its manufacture. We will suppose the value of the machine to have increased fifty per centum because of these conditions. In that case the value on March 1, 1913, would be $25,500, and the future depreciation on the same would be five per centum of an original cost of $30,000, subjecting the remaining seventeen years of its life to a depreciation of $1,500 per annum instead of $1,000 per annum, which would be the amount based on the original valuation. This is proper so far as treatment of depreciation for income purposes is concerned. It would also be proper for treatment of a case where the machine was sold prior to its exhaustion and the cost would in that instance be considered the value on March 1, 1913, less the accrued depreciation from that date to the date of sale. But when we come to the ques- tion of dealing with invested capital we must bear in mind the fact that the appreciation in value of that machine while it may be an absolute fact has not been paid for by the corporation. The actual cost of that machine for the purposes of invested capital is only twenty thousand dol- lars minus all depreciation charges. Under such circum- stances we have the following situation. The original cost was $20,000. The depreciation to March 1, 1913, was $3,000, being at five per centum per annum. The depreciation from March 1, 1913, to date (1920) would be at the rate of fifteen hundred dollars per annum or five per centum on the appreciated value. The accumu- 132 INCOME AND PROFITS TAXES lated depreciation is therefore the sum of three times one thousand dollars and seven times fifteen hundred dollars, a total of thirteen thousand five hundred dollars. It is not quite correct to say that the present value of that machine is only $6,500. As a matter of fact, without the calculation of the depreciation element, the present value is $10,000, based on cost and ten years' use at five per centum per annum. We are, therefore, permitted by the Regulations to restore the value to $10,000 by reducing the depreciation to the rate which bears on the invested capital in the machine and not on the appreciated value. The effect of this permission is the restoration to surplus and undivided profits of so much of the depreciation charges from year to year as have constituted a charge, or a realization against the appreciation based on ap- praisal March 1, 1913. The student should again read this entire illustration, set forth the facts on paper, and analyze the case for a thorough understanding of the prin- ciple involved. The next item entering into the necessary adjustment of the surplus or undivided profits account is that which relates to the income and excess profits taxes for the pre- ceding year. The student will gather that the income of the preceding year is necessarily merged in the surplus and undivided profits at the beginning of the present or taxable year. Against this income there is an income and excess profits tax liability which will have to be paid dur- ing the taxable year. Some accountants after computing the income and excess profits tax for the year set up a reserve for the amount and carry this reserve to avoid overstating the surplus account. The effect is absolutely the same whether or not this is actually done. This tax liability of a corporation on a given year's income is con- strued to be an actual liability as of the close of that par- INVESTED CAPITAL 133 ticular fiscal year whether or not it is entered on the books. It follows, therefore, that in order to determine the true surplus and undivided profits of the corporation, there must be taken out of the same, either by way of a reserve account or by collateral computation for the pur- poses of the return, the amount of these income and ex- cess profits taxes. The law and the Regulations provide that income and excess profits taxes are not payable all at once but in in- stalments. As you will learn, these instalments are due on certain dates at three month intervals during the fol- lowing year. For this reason the amount of these taxes may be included or retained in the surplus until the said taxes are actually due. Let us see the application of this in figures. Assume a corporation dealing with its affairs on a calendar year basis. We will consider the calendar year 1919 and the surplus and undivided profits at the close of such year for the purpose of the 1920 return. This corporation's taxes for 1919 will be due as follows twenty-five per centum of the tax on March 15, 1920 twenty-five per centum of the tax on June 15, 1920 twenty-five per centum of the tax on September 15, 1920 and twenty-five per centum on December 15, 1920. The deduction or adjustment of the surplus of the company for the year 1920, in order to determine Its Invested capi- tal, may be considered either positively or negatively, that is to say that we may either consider that a reserve for these taxes is deducted as of the beginning of the year and then restored for the length of time during which the taxes are not yet due or we may consider that such a reserve has not been created and deduct the taxes from the date that they are due in proper proportion. As the actual setting up of the reserve is less commonly 134 INCOME AND PROFITS TAXES met with than the case where this is not done, we will con- sider the matter from the negative viewpoint. The cor- poration's excess profits and income tax for 1919, we will say, amounted to fifty thousand dollars. We are to de- duct this tax as of the dates when it was due and payable and the process is as follows : The first instalment of twelve thousand five hundred dollars was due on March 15th. There are seventy-four days in the year prior to the date the tax instalment is due, to wit, January, thirty-one; February, twenty-nine; and March, fourteen days. The twelve thousand five hundred dollars or twenty-five per centum of the entire tax must be deducted from the capital for the remainder of the year. In other words, this twenty-five per centum must be deducted for two hundred and ninety-two days. As there are three hundred and sixty-six days in 1920, we find that we must deduct a fraction of twelve thousand five hundred dollars, of which fraction the numerator is two hundred and ninety-two and the denominator is three hundred and sixty-six. We have now covered the first instalment of the tax. The student will note that at this point in deducting the tax, the date on which it falls due is included in the deduction. This means that the amount of the instalment is only assumed to have been left in the business for those days up to the day on which the tax is due. The next instalment of this tax is due ninety-two days later. This number of days added to the previous seventy-four makes a total of one hundred and sixty-six days for which this second instalment may be included in the invested capital. Using this total as a subtrahend we find the remaining number of days in the year to be two hundred. The second instalment must, therefore, be removed from the invested capital for two hundred- INVESTED CAPITAL 135 three hundred sixty-sixths of the year. This procedure will be continued through the third and fourth instal- ments to find the entire deduction. The author, not to inflict his own practices on the stu- dent but as a suggestion, has found it much more simple to determine the number of days remaining in the year after the maturity of each instalment, add these in four items, averaging them by division by four, and then take that as the numerator with the number of days in the year as the denominator of the fraction for computing the de- duction. In this manner of calculation, the result is as follows : The first instalment has two hundred and ninety- two days to deduct; the second, two hundred; the third, one hundred and eight; and the fourth has seventeen. The average of these is one hundred and fifty-four and one-fourth. Therefore, if we take one hundred fifty- four and one-fourth three hundred sixty-sixths of fifty thousand dollars, the result is obtained much more rapidly. There are some other quite important items to be con- sidered in adjusting invested capital. Among these we will find the matter of insurance paid by a corporation on the lives of its officers and employes in which the cor- poration is the beneficiary. The student will recall that the expense of this insurance is not deductible. As this expense is not deductible it amounts to a deprivation to the corporation if it cannot be used as a permanent asset in some way. The Regulations therefore permit that the cash surrender value of the policy may be included as of the beginning of the year. In addition to this, the addi- tional cash surrender value may be added to the invested capital from year to year as it is increased by the payment of additional premiums. The author makes the sugges- tion that this provision on the part of the Bureau is rather 136 INCOME AND PROFITS TAXES illogical. If the entire expense of the premium is a non- deductible item so far as income is concerned, it would appear only fair to permit the inclusion of the entire accumulation of premiums as the policy valuation. This is only mentioned in passing; the Regulations do not permit it and the student is warned against being misled. The true valuation on the policy for the purposes of in- vested capital is the cash surrender value as of the be- ginning of the taxable year. It is specifically prohibited in the statute to consider in any way as a part of the invested capital those profits earned during the taxable year. Current profits shall not be included in invested capital under any conditions. This Incorrect inclusion of current profits might otherwise be attempted, wittingly or unwittingly, in the case of prop- erty taken in for debt, or property received in exchange for other assets of the corporation. Where such change or collection of debts in this manner results in the acquisi- tion of property in excess of the value of the assets sur- rendered, a profit is involved but the valuation on the assets so acquired cannot be included in invested capital at more than the amount actually surrendered. Such profit as has been realized by this method must be con- strued as a profit of the taxable year, and will not affect the capital until the following years. Discount on the sale of bonds has been mentioned un- der a preceding subject. You will recall that there is a considerable discussion of the amortization of such dis- count. Such discount may be included in invested capital but only if it has been properly amortized and reduced to the true present worth of the unamortized balance. It is to be remarked for the Information of the student that many of the banks in the country are in the habit of accruing their earnings with respect to interest. The un- INVESTED CAPITAL 137 earned balances of these discounts are deferred liabilities. It might be better to describe them as deferred gains. These unearned discounts are reserves and cannot be included in invested capital. Collateral to this is the case of those businesses which engage in the sale of property, either real or personal, on the instalment plan and make their return of profits on the instalment basis calculated in proportion to the amount collected from year to year. So much of the profit as is deferred by this method must be excluded in invested capital. The student will see the logic of this provision. If we are permitted to defer the profits on a business of this character in computing in- come, we should be properly and justly prevented from adding the same to the invested capital computed for the following year. There is one striking exception or rather one striking instance in which current profits may by indirection be included in current or taxable year invested capital. This instance arises where dividends are paid in cash out of current profits and the stockholders utilize the funds thus received in the purchase of additional stock in the cor- poration. Of course, it is little more nor less than a stock dividend in such a case except that as long as the option to purchase or not to purchase the stock lies with the individual stockholder and is not controlled by the corporation it cannot be styled a stock dividend, and, therefore, in so far as the dividend is actually paid out of current profits it effects an accretion of these current profits to the invested capital for the taxable year. Lest the student be misled into thinking that this is a wonder- ful method of doing something which is broadly pro- hibited, we feel it only proper to explain the possibilities of such a situation. Under the original law a stock dividend was taxable 138 INCOME AND PROFITS TAXES but that provision of the law was declared erroneous by the Supreme Court of the United States. Now, if a cor- poration is prepared to declare a stock dividend and does so, it follows that as there is nothing going out of the corporation the whole effect of the transaction is merely a book entry diverting a certain amount of money from surplus to capital. There is no change in invested capital effected by the stock dividend. Furthermore the basis of the Supreme Court's decision was that the stockholders receive nothing and therefore could not be taxed since the income was nothing. If, however, a corporation un- der the circumstances described above declares a cash dividend and at the same time offers for sale an equiva- lent in capital stock, making it entirely optional with the stockholder to use his dividend for the purchase of stock in the corporation, this amounts to a sale of stock by the corporation and it would have the same effect as the sale of stock under any other circumstances. It would amount to an addition to the capitalization of the corporation as of the date of sale. So far so good, but the other side of the situation is that in this case instead of being free from taxation on the dividend in this wise, the stock- holder has received a cash dividend and a cash dividend as you know is taxable so far as surtaxes are concerned. It therefore follows that this is not a particularly happy solution of the possibilities of increasing invested capital unless the stockholders are ready and willing to bear their surtaxes on the operation. The converse or reverse of undivided profits or sur- plus is deficit. A deficit exists on the books of any cor- poration in which the actual net worth of the corporation has been reduced below the original proprietorship. Now, a deficit may be incurred in more than one way. It may have been created at the organization of the corporation INVESTED CAPITAL 139 by the issuing of a lot of stock for which no value was received. While this is unlawful in most jurisdictions, it is sometimes done and has been done in the past before corporations were subject to such rigid laws. Such a deficit might also occur from operating losses. Such deficits are usually styled impairment of capital. The use of a deficit of the corporation, if such deficit exists, is always a matter requiring some history of the business. If such a deficit has been incurred by operating losses and expenses, the same need not be deducted from the primary capitalization, which will be understood if we bear in mind that the item we are seeking to recon- struct is invested capital, and where capital has once been actually invested in a corporation, it remains for this pur- pose so long as it is not distributed to stockholders by way of dividends or liquidation. As against such deficit, however or whenever the same may have been incurred, all later earned profits must be applied in reduction before any surplus can be admitted. The theory of admitting a surplus is that it is money earned and left in the business for its use in operations. It would, therefore, be unreasonable to suggest that hav- ing dissipated any portion of the original investment in periods of unprofitable operation, the later profits could be considered an addition to the capital until that capital was first restored to its prime condition. Borrowed capital is not admissible. This means that the funds used in a business but constituting a liability of the company, having equal rank with or priority over the general creditors, cannot be considered a part of the in- vestment on which the concern is operating. It must also be noted that liabilities arising by such processes as the creation of salary indebtedness to be compensated at later periods or withdrawn at the convenience of the employe, 140 INCOME AND PROFITS TAXES cannot be construed to be left in the business for inclusion in the invested capital. Having arrived at a true determination of the actual net worth or the proprietorship of the corporation, we are not confronted with the necessity of dealing with some of the assets at other than their book or true value. In other words, we are confronted with the necessity for adjusting the invested capital by reason of the inadmis- sibility of some of the assets. For this a few definitions will form a very desirable preface. Under ordinary circumstances, the words "tan- gible" and "intangible" have a distinct English meaning which the student of income taxes is compelled to ignore for the purposes of computing invested capital. "In- tangible property" includes those things which the statute enumerates as "patents, copyrights, secret processes and formulae, good will, trademarks, trade brands, franchises, and other like property." It will be recognized at once that this limitation on the meaning of the word does not comprehend its true English significance. In the follow- ing paragraph of the statute "tangible property" is de- fined to include stocks, bonds, notes, and other evidences of indebtedness, bills and accounts receivable, leaseholds, and all other property other than intangible. The latter list, strictly speaking, is intangible property but for the purposes of excess profits taxes the distinction is based not on the question of tangibility but on the character of the property, and is directed to the elimination of those matters usually amounting to "water." In computing the invested capital of a corporation the intangibles above enumerated are to be included to a limited degree only, hence the necessity for care in the definition. All assets paid for with cash or its equivalent are ad- missible at cost of purchase subject, of course, to any INVESTED CAPITAL 141 depreciations which have accrued. All tangible assets paid for with stock are admissible for their fair value as of the date of purchase, also subject to such depreciation as may be applicable and regardless of the par value of the stock issued for the same. Where the par value of such stock is different from the true value of the assets, so equalized, it becomes necessary to modify the Invested capital so far as the capital stock account is concerned. We have discussed the general principles of adjusting capital paid in for the correct valuation of property other than cash in the first part of the chapter. We only men- tion them again In order to lead up to our next subject. Where intangible property has been paid for In stock we are confronted with the theory that such Intangibles nominally represent nothing more nor less than "water." This comprehends that class enumerated above under the definition of Intangibles. Invested capital must be re- duced by the amount of these intangibles In so far as their book value exceeds the specific limit on admissibility. This limit may be briefly stated as follows : First, the cash value of the Intangible asset when ac- quired; second, the par value of the stock issued therefor; third, twenty-five per centum of the par value of the stock outstanding on March 3, 1917, If such asset were acquired prior to that date; and fourth, twenty-five per centum of the par value of the stock outstanding at the beginning of the taxable year. The application of this limitation Is as follows : If the book value of the intangible asset Is greater than any of the above limits, then the difference between the book value and the smallest of the limits must be deducted from the invested capital. You will recall in an earlier chapter the exemption from taxation applicable to certain kinds of investments, most particularly the income from municipal or other govern- 142 INCOME AND PROFITS TAXES ment securities. If such income is not taxable, it follows logically that the taxable income of the corporation is in no wise derived from the amount invested therein. For this reason such assets cannot be included in invested capi- tal. There are some modifications of this rule, however. First, the usual preferential treatment of United States securities in this case permits the inclusion in invested capital of all such, notwithstanding such exemptions as may apply to the income therefrom. Second, stocks from which the dividends are not tax- able must also be excluded from invested capital. As an offset to this exclusion let us revert to the provision that interest paid or incurred to carry securities the income from which is not taxable, does not constitute a deductible expense. The effect of this provision is to nullify the exemption of such income from taxation since the interest thus paid not being deductible as an expense, the benefit of the exemption is virtually neutralized. Where this is the case the assets from which such income is derived become admissible or, as the law expresses it, "not inad- missible" for a corresponding part of the capital invested therein. What is meant by "corresponding part" is not definitely covered by the Regulations, but it seems to be most generally accepted that the proper interpretation Is as follows : Where the corporation owns such tax exempt securities but is carrying loans against them, the proportion of the securities which is not inadmissible is that proportion which the interest paid bears to the income derived, as- suming, of course, that the interest paid is not in excess of the income. There are those who claim that the propor- tion should be computed by deducting from the value of the securities the amount of the loan against them, and that the excess in such case will be the only portion inad- INVESTED CAPITAL 143 missible. This, at least, has the merit of eliminating all questions of differentiating between the interest and in- come rates. It must be admitted, however, that the weight of authority seems to prefer the first viewpoint. There is another modification of the inadmissibility of securities which is based on the fact that regardless of their nature any profits derived from the sale of the same becomes taxable income. It is provided, therefore, that if any of the income of the corporation consists of profits derived from the sale of such inadmissible assets, those assets may be included in the invested capital up to the date of sale and thereafter the question of inadmissibility would depend on the application of the proceeds of such sale. The situation outlined in the aforegoing sentences ex- ists only where the entire income derived from the securi- ties in question consists of the profit earned from the sale. If in addition to this profit any dividends or other income has been realized from such assets, there is a ques- tion of apportionment involved. The amount of the as- sets which is to be deemed not inadmissible is that propor- tion which the profit taxable bears to the entire income derived from such securities. There is an illustration in Article 817 of the Regulations but we believe it should be expressed more clearly. The figures quoted in the illustration include two hundred thousand dollars of stock in the corporation from which was derived as profits dur- ing the year three thousand dollars on the sale of a por- tion and five thousand dollars from dividends. It is not clearly shown as to how the apportionment is made, but the fact is that the amount determined to be admissible is three thousand dollars, or the proportion which the profits from the sale bears to the entire income derived from this security. 144 INCOME AND PROFITS TAXES In using the averages explained in the preceding para- graph, let it be borne in mind that the assets of the cor- poration must be first cleared of all intangible assets. To illustrate this in the example quoted, you will recall that the corporation had one million dollars in assets and half a million in liabilities and that the average of these was taken for the purpose of determining the proportion of inadmissibles as of the beginning of the year. Had we carried this calculation further so as to show the status of this company at the end of the year, it might have pro- duced the following result : Assets, beginning of the year $1,000,000 Assets, close of the year 1,500,000 Average, $1,250,000 Liabilities, beginning of the year $500,000 Liabilities, close of the year 600,000 Average, $550,000 Net worth, beginning of the year $500,000 Net worth, close of the year 900,000 Average, $700,000 Now, if the inadmissible assets of two hundred and fifty thousand dollars are to be used as the basis of com- putation, this amount is twenty per centum of the average assets during the year. The amount to be declared inad- missible, therefore, would be said two hundred and fifty thousand dollars minus one hundred and ten thousand dollars, or twenty per centum of the average liabilities, leaving one hundred and forty thousand dollars to be construed as inadmissible. However, if among the assets there was a good will of which one hundred and twenty-five thousand dollars was inadmissible because In excess of the limitation, we would have to remove this amount from both the assets at the INVESTED CAPITAL 145 beginning and the assets at the close of the year, or in effect from the average. The result would be the reduction of the average assets to eleven hundred and twenty-five thousand dollars of which the inadmissible assets amounting to two hundred and fifty thousand dollars are two-ninths. From the amount of the above inadmissibles, therefore, we could only deduct a corresponding percentage of the liabilities, or one hundred twenty-two thousand, two hundred twenty- two dollars, making the amount of the ultimate inadmis- sibility one hundred twenty-seven thousand seven hundred seventy-seven dollars and seventy-seven cents. Again we suggest that the student set these figures forth in a table so as to understand them clearly. We are not setting them forth ourselves because we believe it is well for the student to do so. The problem involved in all of these foregoing matters of inadmissibility is that of averaging. The amount of the inadmissibility is to be apportioned between the as- sets, admissible and inadmissible respectively, and the liabilities. The law provides that the proportion of as- sets to be termed inadmissible shall be reduced by that proportion of the liabilities which the inadmissible assets bear to all the assets of the corporation. This is on the principle that its liabilities can be assumed to have been incurred ratably for the acquisition of both classes of assets. To illustrate this, assume a corporation's assets to aggregate $1,000,000 and its liabilities $500,000, but that of its assets $250,000 are inadmissibles. The theory of the provision is that as one-fourth of the assets are in- admissible, so one-fourth of the liabilities may be assumed to have been incurred on account of the same, and the following table will illustrate the computation of the in- admissibilities : 146 INCOME AND PROFITS TAXES Total Inadmissibles Admissibles Assets $1,000,000 $250,000 $750,000 Liabilities 500,000 125,000 375,000 Net Worth $500,000 $125,000 $375,000 We have used "net worth" in lieu of capital and sur- plus for simplification. Averaging the ratio of assets to liabilities over the en- tire taxable year confronts us as a still further complica- tion of this question. For simplicity it is usually permit- ted to obtain the average assets and liabilities respec- tively by adding the amounts of each at the beginning and at the close of the year, and dividing them by two. Having arrived at this average, the table shown above would be used against the average net worth, assets, and liabilities respectively in lieu of either the beginning or closing status of the year. That method, however, is not practicable when there are any wide variations in the ratio of admissible to inadmissible assets during the year. In such case the several periods marking the changes in the inadmissibility should be utilized independently of each other in computing an average for the year. In other words, starting with the beginning of the year, the first period to be considered would be that period during which there was no change in the amount of inadmissible assets. At the end of that time an average of the assets and lia- bilities at the beginning and closing of that period would be used in determining the proportion of inadmissibility applicable for the number of days in the period. This same process would be repeated for the next period dur- ing which no changes occurred. Each period, of course, is measured in days as three hundred sixty-fifths or sixths of a year. Of course all of the aforegoing discussion of invested INVESTED CAPITAL 147 capital is on the assumption that we are considering a full year of twelve months. If a return is made for a period less than a year the average in every instance must be made on the actual number of days in the period cov- ered by the return. In a case where a return was being made for a period beginning July 1st and ending Decem- ber 31st, the denominator of all of the fractional adjust- ments above described would be one hundred eighty- fourths instead of three hundred sixty-fifths or sixths. In addition to this the invested capital at the beginning of the period is only effective, or made use of, for the earning of income during the six months in the period. It follows that our invested capital must be reduced to six- twelfths of the amount in order to determine to what ex- tent it should be used in adjusting the exemption of the corporation for excess profits taxes. This has been ex- plained in another way in a previous chapter. In that chapter we stated that all exemptions and credits, all brackets, and other stages of the calculation of an excess profits tax for a period of less than one year must be divided by the number twelve and multiplied by the num- ber of months in the return. In other words, you take so many twelfths of all of the brackets and the exemp- tions as the number of months in the return bears to the calendar year. The student will note that the application of the number of the months for the purpose of these adjustments in the one case is quite different from the ap- plication of the number of days in another, and care must be taken to apply the right principle in each case. We have now considered the calculation of capital for intangibles and inadmissibles. Up to the present point we have dealt only with the basic capital of the corpora- tion as of the beginning of the taxable year, the only ad- justments amounting to an averaging, being in respect to 148 INCOME AND PROFITS TAXES the inadmissibilities and the income tax reserve. The principle of averaging, however, must be carried consid- erably further. All changes in the invested capital occur- ring during the year must be reflected in the average capital on which the exemption is to be computed. These changes in the invested capital arise from additional capi- tal acquired or capital or profits distributed. The most common item which would affect the capital account would consist of the sale of treasury or original stock, or the purchase or retirement of stock by the corporation. If the corporation sells its stock during the year. It neces- sarily Increases the investment in the business to the amount of the proceeds of such sale. If a corporation purchases its own stock, it necessarily reduces the invest- ment of the business by the cost of the same whether or not such stock be retired or held in the treasury. Again, a corporation may acquire additional capital by levying an assessment on its stockholders, or it may reduce Its capital by what is known as liquidation of part of its capitaliza- tion. Any of the foregoing transactions would affect the capital from the date of Its occurrence to the close of the year. By way of illustration assume that a corporation had $10,000 In stock outstanding at the beginning of the year and on the first of July sold an additional $10,000 in stock. This additional investment would have been a part of the invested capital of the business for 184 days of the year. The amount realized, therefore, can be added to the capital to the extent of 184/365 (or 184/366) of the $10,000. This method of calculation would apply equally to a reduction of the Investment by the purchase and retirement of stock, or in any other manner above set forth. Changes in the earned surplus of the corporation occur by reason of profits or losses during the year, and by dis- INVESTED CAPITAL 149 tributlons of the same in dividends In case of profits. It Is specifically provided, however, that the gain or loss dur- ing the taxable year shall in no case be permitted to effect a change in the invested capital. Consequently the only Item which can affect the undivided profits, in fact, is the matter of dividends, or other distributions. Where such dividends are made they are assumed to be paid from the undivided profits as shown by the books at the beginning of a taxable year, unless It can be demonstrated that such dividends were In fact paid from the current gains of the corporation, and such current gains were adequate to meet the said dividends at the date of their payment. In the absence of proof to the contrary, a period of sixty days from the beginning of the taxable year is pre- sumed to be that period during which any dividends, if paid, would have been paid from the previous year's ac- cumulated profits. After such sixty-day period the nor- mal presumption Is that the dividends are probably from current earnings provided such current earnings are suffi- cient to meet the same. The presumption In the above mentioned case must be supported by a proper showing of fact to support a claim that the dividends were paid from adequate current earnings. When such dividends do result In a necessary deduction from previously earned profits, the computation Is the same as that with respect to the sale of stock, to wit, that from the date on which such dividend was paid to the close of the year, both dates inclusive, the number of days must be taken as three hun- dred and sixty-fifths (or sixths) of the year and the de- duction from capital apportioned accordingly. In determining whether or not the accumulation of current earnings is sufficient to meet the dividend, the tax- payer must proceed as follows : First, the income already determined for the year will be apportioned up to the 150 INCOME AND PROFITS TAXES time the dividend was paid; next, the amount of accrued earnings must be reduced by the amount of the accrued federal income and profits taxes to the same date, these taxes being the taxes pertaining to the current year ; then, from this amount must be deducted any dividend paid prior to the one under consideration unless paid out of prior years' earnings; and then this remainder must be still further reduced by any withdrawals of capital, such as amounts paid for its own stock to retire same or hold in the treasury. The net result will disclose whether or not the dividends under consideration could have been paid out of current earnings. The student will note that one of the items to be de- ducted in determining this net result is the income and excess profits taxes for the current taxable year accrued to the date of payment of the dividend. It is, of course, apparent that any such taxes cannot be calculated without advance knowledge of the extent to which the invested capital is to be affected by the dividends, the application of which dividends we are now striving to ascertain. As a tentative computation of taxes, therefore, the corpora- tion is permitted to use its invested capital at the be- ginning of the year plus any additions prior to the end of the year and minus any withdrawals prior to the end of the year. This gives us a tentative base for the estima- tion of the income and excess profits taxes, and on this estimate the average for the purpose of determining whether or not the dividends may be considered as paid from current earnings. Stock dividends have no effect whatsoever on any of those calculations. All of the aforegoing described adjustments of invested capital are not necessarily to be made a part of the actual book records. The Department recognizes that it would be highly improper to adjust one's books to meet all of INVESTED CAPITAL 151 the contingencies necessary in calculating a return of this character. Collateral records, however, must be kept so that the methods of computation used for these purposes may be properly demonstrated when the occasion arrives. We have made some mention of the necessity for mak- ing a consolidated return in the case of corporations which are affiliated. The reason for this requirement is as fol- lows : If a number of corporations are owned by a group of stockholders practically identical, it follows that the corporations are in reality one single investment enter- prise. If the provisions for consolidated returns were not contained in the law, it would be a very simple matter by reorganizing a lot of small corporations so to adjust the income from one to the other as to evade a great deal of taxation. For this reason it is provided that in cases where such affiliations exist, the corporations so related must be considered one unit. They must be considered as one unit with respect to their entire income and as one unit with respect to their entire invested capital. Let us now consider the methods of setting up the invested capi- tal for the purposes of an affiliated corporation. Consolidated balance sheets are made in a great many cases where corporations are affiliated or about to be merged, or for other purposes. Such balance sheets con- tain one very large principle which is peculiar to them. We refer to the elimination from such balance sheets of those items which are debits or credits between two or more of the companies. That is to say that if two com- panies are affiliated and technically or ostensibly a part of the liabilities of the first company consist of debts to the second company, it follows that in setting up a con- solidated balance sheet or other statement it is deceiving to leave these matters without adjustment. The proper 152 INCOME AND PROFITS TAXES method, therefore, is to eliminate these items and reduce the assets of the second company by the amount which the first company owes to it, correspondingly reducing the lia- bilities of the first company. This gives the true net worth of the two corporations as a whole and by true net worth we mean the assets eliminated from all merely book records and the liabilities correspondingly cleared. This is the initial principle in setting up returns for affilia- tions of corporations. The elimination or depletion of the inter-company items, both as to assets, liabilities, and stock held in one by another of the group, is necessary in the determination of the true invested capital of the con- solidation as a unit. Affiliations among corporations arise from two princi- pal characters of relationship. The first of these is the owning or controlling of all, or practically all, of the stock of one or more other companies by one corporation. In such case the main or principal company may be a holding company for the stock of the others, or it may be the principal operating company of which the others are subsidiary operating entities. In such case it is ap- parent that in setting up a consolidated balance sheet it would be necessary to eliminate stockholdings in sub- sidiary companies from the assets of the parent company in order to determine the true net worth of the group. The other method of consolidation is where the stock in two or more companies is held in common and parallel ownership by a group of persons and not by a parent cor- poration. In such case it is, of course, apparent that there are no stockholdings to be eliminated because it is not a case of one corporation owning the stock of the others. In such case the method of computation must be applied to all of the companies and the aggregate deter- mined in this wise. Under these circumstances, however. INVESTED CAPITAL 153 there still remains the question of elimination of inter- company exchanges of debits and credits. These principles of elimination are particularly im- portant when we come to determine the question of averages for such corporations with respect to admis- sible assets. You will recall that this calculation is rather complex, being based on the proportion of inad- mlssibles to all assets on the one hand, and the liabilities of the corporation on the other. Where we are dealing with a group of several corporations these inadmissibles must be computed after the elimination of the inter- company items which necessarily means that they are computed after a considerable reduction of the apparent assets in most cases. Concerning the question of paid-in stock in the case of an affiliated group, it is to be remembered that where one company owns the stock of one or more other com- panies, it is obliged to eliminate this stock from its assets. It is further provided, however, that the amount paid for such stock in case of a fair purchase for cash or its equivalent constitutes a measure of the value of the assets of the corporation whose stock was thus acquired, and constitutes a limit which must be placed on such value subject, however, to an apportionment of the stock held by the parent company against the entire capital- ization of the subsidiary. To illustrate this, if the parent company held seventy-five per centum of the stock of the subsidiary under circumstances which would other- wise create an affiliation but paid for the same only sixty per centum of the par value of all of the stock of the subsidiary, the assets of the subsidiary would be considered for the purpose of the affiliation as being only worth sixty seventy-fifths or four-fifths of the book net worth of the said company. Although in this illus- 154 INCOME AND PROFITS TAXES tration for simplicity we have used percentages which are not nearly one hundred, this principle will only apply when the parent company owns or controls practically all of the stock of the subsidiary. For all normal and ordinary purposes, practically all is held to mean ninety- five per centum as a minimum. Where the parent company has acquired stock of the subsidiary in exchange for its own stock, the assets of the subsidiary are treated as if they and not the stock had been purchased. You will recall that the question of whether assets are paid for in stock or cash has a considerable bearing on the question of the admissibility of intangibles. In the case of insurance companies we are particularly reminded that reserves, the additions to which are de- ductible from income, should not be included in the in- vested capital. The reserves particularly affected by this provision in the case of insurance companies are those which are required by state or governmental author- ity for protection of policy holders. It follows that such reserves being in reality in the same general class as other deferred gains or deferred liabilities, whichever term is most used, they are not a part of the segregated surplus of the company and should not be included as a part of the surplus. Before closing the general subject of invested capital, it will be well to remind the student that the word in- vested must be taken rather literally. We have sug- gested the necessity for the adjustment of the book value of assets, especially in cases where the same have been paid for with capital stock of the corporation and intro- duced on the books at some valuation entirely different from the true one. We have also suggested that the fact that depreciation charged in excess of those rates INVESTED CAPITAL 155 which are permitted by the Bureau may be restored to the valuation of these assets for the purpose of deter- mining the remaining invested capital. It is now well to remind you that appreciation already has been mentioned under several relationships as having no place whatso- ever in income tax computations. It follows, therefore, if such appreciation has been recorded or reflected in the accounting of the company, it is absolutely neces- sary that an adjustment of the value be made so as to eliminate them. Much effort has been devoted since the enactment of the first excess profits law to a restoration to book values where the same are considered less than the true value. Appraisals of plants are advertised extensively by en- gineering and statistical concerns as a means of relief from excessive taxation. The theory is that many con- servative companies have in the past permitted their depreciation rates and accounting generally to diminish the value of assets excessively in order to avoid a show- ing of excessive profits. These appraisals are dangerous unless great care is taken that no element of change in market value is permitted to enter the calculations. It is unnecessary to remind the student that prices have been at a very high level for several years and that this level can hardly be considered a normal or permanent one. An appraisal made today of a plant containing a large quantity of machinery may, even with utmost care, be almost impossible without some injection of these high level prices into the valuations. Such an element, however, amounts in the last analysis to an appreciation and In so far as it does It Is not a proper basis for at- tempting to adjust the Invested capital involved. If such appraisal can be made with an avoidance of this danger It Is very frequently an efficient and entirely commenda- 156 INCOME AND PROFITS TAXES ble method of revising the depreciation rates previously used so as to restore the property to a valuation more nearly commensurate to its actual condition, but the great danger is that in permitting such appreciation to intrude the whole proposition loses its effectiveness and becomes to all intents and purposes a lost effort. The student will now read, in the order given. Regu- lations 45, Articles 831; 836; 834; 835; 833; 832; 861; 862; 837 to 848 inclusive; 850; 849; 860; 812; 813; 814; 811; 851; 815; 816; 817; 818; 852 to 857 inclu- sive; 1542; 858; 859; 863 to 868 inclusive; 870; 1561. CHAPTER XI RETURNS In the case of Individuals, returns are required of every single person whose net income exceeds one thou- sand dollars. Married persons living with the husband or wife, as the case may be, must make a return if the net income of the two combined is in excess of two thou- sand dollars. The student will note particularly that the exemption of the head of a family although two thousand dollars does not relieve him from making a return if his income is In excess of one thousand dollars. The only two thousand dollar minimum for return pur- poses is in the case of married persons living with hus- band or wife. The form commonly used is the form known as 1040 or 1040A; Form 1040 being the form for cases where the income is in excess of five thousand dollars; and Form 1040 A where it is less than five thousand dollars. It will be recalled that five thousand dollars is the maxi- mum income which does not call for any surtax. In the case of a husband and wife living together who might if they preferred make a single return of their income, it is preferable if either of their incomes exceeds five thousand dollars, or their combined income exceeds six thousand, to make their returns separately. Let us illus- trate this by a brief example. If the husband has income of ten thousand dollars and the wife six, it would follow that a single return would call for a sixteen thousand dollar net Income. The surtax on a sixteen thousand dollar net income is four hundred and ten dollars, as will be seen by refer- ence to a table. On the other hand, the surtax on a 157 158 INCOME AND PROFITS TAXES six thousand dollar net income is only ten dollars, and on a ten thousand dollar net income is one hundred and ten dollars, or a total of one hundred and twenty dollars, which is quite a saving in surtaxes by making separate returns. Besides this, the husband's income at ten thousand dollars, less a credit of two thousand, would normally be taxable, four thousand at eight per centum and four thousand at four per centum, totaling four hundred eighty dollars; the wife's, at six thousand, would be tax- able four thousand at four per centum and two at eight, a total of three hundred twenty. The aggregate of these is eight hundred dollars. If, however, we consider them in one return, we have a sixteen thousand dollar total income, a two thousand dollar credit, taxable four thou- sand at four per centum and ten thousand at eight per centum, or nine hundred sixty dollars, a difFerence of one hundred sixty dollars. While the Bureau suggests the separate calculation of taxes even where a single return is filed for both hus- band and wife, it is much simpler to deal with it as above suggested. A return may be made by the individual himself or by a duly authorized agent or representative provided the latter is in a position to know the facts concerning the income of the principal. The excuses for making a re- turn by an agent, however, are cited as being a case of Illness or unavoidable absence. In the case of a minor or a person under twenty-one years of age, If the Income of the minor is sufficiently large a return must be made either by or for him. If made for him. It should be made by his parent or guardian. In determining whether his income is sufficiently large to require him to make a return, there must be included in his entire net income RETURNS 159 all sums due him from fiduciaries, even though not ac- tually distributed. Where a minor Is subject to his parent's control with respect to such earnings as he may acquire, it must be understood that the minor's earnings being the property of the parent, must be Included in the parent's return and not in a separate return for the minor. In a previous discussion we have mentioned that the ownership of stock Is presumed to He in the person in whose name such stock Is recorded on the books of the corporation, that Is to say, that the record owner Is presumed to be the actual owner until evidence to the contrary Is presented to the Department. We reiterate In order to advise that in making returns of dividends on which the necessity of any such disclosure exists the same must be Included so as to disclose the fact or make the record owner responsible for the income. Returns must be made under oath or affirmation. Per- sons in the United States service may attest their returns before those officers provided for the attestation of ser- vice depositions or other forms and documents. It Is provided that persons living abroad may make their returns before consuls without being charged a fee. Re- turns may be sworn to before notaries public and justices of the peace In this country and also before collectors or deputy collectors, or agents of the Bureau of Internal Revenue. As the latter take such oaths or affirmations as a part of their official duties, no fees are charged for the same. In the case of persons living abroad who do not find It possible to make their oath or affirmation before a United States representative It is permitted that they appear before a notary or equivalent officer of the for- eign country in which they are temporarily abiding. In 160 INCOME AND PROFITS TAXES such case the capacity of the officer must be duly certified to under the usual requirements for the certification of notarial seals and signatures for conveyancing purposes. The use of the prescribed forms, 1040 and 1040A, while required as a general rule, is not absolute. In- ability, for instance, to obtain a return from a collector would not be an excuse for not filing a return. In case the prescribed form cannot be obtained, the taxpayer is permitted to furnish the Department with a complete statement of his income and affairs in such statistical arrangement as to disclose the taxability, and that will suffice until the form can be obtained. The responsibility for filing returns for estates and trusts is, as has been said, upon the fiduciary. Where there are several fiduciaries any one of them may make the return for the group. A fiduciary having custody of the person as well as the property is also responsible for the return of his ward or committee. In the case of the death of an individual, his admin- istrator or executor is responsible first, to make a return for the income of the decedent from the date of his last previous return to the date of his death, and second, to make his own return as administrator or executor, as the case may be, when the same becomes due. In such case let it be mentioned that irrespective of the time elapsed between the last return and the date of death the one thousand and two thousand dollar exemptions for single or marital status respectively apply as of the date of the death. Of course, if the ward of a guardian or committee is capable of making his own return there Is no objection to his doing so, but his failure is no excuse for his fiduciary. Where there are several trusts created by one donor, one return is sufficient for all In those cases where the RETURNS 161 trustees are the same in all. However, If a trustee is acting in common for several trusts created by several donors there must be a return filed for each trust not- withstanding that the beneficiaries may be Identical in every case. In addition to making return for his estate or trust, a fiduciary who collects income due to a non-resident alien beneficiary is also primarily responsible to make return for such non-resident alien. If there are two or more such non-resident alien beneficiaries, it is of course neces- sary to make a separate return for each. The fiduciary form Is known as Form 1041. Partnerships are required to make return. These re- turns constitute the basis of the information to the De- partment as to the distribution of the earnings to Its various members. The form provided is numbered 1065. Attestation of the form by oath or affirmation may be made by any member of the firm. We believe that we have sufficiently explained that the basis of the return of a partnership is primarily a fiscal year. The data required on the return Is for the purpose of determining the net income in the same general manner as any other required data as In the case of an individual or corporation. In addition to this, however, it is necessary that names and addresses of the distribu- tive owners of the partnership must be shown, together with their respective interests In such Income. Informa- tion must be also disclosed as to the collection of divi- dends, interest, and other qualifiedly taxable items and as to payments of taxes to foreign countries in order that the Department may satisfactorily check any claims in respect thereto, which may be made by the individual partners. Every corporation not specifically exempted by the 162 INCOME AND PROFITS TAXES provisions in Section 231 of the tax law and also every personal service corporation is required to make a return. The return for a personal service corporation is Form 1065, the same as is used for a partnership. The return for an ordinary corporation is Form 1120. Even though the corporation may have been in existence less than one full year up to the time when the return is due, it must nevertheless make the return. If a corporation is in process of liquidation, the re- ceiver or trustee must necessarily make the return for it. The receiver or trustee will make the return on the usual form required for the corporation, there being no dis- tinction between the status under the receivership and the status as a corporation. It might be mentioned in passing that this principle in regard to receivers would apply to any organization which was in the hands of any such fiduciary. Where receivers are appointed for specific temporary purposes, such as receiving the income from a given property during some period of legal controversy, or other purposes of that sort, these receivers have no stand- ing for tax purposes. That is to say, they do not stand in the place of the person for whom they receive, their status being entirely too temporary to justify the assump- tion of tax responsibility. Corporations in that class known as insurance com- panies in connection with their return are required to file copies of their usual state reports covering the same period as that involved in the making of the return. Where it is inconvenient to file the whole of such report, it is permissible to file those pertinent portions which will enable the Department properly to verify the matter of income and capital in so far as they are affected by the income tax law. RETURNS 163 Personal service and all other corporations are ex- pected to make returns on the basis of their fiscal years. A change In the period, as has been explained, requires a return for such time less than twelve months occurring between the last due date under the old custom and the first closing date under the new. The usual facts of income and expense are required In the case of personal service corporations as In the case of partnerships; furthermore it is expected that the personal service corporation will disclose a complete list of the stockholders, their distributive shares, and the distribution actually made to them with addresses and the dates of such transactions. We have mentioned affiliated corporations in a pre- vious chapter. An affiliated group is required to make a single return as if It were one corporation. Such a return is called a consolidated return. The ordinary cor- porate form is used and the schedules and additional data attached must properly explain all matters affecting the income and capital of each individual company separately, and must also disclose the elimination of items of inter- company income and expense, and assets and liabilities in order that the whole may be reduced to a proper basis or unit. The responsibility for such a return Is primarily on the parent company. Where, however, there is not a parent company but a number of companies simply controlled by the same Interests, any one of them would be responsible to make the return. In addition to the ordinary data, there is required In such case a complete schedule of the names and addresses of the affiliated cor- porations, the stock outstanding in each, the stock held by common ownership in each, or the stock controlled by the parent company in each, and the names and addresses of the Individuals who or for whom the common control 164 INCOME AND PROFITS TAXES is held. It is also required that some apportionment of the tax be made against the several companies. It is per- missible for a group of corporations under such circum- stances to apportion its taxes at its own figure, but the Department requires knowledge of the facts. Corporations are deemed to be affiliated for the pur- poses of a consolidated return, as mentioned in the pre- ceding paragraph, either when one company owns or controls one or more others, or when two or more com- panies belong to common ownership. What constitutes ownership or control or controlling common ownership in either case is, roughly speaking, a minimum of ninety- five per centum of the common stock held by the same persons in about the same relative proportion. How- ever, in order to cover cases where doubt might exist as to the existence of an affiliation, it is required that in all corporation returns there shall be disclosed informa- tion as to any outstanding mutual stock interest exceed- ing fifty per centum of the corporation reporting and exceeding fifty per centum of any other corporation. This would apply even though otherwise there would be no affiliation whatsoever between the companies. It is a matter of information on which the Department reserves the right to adjudge the necessity for a consolidated return. Where the ownership of a group of affiliated corpo- rations changes during the year, which might be where one company was sold out of the group, or additional companies were acquired into the group, the Department makes no definite rule as to the method of computing these affiliated situations. It requires merely that the whole history of the situation be disclosed in conjunction with the return made by the consolidated group, and that the Department will at its own discretion make proper RETURNS 165 adjustment of the taxability as a unit or as separate corporations. In any case where one corporation in a group is deriv- ing its chief income from government contracts, such a corporation must be reported separately in every respect. It cannot be included in the group. The reason for this lies in the different rate of taxation on government con- tracts. The remaining corporations still remain affiliated and must file a consolidated return exclusive of the one engaged in government work. Where a domestic corporation is affiliated with a for' eign corporation there is no necessity for a consolidated return. In such case the domestic corporation shall de- duct from its own tax liability the amount of the income or excess profits taxes paid by its parent affiliate to a foreign country in the proportion which the dividends derived from such foreign corporation bear to the total taxable income of the foreign corporation upon or In respect to which taxes were computed and paid. It is provided, however, that in no case shall the deduction for taxes paid by such foreign corporation be allowed the domestic corporation in excess of the dividends re- ceived therefrom. Where the group of affiliated corporations close their affairs under different fiscal years the income and invested capital must be reported on the basis of the fiscal year of the parent company of the group. In such case com- plete information as to the overlapping of such fiscal years must be furnished the Commissioner in order that he may make proper provision for the taxing of such portions of the fiscal years of the subsidiaries as was earned prior to the beginning of the taxable year of the parent. As has been heretofore stated on many occasions, there 166 INCOME AND PROFITS TAXES is no return permissible for a period of more than twelve months. In any case where the adjustment of the fiscal year is necessary it is required that the period from the last date of closing under the old method to the first closing date under the new method must be reported as a fractional part of a year, and in any case must be for a period of even months. Where a return for a corpo- ration is made for such a period of less than one year, the apportionment of all brackets and credits must be made in ratio equal to the number of months in the re- turn as compared with the twelve months of a full cal- endar year. In case of the organization of a new corporation, how- ever, where it makes a return for a fractional part of a year which includes not all full calendar months, it fol- lows that it would be necessary to adjust the return for the number of days not amounting to a whole month which may have occurred in the opening of business by the company. In such case that number of days as a numerator and the number of days in such calendar month as a denominator constitutes the fraction by which the period must be computed. In other words, a corpo- ration beginning business on the fifteenth day of June and making its first return on December 31st would report six-twelfths of a year for the period from July 1st to December 31st and also sixteen-thirtieths of a twelfth for the period from June 15th to June 30th, inclusive, June having thirty days. The credits, exemp- tions, and brackets in such cases would be taken in six and sixteen-thirtieths twelfths of the period. Returns are due on the fifteenth day of the third month after the close of the taxable year, either fiscal or calendar as may be the basis of the report. Upon the death of a person or the termination of an estate or RETURNS 167 trust, the duty of the trustee or administrator is to file a return as soon as is reasonably practicable. This means merely that it is not necessary or advisable to wait until the close of the year before doing so. So much for the subject of filing returns in general. Let us now consider the possibilities for covering cases where returns are not possible of proper preparation within the time provided. In the case of sickness or ab- sence, the taxpayer's time for filing the return may be extended for a period not to exceed thirty days by appli- cation to the Collector of his district. The application for such an extension must precede the date when his return is normally due. In the case of corporations, the absence or sickness of the officers whose responsibility it is to make the return will also enable the Collector to grant such an extension, but it is only excusable under such circumstances if there are no others who have knowl- edge or authority to act. In all such circumstances, it is cited that the Collector may at his own discretion require the filing of what is known as a tentative return at the time of granting the extension. The tentative return consists of an estimate of what the income and tax may be when the final return is filed and this tentative return is accepted in lieu of the return until it can be properly prepared. Where an instalment of tax is due on the date of filing the return, the first payment will be based upon the tentative return. Under proper circumstances and at his own discretion, the Commissioner of Internal Revenue may grant exten- sions of time in addition to those obtainable from Col- lectors. Such further extensions, however, should not and cannot exceed the time when the third payment un- der the tax is normally due and payable. While the tenta- tive return is usually required in either of such extensions, 168 INCOME AND PROFITS TAXES in extreme cases even the tentative may be excused by the Commissioner. In the case of persons living abroad, there is a gen- eral extension of time not to exceed ninety days after the termination of the war with Germany. This pro- vision was originally made as a protection for persons in the various services and collateral branches of govern- mental and civil activities who were in the European field of conflict. Technically this expiration is not yet complete because peace has not yet been declared with Germany, but as a matter of fact there is no logical rea- son now, except In those countries which are still engaged In active warfare, why returns should not be filed within a reasonable time. Under all cases where any such ex- tensions of time are made, however, the whole of the tax must be paid with the return and not merely the first Instal- ment. Furthermore, the reasons for the delay in such cases must be duly explained by affidavit of the taxpayer at the time of filing the return. This Is because the ac- ceptance of the return is provided notwithstanding the failure to apply for the delay in advance. In the case of those persons who are enemies of the United States, the provision in the above paragraph applies as to the others. As to those enemies, whose affairs under the Trading with the Enemy Act are com- mitted to the care of the alien property custodian, the return of Income must be filed for such a period elapsed between the last previous return, if any, and the time of delivery of their affairs into the hands of such cus- todian. The responsibility for this return, however, is on the domestic representative of the said alien. In conformity with the usual custom. If the last due date of any period provided under the income tax law and the regulations falls on a Sunday or a legal holiday, the RETURNS 169 following day will suffice as coming under the provisions and requirements. Where the returns or payments are to be made by mail, it must be remembered that the mailing time is not an additional factor in case of delay under most conditions. All returns and payments must be mailed so as to arrive in the ordinary course of events at the place of destination on or before the date on which the same are due. The only qualification to this is that if the delay is attributable to the mail service itself and it can be demonstrated that under normal conditions the mail would have reached its destination within the re- quired time, the delay is excusable. Corporations in process of liquidation may file their returns without waiting for the close of their fiscal year if desired. The place for filing returns is the office of the Col- lector of Internal Revenue for the district in which the taxpayer resides or has his principal place of business. In many instances, the Collectors of Internal Revenue have branch offices superintended by Deputy Collectors in other cities coming within their jurisdiction. Where such is the case, the local office of a Deputy Collector will serve entirely well as the office of the Collector of the district himself. In the case of all persons living abroad, including those persons out of the country by reason of military or naval service, the return must be filed with the Collector of Internal Revenue at Baltimore, Maryland. Foreign corporations or non-resident aliens having offices or agencies in this country are required to file their returns in the office of the Collector of the district in which such office or agency is located. Where there are several such agencies, the normal procedure would be to file the return in the office of the location of the principal agency. 170 INCOME AND PROFITS TAXES As a matter of administration, it is provided that the Collector of Internal Revenue, after conference with the taxpayer in respect to any return as to which he has sus- picions or surmises of error, may increase the amount of the tax at his discretion. In such cases the increase is an assessment of an additional tax and the procedure for obtaining an abatement or refund, explained in a later chapter, will be the only redress. Original jurisdiction was granted by the statute to the Commissioner of Internal Revenue to amend the return of any taxpayer in any respect which in his discre- tion he is justified in under the law. This means that he is thoroughly authorized to make corrections in returns to any extent where errors are found in respect to facts or interpretations of the statute and Regulations. The subject of returns of information will be men- tioned in a later chapter, but it is well to state here that partnerships, personal service corporations, and fidu- ciaries generally who file returns, which indicate on their face the distribution of income to specifically named persons, are expected, in addition thereto, to file in re- spect to such persons one of the usual returns of infor- mation as to such distribution. The form in such case is known as 1099 and is a form simply used by the Bu- reau as a basis for affording an income record in check- ing up the reports of individuals against whom the in- formation is disclosed. Unless a return is filed within the prescribed time limit, there is a penalty of twenty-five per centum of the amount of tax shown thereon. This penalty is excused, however, if the return is subsequently filed and the delay is shown to be entirely reasonable. Reasonableness for such pur- poses means ordinary business care and prudence, and to justify the delay a reasonable effort will be predicated RETURNS 171 on such a state of circumstances as would not have served to prompt the taxpayer to file under ordinary care and prudence in respect to the matter. In case of under- statement in returns there are certain specific penalties which must be carefully differentiated and understood. If the return contains an understatement due to the negligence of the taxpayer but without fraudulent in- tent, there is a penalty of five per centum to be added to the amount of the tax, but where the understatement is deliberate and fraudulent there is a penalty of fifty per centum of the entire tax and the possibility of criminal prosecution. The student will now read, in the order given. Regu- lations 45, Articles 401; 402; 403 ; 405; 406; 407; 421 422; 423; 425; 411; 412; 621; 424; 622; 623; 624 631 to 638 inclusive; 431; 626; 441 to 447 inclusive 651; 448; 451; 1073; 1004; 1005. CHAPTER XII PAYMENTS AND CLAIMS The tax is normally due In four instalments. The first of these instalments Is due on the fifteenth day of the third month after the close of the taxable year. The student will recall that this is simultaneous with the time for filing the return. This first instalment is due, how- ever, notwithstanding an ordinary extension of time m filing the return if a tentative return is required In lieu thereof. Where an unconditional extension of time for filing the return is made, however, such extension auto- matically postpones the payment of the first instalment of the return only. The remaining Instalments of the tax are due on the fiscal day of the sixth, ninth, and twelfth months respectively after the close of the fiscal year. In other words, the Instalments are due quarterly beginning on the fifteenth day of the third month after the fiscal year. In case of failure to pay any Instalment of the tax when It Is due and payable, the entire remaining and unpaid instalments become Immediately due and demand- able by the Collector. In case of any recomputatlon of the tax by the Col- lector if the said recomputatlon results in disclosing underpayment of the tax, the result Involves Interest on the amount of underpayment. In such case the interest is at the rate of twelve per centum per annum. If such recomputatlon discloses an overpayment of tax, the over- payment is applied to the remaining unpaid instalments. If any, or if none a refund is necessary in order to cover the said overpayment. In case a return Is not made on time, It Is the duty of 172 PAYMENTS AND CLAIMS 173 the Commissioner or Collector of Internal Revenue to prepare a return in the case. This, of course, does not apply where sickness or absence causes the delay and application has been made for an extension as explained in the preceding chapter. When the Commissioner or Collector makes such a return after the computation of the tax from information obtainable, a penalty of twenty-five per centum is added. We have seen in a preceding paragraph that where a return is fraudulent the penalty is fifty per centum in- stead of twenty-five. In addition to this, under such cir- cumstances the whole amount of the tax is due on notice and demand and is not permitted to be paid in the in- stalments provided in the Act. We will recall that in the case of inability to prepare the return on time under circumstances justifying the granting of an extension by the Commissioner or Col- lector, such extensions also extend the time for the pay- ment of the first instalment of the tax. In addition to this, the Commissioner may also on application and if he deems the circumstances justify, further extend the time for paying the remaining instalments. In all such cases the time for payment having been extended upon application and request of the taxpayer, he is required to pay interest at the rate of six per centum per annum on all of the amounts so postponed from the date upon which they fall due until the date when they are paid. If an understatement in the return due to negligence without fraud results in the assessment of additional tax, payment of interest at the rate of twelve per centum is required of the taxpayer on the additional amount. Interest is also required at the same rate of twelve per centum if the taxpayer under due notice and demand of the payment of the tax fails to pay the same within the 174 INCOME AND PROFITS TAXES required time. However, In such event if the taxpayer files a bona fide claim for abatement Instead of paying the tax, the amount covered by the claim for abatement is taxable only at the rate of six per centum. A bona fide claim for abatement is presumed to be a claim which is based on a reasonable Interpretation of the law even though ultimately disallowed or disagreed with by the Bureau. There Is one exception to this rule and that Is in the case of losses In Inventory which we will discuss later. The provided interest in all cases where claims for abatement are based on inventory losses Is twelve per centum per annum. Fundamentally, the filing of a return stands in lieu of or constitutes notice and demand of the due date of the first instalment. In any case of failure to pay within ten days after notice and demand of the amount of the tax then due a penalty of five per centum Is added in addition to the interest hereinbefore described. A bona fide claim for abatement relieves this penalty if filed within ten days after the notice and demand. It becomes the duty of the Collector to renotify the tax- payer if the claim for abatement is rejected. If the claim for abatement Is allowed In part, it relieves the taxpayer of penalty as to the amount so allowed. Of course, if the claim for abatement only covers a part of the tax and there Is a failure on the part of the taxpayer to pay the remainder, the penalty applies In respect to the un- paid portion. There is a special provision in the Regulations that the estate of a deceased or insane person shall not be chargeable with delinquency so as to be penalized by reason of the failure of a fiduciary to make the proper return. Later on we will discuss the question of collect- ing the tax by process and it might be well to mention PAYMENTS AND CLAIMS 175 here that in the case of any warrant of distraint being issued a penalty of five dollars is added to all other penalties in such case. The time from the date of mailing of the notice of demand by the Collector is used as the basis of deter- mining the due date of the payment so demanded. In the case of the absence of the taxpayer under circum- stances which prevent him from receiving the notice in due course or where an extended distance between the office of the Collector and the taxpayer render time nor- mally allowed for such notices too short, there is an automatic extension for a reasonable time. In the latter case, however, it is the duty of the Collector to establish an adequate date for the final payment. In any case where the taxpayer can produce evidence of failure to receive a notice of payment he is thereby relieved from penalties and interest. This would not apply if the due date was a fixed one. Provision is made In the statute and the Regulations for the collection of tax by suit. In such case the suit is brought in the name of the United States through the District Attorney for the jurisdiction in which the tax- payer resides or has his principal place of business. A Collector has no authority to bring suit in any case, however, without the consent of the Commissioner of Internal Revenue. In case of the neglect or the refusal of the taxpayer to pay the taxes on notice and demand It Is lawful for the Collector or his deputies to collect such taxes with a penalty of five per centum and interest at twelve per centum per annum added, by distraint and sale of goods, chattels, or effects including stock, securities, and evi- dences of debt of the person delinquent. When person- alty, that is to say, goods, chattels, and effects, sufficient 176 INCOME AND PROFITS TAXES to cover the amount due is not found by the Collector or Deputy Collector, he is authorized to collect such taxes by seizure and sale of real estate. Where the sale of real estate is necessary for the satis- faction of the tax liability, a bill in equity may be filed in a district court of the United States. This bill is filed in the name of the United States for attachment of real estate of the delinquent taxpayer or in which he has any rights, title, or interest. In all such cases, however, it must be borne in mind that the rights of mortgages or prior judgments or attachments against this property or any such interests prior to that of the taxpayer cannot be affected by the acts of the Collector, or attorney in the name of the United States. Furthermore, such a lien in favor of the United States would not be valid as against a subsequent mortgagee, purchaser, or judgment creditor of the taxpayer until due public notice thereof had been filed in the proper public office provided for such records. A Collector of Internal Revenue is required to give a receipt for taxes collected whenever demanded by the taxpayer. This provision is valuable in cases where further claim in respect to the taxes may necessarily have to be prosecuted. There are certain provisions in the statute and Regu- lations with respect to payment of taxes by the medium of United States Treasury Certificates of Indebtedness. These are acceptable at par by the Collector for the amount thereof in payment of any tax due under the Revenue Act of 1918. The different requirements with respect to the different issues of certificates of this sort and to their use in the payment of taxes are not par- ticularly important to the student. As a practical proposition, however, it must be borne PAYMENTS AND CLAIMS 177 in mind that the certificates may be used for payment of taxes but cannot be cashed by such roundabout method as delivering certificates in excess of the amount of the tax and obtaining cash refund of the excess. Further- more, the matured coupons on any of these certificates of indebtedness must be detached and cannot be accepted as a part of the payment. Accrued interest not repre- sented by coupons on the certificates shall be remitted to the taxpayer by the Federal Reserve Bank in which the certificates are deposited by the Collector and shall not be adjusted by the Collector as a part of the payment of the tax. Where a taxpayer has certificates of indebtedness on deposit at one of the federal reserve centers he may avoid the necessity of transmitting these certificates from the Reserve Bank to himself or to the Collector by ob- taining permission to deposit in the said bank to the credit of his Collector a sufficient number of certifi- cates to cover the tax. Under such circumstances the Federal Reserve Bank will merely transfer the certifi- cates to the credit of the Collector of Internal Revenue and so notify him. The tax may be paid by uncertified checks if desired, provided such checks are collectable at par without any charge for exchange or collection. Where one check is transmitted for the payment of the taxes of two or more persons a detailed statement must accompany the check showing the application of the check to the pay- ment of the taxes of each of them respectively. Wherever a check which has been presented for the payment of taxes is ultimately dishonored by the bank drawee, the effect is as if the check had never been given, so far as payment of the tax is concerned, but in addition it is provided that the Collector shall not pay the charges 178 INCOME AND PROFITS TAXES for protest which may arise from the dishonor. Such charges for protest fees must be charged directly by the bank to the taxpayer. In the case of citizens of the United States, whether resident or non-resident, who derive income from sources In a foreign country, including the United States pos- sessions, there are special provisions permitting a reduc- tion of their tax liability. In the first place, a citizen of the United States may deduct from his tax liability to the United States the amount of income or excess profits taxes paid during the year to a foreign country on Income derived from sources in such country. Then he may deduct the amount of any Income taxes paid to any pos- session of the United States. It will be noted that this is not qualified by the provision that the income be de- rived from sources in such possessions. In the case of a resident of the United States he may deduct from his tax liability the amount of the taxes paid during the year to a possession of the United States. Also, an alien resident, being of course a citizen or sub- ject of some foreign country, may deduct the amount of taxes paid during the year to his native country on in- come derived from sources therein If the country Imposes an Income tax and allows similar credits to citizens of the United States residing therein. In the same manner as we found in dealing with the question of personal credits the word similar here used does not relate to the amount allowed but to the principle of deduction. In any of the aforegoing cases, where the party In- volved Is a member of a firm or the beneficiary of an estate or trust, his proportionate share of the taxes paid by the partnership or the estate or trust during the year may be treated in a like manner in so far as his own tax is concerned. Although the statute does not so state in PAYMENTS AND CLAIMS 179 the particular section under which these provisions are set forth, it is recalled that as a broad proposition the word paid when used in the law is In the sense of paid or accrued. The accrual of taxes in such cases would con- stitute payment for the purposes of this section, but if the tax when ultimately paid differs from the accrual, an adjustment will be necessary either by way of refund for overpayment or additional payment of the amount by which the actual tax exceeds or Is less than the esti- mated tax. Where a taxpayer wishes to make use of the accrual principle with respect to these taxes, he may at the dis- cretion of the Commissioner be required to give a bond with a surety satisfactory to the Commissioner, In such sum as he may require, conditioned for the payment of the amount of tax which may ultimately be found to be due on redetermination. A few words of definition in connection with this sub- ject might be appropriate. The word taxes means exactly what It says, that Is, taxes without consideration being given to any interest or penalties incurred in the collec- tion of the same. The term foreign government does not mean a foreign city or subdivisions which may levy income taxes independently of the general government. What is meant is an Independent foreign government. In claiming credit for taxes under such circumstances the return of the taxpayer must be accompanied by a form known as Form 1116 setting out the facts and further accompanied by receipts for taxes paid or a copy of the return by which the calculation of the taxes ac- crued were based. Authenticated or sworn copies of such receipts or returns may be used in place of the originals if desired. Where a possibility of a future reduction of 180 INCOME AND PROFITS TAXES the tax exists and the Commissioner at his discretion requires a bond the form in such cases is Form 1117. When the tax is finally determined, that is to say, the foreign tax, the Commissioner must be notified and he will thereupon reassess the United States taxes. Where the assessment results in a reduction of the tax liability to the United States, a claim for abatement or refund will lie. With respect to corporations the same general prin- ciples apply, to wit, the corporation may reduce its tax liability by the amount of taxes paid to a foreign govern- ment on income derived from sources therein, and taxes paid to a possession of the United States. The same general provisions for adjustment of taxes used in attain- ing this credit where the same has been not actually paid but merely accrued applies in the case of corporations as in the case of individuals. The forms to be used, how- ever, are Forms 1118 and 1119, the second being used when a bond is required. The provision in the law for the refunding of taxes erroneously paid is very general and simple. Where upon examination of a return, it is found that the tax- payer has overstated his income for his tax liability and has consequently overpaid the same, the amount of the excess shall first be used in covering any unpaid balances of income and excess profits taxes then due by the tax- payer. Any balance after such provision for other unpaid amounts shall be immediately refunded to the taxpayer. While this provision would seem to place the initiative in the matter upon the Bureau of Internal Reve- nue such is not the case. The precedure is that the tax- payer must make a claim for the amount. These claims are properly divided into three general classes: first, PAYMENTS AND CLAIMS 181 claims for abatement; second, claims for refund; and third, claims for credit. A claim for abatement is made on Form 47. Such a claim amounts to an appeal from an assessment or a petition for the reduction of the tax liability previously erroneously reported or assessed. Logically the claim for abatement can only lie where the tax has not been paid, and it can only serve as a reduction or as an offset to the payments which would be otherwise required. The claim for credit. Form 47A, is similar to the claim for abatement. It requests in the first place the abatement of a tax, and in the second place the applica- tion of the amount by which the said tax is reduced to the payment of other taxes. Claim for credit by one taxpayer cannot be used in payment of taxes of another taxpayer. This is even so where one member of a firm claims an abatement and other members of the firm might otherwise utilize the claim in substitution of their required payment, but such treatment is not allowed. Neither can the officers of a corporation substitute claims for abatement of the taxes of the corporation in place of their own payment, nor could one of the companies in a group of affiliated corporations substitute claims of another corporation in lieu of its payment. The claim for refund, P^orm 46, lies where the tax has been paid and should only lie where there is no other tax liability remaining unpaid on the part of the taxpayer. Such a claim, as will be understood by its title, asks a return of the sum paid in excess of the actual liability. For reduction of the detail in the handling of tax matters, it is provided that where a mere overpayment exists, known to the Collector, he may make a refund of the overpayment without actual filing of claims. Such 182 INCOME AND PROFITS TAXES cases can only arise by the very simplest combination of circumstances. For instance, if the amount remitted for the tax is in excess of the tax liability, a Collector would refund, but where there is any question of opinion or judgment or reduction of the taxes involved, the Col- lector has no such authority. Claims for refund can- not be made nor has the Commissioner any authority to grant such claims on any grounds other than illegality with respect to the refunding of penalties. Such penalties when once lawfully assessed and collected cannot be re- funded. If a taxpayer files a claim for a refund and subsequently incurs further tax liability to the Government, it is possi- ble for him to convert the claim for refund into a claim for credit and utilize the same in the payment of his subsequent liability. A general word of instruction in regard to filing any or all of these claims is now pertinent to our subject. The procedure is quite informal with the exception that the use of the numbered form is required. There are certain facts required by the form, particularly going to the detail routine office records of the Department in order to enable them properly to identify the matter with which the claim deals. Aside from that, however, the general basis of the claim is a mere statement of fact or bill of particulars not formal in its requirements and any clear and concise statement of facts on which the claim is based will serve every purpose. Having his claim, the taxpayer must wait until a de- cision is rendered thereon. If, however, the Bureau of Internal Revenue delays decision on the application for refund or credit for six months or more the taxpayer is then at liberty to enter suit in the proper court for the recovery of the tax. PAYMENTS AND CLAIMS 183 Collectors of Internal Revenue have a right to sue, as will be recalled from a previous paragraph. Where taxes are recovered by suit in this wise and the taxpayer has equitable and legal grounds for claiming that the tax notwithstanding the court proceeding was unlaw- fully collected, he may file a claim for a refund on Form 46, which claim must disclose a complete history of the cause of action which determined his liability. A certi- fied copy of the final judgment, a certificate of probable cause, and an itemized bill of the cost paid by the tax- payer duly receipted by the clerk or other proper officer of the court, together with a certified copy of the docket entry in the case or so much as may be required by the Commissioner, must be attached to the claim in such case. The certificate of probable cause in this case means that the court in which the case was heard must certify that there was probable cause for the action brought by the Collector or other officer, or that such officer acted under direction of the Secretary of the Treasury or his other proper superior. The reason for this is that if there was probable cause for the action of the Collector, the execution on final decision does not lie against the Col- lector himself but must be paid out of appropriations in the Treasury. Among the provisions of the Revenue Act of 1918 was the creation of a board called the Advisory Tax Board. This Board was composed of six members ap- pointed by the Commissioner of Internal Revenue with the approval of the Secretary of the Treasury. The Board was appointed for a period of two years only. This means that the Board was supposed to remain in existence for no longer than two years after the passage of the Act. The Act was passed on February 25, 1919. The Board would have normally functioned until Febru- 184 INCOME AND PROFITS TAXES ary 25, 1921, but the Board has been out of existence for some months at this writing. Its duties and func- tions have been largely taken over by what is known as the Board of Appeals and Review, an internal or- ganization of the Bureau designed to hear cases and render decisions which shall be final and have all author- ity of regulations until reversed by a court of competent jurisdiction. Because of the present non-existence of the Advisory Tax Board, the author does not deem it at all desirable to go into any questions as to the details of procedure before this Board as provided in the Act and the Regulations. In addition to the penalties consisting of additional taxes as described in a preceding paragraph for non- payment and failure to make return, there are certain specific penalties which should be enumerated here. Fail- ure to make a return or pay or collect a tax may incur a penalty not to exceed one thousand dollars. This pen- alty is levied by the Commissioner of Internal Revenue and is limited to cases where no criminal procedure is involved. If the failure to make such return or the failure to pay or collect such a tax has been willful the offender is further liable to imprisonment for not longer than one year and fine not to exceed ten thousand dollars or both. Such fine or imprisonment, however, as the student will readily understand, could not be assessed or ordered by the Commissioner. It would be only within the purview of the courts of the land to make any such determination of the case. Certain provisions are made whereby the Commis- sioner may compromise taxes under proper circumstances. Before actually commencing suit, for Instance, the Com- missioner may compromise any civil or criminal cause with the consent of the Secretary of the Treasury. After PAYMENTS AND CLAIMS 185 suit Is commenced the consent of the Secretary of the Treasury must be further augmented by the additional approval of the Attorney General of the United States. In any case where compromises are made and the amount collected in settlement of said compromises, no claim for refund may ever be filed in respect to such amount even though it is subsequently discovered that the tax- payer would not have been liable for any payment in respect to the matter involved. As an administrative provision we have mentioned that a Collector may revise returns. In addition the Collectors are authorized to recompute all returns and determine whether the amounts reported as tax liabil- ities are correct. Furthermore, the Commissioner is charged with the duty of verifying all returns and cor- recting the assessments of tax. The student will prob- ably be familiar with the fact that the Commissioner maintains a large field force of auditors who are en- gaged in the business of auditing and examining into the affairs of those taxpayers whose returns are assigned to them for investigation. The reports of these auditors constitute the basis of such reassessment as is found necessary. There Is just one limitation on this provision and that is that no reassessment can be made at any time after five years from the date when the return is due. In order to avoid the effect of this provision It is cus- tomary in dealing with cases where the Items involved run back for years prior to the five year limitation to obtain from the taxpayer a waiver of the limitation thus placed. These waivers merely constitute an acceptance by the taxpayer of the reaudit and reassessment for those periods which would otherwise be barred from review and In most cases the signing of these waivers amounts to a pure formality. 186 INCOME AND PROFITS TAXES In fact there is not a statute of limitations that is possible against the United States Government and al- though the Commissioner is not authorized to review returns for periods prior to five years from the date of the review, there is nothing in the world to prevent proper action by a court compelling the taxpayer to re- open the matter or to permit the Commissioner so to do, hence the granting of the waiver is merely to avoid the necessity of action on the part of the Commissioner by way of procedure in court. Where a person intends departing the country the Commissioner may, if in his judgment the departure is determined upon for the purpose of evading taxes, de- clare the termination of the tax period In respect to the taxpayer so intending to leave. The procedure is to declare the last of the preceding or current month the end of the taxable year, and require a return thereof. As a standard for the method of computation of taxes. It Is provided that at any step where the calculation re- sults in a fractional part of a cent, unless the fraction is one-half of a cent or more, it shall be Ignored, but where such fraction is one-half of a cent or more It shall be increased to one cent for the purposes of the Act. Many of the aforegoing provisions are not specifically contained in the law known as the Revenue Act of 1918 except by inference and reference. A large por- tion of the administrative provisions is based on exist- ing law. As a sweeping provision to meet this condition the Act Itself provides that all existing laws relating to the subject of internal revenue, collection of taxes, and so forth, shall be made a part of the Revenue Act of 1918 by inference except where the character or nature of the said statute or other existing law is repugnant to the meaning of the Revenue Act. PAYMENTS AND CLAIMS 187 As an aid to the collection of taxes, the Commissioner is authorized to require the keeping of satisfactory records. The degree to which this requires the taxpayer's employment of any particular line of procedure in his accounting is not definitely determined nor will it be until some litigation arises over a point thereunder. As a matter of fact, however, it is perfectly reasonable to suppose that the Commissioner is entitled to reasonable assistance on the part of the taxpayer with respect to accounting for his affairs so that the same may be ex- amined and verified when the return for the income tax is made. The tendency of the income tax laws to bur- den the taxpayer with a great volume of additional de- tail accounting and other record work is one of the greatest bases on which objection is made to this method of taxation. It must be confessed that the attitude of the Department is not helpful but that, as a matter of fact, it is inclined to place the burden not merely for the keeping and maintenance of records but for examina- tion and reexamination of the same for the purposes of making reports subsidiary to the regular return upon all sorts and kinds of detail connected with it. It is to be hoped that the Bureau will ultimately work out some simpler and more efficacious method of arriving at the desired information without, as it now does, so fre- quently requiring after the filing of a practically detailed return of income that the taxpayer shall furnish large quantities of additional itemized schedules in respect to portions of such returns in order to satisfy the auditors in the Bureau that there are no single items in any of the classifications which might be made the subject of rejection. Of course, on the other hand, unless some such requirement were possible the opportunity for dis- honest taxpayers would be so great as to open the way 188 INCOME AND PROFITS TAXES for enormous fraud, but between the two horns of the dilemma some reasonable basis of conclusion in the mat- ter may reasonably be expected to eventuate. The student will now read, in the order given, Regu- lations 45, Articles 1001; 1002; 1003; 1006 to 1010 inclusive; 1021; 1731; 1732; 1733; 1734; 381; 382; 383; 384; 611; 1031 to 1038 inclusive; 1701; 1702; 1041; 1011; 1012; 1013; 1721; 1711. CHAPTER XIII WITHHOLDING The subject of withholding and information at the source, as it is called in the revenue law, is one consist- ing largely of a recital of general formal procedure. Discussion of the subject would consist mainly of a lot of enumerations of forms required and specific data in connection with the same. The author, however, believes that instead of following this line of discussion, the student will learn more of the meaning by a practical consideration of its purposes and general trend, and can learn the details in any case by proper reference to the Regulations, especially the Articles and Sections enu- merated at the close of this chapter. Withholding at the source and information at the source as administrative aids to the Bureau in the collection of the revenue derived from income and excess profits taxes originated in this country so far as our own laws are concerned with the Act of 1913, into which pro- visions of this character were first introduced. Of course, this was our first tax act in the present epoch but our previous laws contained little or no provision of that character. The student of auditing will be familiar with the prin- ciple of obtaining information from the source, that is, from the creditor or debtor of a person or concern under audit, in verification or refutation of the facts or figures disclosed by the books and accounts of the audited person. The principle of withholding at the source is entirely analogous to this. It amounts to procuring from those upon whom lies the responsibility of paying the income to such persons a first hand statement of the facts 189 190 INCOME AND PROFITS TAXES and amounts surrounding such a tax, or it amounts to charging them with the responsibility of collecting all or a part of the taxes of such persons in respect to income so paid. Broadly speaking, therefore, withholding and infor- mation at the source are nothing more nor less than audit practices injected into the Revenue Act administration. Some of the provisions, however, in this respect would seem at first hand to be entirely anomalous, rather incon- sistent, and in some respects unjust. The first class of persons against whom this withhold- ing of tax is required is that of non-resident aliens. All persons in the United States having the payment to non- resident aliens of a fixed periodical or determinable in- come are required to withhold with respect to the income so paid a normal tax of eight per centum, it being pre- sumed that such income will be subject at least to the normal tax. In the case of foreign corporations the rate required to be withheld is ten per centum, or the normal tax of the corporation. One of the large items entering into the class of income normally coming within the definition of fixed annual determination of income is interest on bonds of corpo- rations. It is quite common for such bonds, or the trusts or mortgages securing the same, to contain a provision that the income derived from the bonds shall be made free from tax by the debtor corporation, or, in other words, the debtor corporation will guarantee the holder of the bonds against tax liability with respect to this income. These provisions are made, of course, with the idea that the debtor corporation will assume the pay- ment of taxes which might be incurred, and is offered as an inducement for the sale of the bonds. Where the WITHHOLDING 191 income of a non-resident alien or a foreign corporation consists of interest from such bonds, called tax-free cov- enant bonds, the foregoing provisions for the collection of eight or ten per centum, as the case may be, do not apply. There is a special provision relating to these bonds in the law which Is not limited to non-residents or foreign corporations but applies to all bondholders ex- cept domestic corporations. The provision for with- holding the tax In respect to such bonds is for with- holding at the rate of two per centum of the income paid. It applies to the interest paid on such bonds as bear the tax-free covenant clause irrespective of the domestic or alien status of the bondholder. This provision for with- holding two per centum on tax-free covenant bonds also applies to foreign non-resident corporations, by which is meant corporations not having an agency or place of business in the United States. To discontinue the subject of interest on tax-free cov- enant bonds in order to discuss the more general phases of these provisions, we may say that fixed or determinable annual or periodical income is generally held to be In- come which is paid in amounts definitely predetermined at annual or other periodical times, and that definitely predetermined includes those cases where there is a basis of calculation by which the amount paid may be ascer- tained. It is held generally that accrued salaries, wages, and compensations for services rendered, except where such services are rendered In a foreign country under those conditions which do not constitute them taxable income as being derived from sources within the United States, which has been explained before, are not such in- come. Where the recipient of the income Is a professional man, merchant, or an agent whose compensation is not fixed, is not regular, and Is based on occasional services of 192 INCOME AND PROFITS TAXES various degrees, the compensation cannot be held to be regular or determinable. It is also generally held that payments constituting the share of the profits of the em- ployer are fixed determinable and annual income. A payment added to a salary unless it is a gift or gratuity is fixed or determinable income. In distributions of a partnership, including such salaries as may be agreed upon between the partners, or interest on their partner- ship balances, the payments would constitute fixed and determinable income, but dividends of corporations ex- cept personal service corporations are not fixed and deter- minable income and are not subject to withholding of the tax at the source. In the case of personal service corporations, it will be recalled that their status to all intents and purposes is practically the same as that of a partnership. Interest generally is fixed and determinable annual or periodical income but not subject to general information or withholding in those cases where it is covered by a tax-free covenant clause on the bonds. Rent, royalties, and similar regular payments are, of course, fixed and determinable. Payments for goods sold would be neither fixed nor determinable. All of these general matters are therefore subject to the eight or ten per cent provision according to whether the recipient is a person or a corporation. The creditor or recipient of such income has certain privileges with respect to obtaining exemption or im- munity from this withholding. With respect to interest on bonds, a form known as Form 1001 may be filed with the withholding agent, claiming such personal and de- pendency exemption as the taxpayer is entitled to receive. These forms should be filed annually with the with- holding agent and on or before the first of February of each succeeding year. Such forms when filed exempt the WITHHOLDING 193 taxpayer from withholding or rather exempt the agent from the responsibility to withhold. The collection of interest by coupons cut from the bonds fundamentally precludes any possibility, except where such bonds are registered, of a knowledge of the owner of the bond. It follows that the tracing of the income would be virtually impossible without some pro- vision protecting the Bureau in connection with it. To meet this it is required that all coupons must be accom- panied by certificates of ownership, that is to say, certifi- cates disclosing ownership of the bonds from which the certificates were cut. These certificates must accompany the coupon whether the bond be in the tax-free covenant class or not. The responsibility for seeing that the cer- tificates required are properly attached Hes upon the bank handling these items as a part of its routine work. These banks have certain prerogatives with respect to the manner of handling these certificates. They are priv- ileged to detach the ownership certificates and file them directly with the Commissioner, substituting their own certificates in their place. This enables them to pre- serve the incognito of the owner. Such privilege does not extend, however, to cases where the owners are non- resident aliens, firms, or corporations. For the protec- tion of banks which may receive such coupons without accompanying ownership certificates there is a provision that they may in the absence of such certificates require an aflidavit from the person presenting the coupon, which affidavit shall disclose either his knowledge or lack of knowledge of the real ownership of the bond. A withholding agent is a person who is charged with the responsibility of withholding the tax at the source from a particular class or kind of taxpayers. There are specific formalities required with respect to persons act- 194 INCOME AND PROFITS TAXES Ing as withholding agents in the matter of accounting for the taxes which they thus collect. They must make an annual return of the amount collected on or before March 1st of each year, which return shall cover the amounts collected during the preceding calendar year. They must also make monthly returns without payment on the twentieth of each month after the close of the month for which return is made. Ownership or substi- tute certificates should accompany these returns. Where the withholding is not in respect to interest, a series of forms is required covering the amounts collected by the withholding agent in gross and also the segrega- tion of these withholdings with respect to the various and sundry persons against whom they are withheld. Taxes collected in this manner must be paid in every case on or before June ISth of the following year. With respect to the effect of this withholding upon the income report of the taxpayer, it is apparent that the withholding of amounts from payments for his account is a portion of his taxes. It follows, therefore, that the amounts so withheld against him may be used by him as a reduction of his tax liability when he is making his return. A peculiar modification of this provision is found in the case of tax-free covenant bonds. The covenant to pay taxes for the creditor on the bonds amounts to a guarantee or additional promise on the part of the debtor corporation to pay the tax without deduction from the actual Interest. This means that the corporation pays the interest and also pays the two per cent tax on the same to the Government. It also means In effect that the holder of the bonds receives his interest without deduction of the tax, but at the same time Is permitted to utilize the two per cent so withheld against him in reduction of his own tax liability, conse- WITHHOLDING 195 quently, it is required that in making his return he shall add the two per cent to the income received from the bonds and then deduct it as a credit against his tax lia- bility. Of course, this amounts to making his taxable income larger by two per cent of the amount of interest on such bonds, but as he utilizes this additional two per cent in the actual liquidation of his liability for income taxes he gets the benefit indirectly. There has been a good deal of protest against this procedure on the ground that it arbitrarily increases the taxability of the tax- payer. Where the tax with respect to income is not actually to be withheld there is the duty on the part of the person upon whom lies the burden of paying the same. In such case wherever the amount paid exceeds one thousand dollars in any one calendar year, the Regulations and the statute require that information as to the amount and character of such payment and the names and ad- dresses of the persons to whom paid shall be furnished the Department on forms provided for the purpose. The purpose of this is to enable the Bureau properly to trace against the various persons such payments as are made to them in amounts sufficient to justify the pre- sumption that they have a taxable income. These pro- visions for information at the source cover all forms of fixed annual determinable or periodical income under the same general category and description as was set forth in our discussion of actual withholding. There are some specific instances, however, which might be mentioned as not requiring the return of in- formation. Among those we find interest on United States obligations, dividends (except from personal ser- vice corporations), payments by brokers to customers, payments to corporations generally, bills for merchandise 196 INCOME AND PROFITS TAXES or for telephone and telegraph or for freight or storage or both, bills for board and lodging, and traveling ex- penses of employes, annuities which constitute a return of capital, rent paid to agents (but it is noted that the agents themselves are required to report against their landlords the amount collected in their behalf) , also pay- ments by branches of domestic business enterprises to alien employes where the said alien employes are not taxable. We must again revert at this point to the general status of the alien employe whose wages are earned en- tirely for services rendered within a foreign country and thus is not considered to be income from sources within the United States. A last provision for character of income not required to be covered by a return of infor- mation is in the case of payments by the United States Government. The return of information in the case of interest on corporate bonds is naturally not required in the form here mentioned because the ownership certificates ac- companying the coupons are virtually the same thing. Returns of information by the withholders of income render unnecessary any further returns in this respect. In the case of what is called foreign items, that is to say, items arising from sources in foreign countries, the first agent in the United States assuming responsibility for the collection of such items must make a return of in- formation in respect to the same. Foreign items for this purpose mean dividends on the stock of non-resident for- eign corporations, and interest on bonds of such corpo- rations or on bonds of foreign governments. If the corporation has a fiscal agent in the United States who is handling the matter of this income, he may be consid- ered the source and is responsible to make any returns WITHHOLDING 197 of information required in the case. If not, the first bank acting as a collecting agency within the United States constitutes the source for the purpose of the return. We mentioned above that wherever the bank receives bond coupons without knowledge of the actual owner- ship it should and must require an affidavit from the payee or the person from whom such coupons were re- ceived as to his knowledge or lack of knowledge of the real ownership of the bonds. It is provided that if the recipient of such a payment does not disclose the owner- ship, he is liable to penalty for failure to supply infor- mation. We will recall those penalties from the previous discussion of penalties in general under the heading of returns and payment. Banks and other agents desiring to handle foreign items as described in the last paragraph must obtain a license for the same. General information with respect to the payment of dividends is not within the purview of the provisions, but upon his discretion the Commissioner may require corporations to furnish full information concerning the payment of all dividends. This information is to include the names of the recipients of the dividends and date of payment, and must allocate the dividends against the year of the accumulation of the surplus from which paid. Brokers are, as will be recalled, exempted from mak- ing returns of information as to transactions with respect to their principals. However, they may be called upon notwithstanding this exemption to disclose any informa- tion with respect to transactions so handled that may in the discretion of the Commissioner be desirable for the Bureau. The student will probably understand without being 198 INCOME AND PROFITS TAXES told that the purpose of all this provision is the furnish- ing to the Department of a means of tracing or auditing the income of those persons who are or might be subject to income tax. The method of handling the matter is to file all these returns in the Sorting Division of the Treasury Department where they are assembled with respect to every taxpayer involved in the situation. It follows that there is an accumulation of an enormous amount of private information in the Bureau which might, if open to general inspection, cause a great deal of trouble and annoyance, possibly losses and serious embarrassment, to persons concerning whom it was dis- closed. As a protection against this, it is provided that the returns and information of any sort filed in the Bu- reau of Internal Revenue are not public records, and cannot be inspected by any person excepting the taxpayer himself. Where, however, a state government imposing an income tax is for any reason desirous to obtain informa- tion concerning the federal income tax or the income reported by any corporation within its jurisdiction, the Governor of the State may by proper application obtain authority to inspect the return of such corporation. This is a mutual protection arrangement between the states and the United States, and is a part of the general desire to protect the Government against imposition or fraud. When a stockholder of a corporation has just reason to require any knowledge concerning the affairs of the company which the officers may for one reason or an- other refuse to disclose, he may on a proper showing apply and obtain permission to inspect the returns of the corporation. A stockholder to avail himself bf this must be a bona fide stockholder, and by that is meant one who has not merely acquired his interest in the cor- WITHHOLDING 199 poration for the sake of prying into its affairs, but must further own at least one per cent of the stock of the corporation. When such an application is filed by a stockholder, the Commissioner is charged with the re- sponsibility and duty of giving the corporation due notice to show cause why the disclosure should not be made. Stockholders obtaining such information are, of course, subject to penalty if they unlawfully disclose the infor- mation acquired. This is in line with the general provision that officers and agents of the United States are guilty of misdemean- or and subject to fine not to exceed one thousand dollars and to imprisonment not to exceed one year or both if they disclose the information obtained in their duties as agents of the United States Government. For the general information of Congress and the pub- lic, the Commissioner is required to publish periodical information concerning statistics of income, but the same is required to be published in such form as not to dis- close the identity of any of the persons about whose income and affairs the information is furnished. The student will now read, in the order given, Regu- lations 45, Articles 1533; 361 to 370 inclusive; 373 to 376 inclusive; 601; 1071 to 1080 inclusive; 1111; 1051; 1061; 1091; 1092; 1093; 1094; 1101. CHAPTER XIV MATTERS PARTIALLY OBSOLETE In considering excess profits taxes, we made mention of the tax rate under the 1918 provisions of the present law. It will be recalled that these rates were higher and that there was a third bracket to be considered in addition to the two corresponding to the 1919 brackets. This third bracket is what is known as the war profits tax. In order to understand it better, it seems well to review briefly a few of the incidents of the excess profits tax, especially as affected by the 1918 rates. The first bracket in 1919 was twenty per centum on so much of the net income as exceeded the excess profits credits and did not exceed twenty per centum of the invested capital. The second bracket was forty per centum on the amount of the net income in excess of twenty per centum of the invested capital. There was an additional proviso that if eight per centum of the invested capital plus three thousand dollars, which con- stituted the excess profits credit, should exceed twenty per centum of the invested capital, the excess of such credit might be used in reduction of the amount taxable under the second bracket, or the amount taxable at forty per centum. Now If we apply this same statement to the 1918 rates, we find that the first bracket is subject to a tax rate of thirty per centum instead of twenty as in 1919. The excess profits credit is the same, eight per centum of the invested capital, plus three thousand dollars. The second bracket is subject to tax at the rate of sixty- five per centum instead of forty as in 1919. The same application of any excess of the credit over twenty per 200 MATTERS PARTIALLY OBSOLETE 201 centum of the invested capital may be made with respect to this second bracket at the sixty-five per centum rate. Now the war profits tax constitutes the third bracket of the 1918 excess profits tax. It has no corresponding bracket in the 1918 rate. There is nothing in the 1919 rate beyond the first and second bracket, except the in- come tax. The third bracket is a complicated amount, being eighty per centum of the entire net income, irrespective of all previous brackets. Against this there is a war profits credit and this is in most cases a considerably larger credit. This third bracket, therefore, amounts to a tax of eighty per centum on the entire net income in excess of the war profits credit. This bracket does not apply in any case where the tax computed does not exceed the first two brackets at the 1918 rate. The tax under the third bracket is, therefore, that amount by which eighty per centum of the entire net income in excess of the war profits credit exceeds the tax computed under the first two brackets. It is spe- cifically provided that the third bracket shall not be con- strued to be a reduction of the amount of the first two, hence, the third bracket is a nullity if it does not exceed the first two brackets; said first two being the minimum tax. To understand the war profits tax we must go back and deal a little with previous conditions as applied to corporations. In the first place, the war profits credit is computed by comparison with conditions of the corporation during what is known as the pre-war period. This pre-war period consists of the calendar years 1911, 1912, and 1913, or if the corporation was not in existence during all three of those years, it consists of those whole calen- 202 INCOME AND PROFITS TAXES dar years of that period during which the corporation was actually In existence. To Illustrate this, if a corpo- ration opens Its business on July 1, 1910, and continues to date, it would have been In existence during all of the above three years. However, if it opened Its business on July 1, 1911, it would have been in existence only during the entire calendar years 1912 and 1913. The fractional part of any one of the pre-war years must be entirely disregarded. Let us remark at this point that where a corporation computed Its Income on the basis of a fiscal year, It can- not utilize a fiscal year in lieu of a calendar year. The proper method of adjustment in such case is not ex- plained in the Regulations, but the practice of the De- partment will be described by the author so far as he is informed on that subject in a later part of this chapter. Having determined the pre-war period of the corpo- ration, we now come to the point of computing Its war profits credit. This credit consists of three items : First, the average net Income of the corporation for the pre- war period; second, ten per centum of the increase or decrease in the Invested capital of said corporation since the pre-war period; and third, a specific credit of three thousand dollars. Let us take the three elements of this credit under consideration one at a time, and determine the various angles from which the same is considered. First, we have the average pre-war net Income. This average net income consists of the net Income of the corporation for all those whole calendar years of the pre-war period during which said corporation was In ex- istence, divided by that number of years. To illustrate : in the case of the previously mentioned corporation, open- ing business on July 1, 1910, and continuing throughout MATTERS PARTIALLY OBSOLETE 203 the pre-war period, the entire net Income from January 1, 1911, to December 31, 1913, would be divided by three to determine the average. In the second example, a corporation opening business on July 1, 1911, there be- ing only two whole calendar years of the pre-war period during which It operated. Its entire net Income for the two years from January 1, 1912, to December 31, 1913, would be divided by two to determine Its average pre- war net Income. So determined, this average pre-war net Income constitutes the first Item of the credit. We now come to the question of adjustment of changes In the Invested capital of the corporation. The invested capital of the corporation is to be found by taking the said Invested capital, computed In every respect as In- vested capital Is computed for the purposes of excess profits taxes, for the beginning of each of the whole cal- endar years in the pre-war period during which the cor- poration was In existence. Let us revert to our first corporation in the above illustration. Being engaged In business throughout the pre-war period. Its invested cap- ital for that period would consist of the sum of its In- vested capital as of January 1st for 1911, 1912, and 1913 divided by three. Having divided this pre-war Invested capital by the number of years, we find the aver- age for the pre-war period. Against this average we compare the Invested capital at the beginning of the current year, and it must be remembered that for this purpose the year 1918 only Is meant except In the case of those corporations deriving Income from government contracts. We compare the invested capital at the be- ginning of that year with the average pre-war Invested capital as determined above. If the difference shows that the Invested capital has been Increased, ten per centum of the amount of the increase may be taken as 204 INCOME AND PROFITS TAXES the second item of the war profits credit. If the com- parison discloses a reduction of invested capital, ten per centum of the amount of the reduction must be taken as a minus quantity or deduction from the other items of the war profits credit. Of course, the three thousand dollar specific exemp- tion does not need an explanation. It is simply added to the amount determined by the first two items. Now if the entire war profits credit as computed by the aforegoing process amounts to less than ten per centum of the invested capital of the corporation for the taxable year, instead of using the credit so computed the Regulations provide that ten per centum of the in- vested capital must be used, that being the minimum for the first two items, and to this will be added the specific credit of three thousand dollars. The ten per centum minimum only applies to those two items of the war profits credit which are covered by income and increase or decrease of invested capital. In any case where a corporation makes a return for a period of less than twelve months, the same principle applies in the adjustment of the war profits credit as is used for the determination of the excess profits credit. The number of months covered by the return is to be taken as the numerator of a fraction of which the de- nominator is twelve, and that fractional part of the war profits credit determined in the usual manner constitutes the war profits credit for the purposes of such a return. In the case of corporations which were not in exist- ence during any whole calendar year of the pre-war period, there are two methods provided by which they may compute their war profits credits. The first and simplest is to use the minimum described in the last para- graph, that is, ten per centum of the invested capital MATTERS PARTIALLY OBSOLETE 205 for the taxable year, plus three thousand dollars. The second method consists of taking that percentage of in- vested capital of the corporation for the taxable year which is equal to the percentage of net income to invested capital for the pre-war period In the case of corporations engaged in the same general class of business as that conducted by the taxpayer and similarly situated In gen- eral with respect to the size of the company, and so forth. To this calculation, however, the provided minimum ap- plies so that the credit shall not be less than ten per centum of the invested capital, plus three thousand dollars. There are two Instances in which this method of com- puting war profits credits for corporations not in exist- ence during the pre-war period is prohibited: First, where at any time during the taxable year the majority of the stock of the taxpayer corporation was owned or controlled by a corporation which was in existence during the whole of any one calendar year during the pre-war period; second, where fifty per centum or more of the gross Income of such corporation consists of Income de- rived from government contracts. It Is easy to deduce that this restriction was placed to avoid any abuse of the opportunity of corporations for reorganizing or otherwise avoiding taxes by readjustment of their corpo- rate connections. In the case of affiliated corporations generally, it must be remembered that only one credit of three thousand dollars is allowed the entire group, as in the case of the excess profits credit. The other items of the war profits credit are computed in the usual manner on their con- solidated income and capital. There is another provision affecting affiliated corpo- rations in respect to the elimination of Inter-company 206 INCOME AND PROFITS TAXES items, Interlocking stockholdings, and so forth. The method of calculation Is the same as in any other cases of preparing consolidated balance sheets. However, If a group of affiliated corporations contains companies which were not a part of the group during the pre-war period but existed during that period, the method of determining the pre-war invested capital is to take the pre-war invested capital of the group in the usual man- ner so far as comprised during the pre-war period and to add to that the average Invested capital of the other later affiliated corporations. In such cases the Income and the Invested capital for the taxable year shall be computed over the entire group as a whole. Where a corporation Is the successor in business of an unincorporated organization existing during the pre- war period. It is provided that the corporation now re- porting shall consider the predecessor business as If the said corporation were at that time operating the same. In making Its return the corporation shall consider the net income and invested capital of such predecessor trade or business, and shall compute Its war profits credit on the basis of the net Income and invested capital of such predecessor. In such case the rules for the determination of average net income and invested capital for the pre- war period must be observed in determining the average net Income and invested capital of the predecessor during the pre-war period. Furthermore, adjustments of such items as may appear on the books of the predecessor and not on those of the successor, or vice versa, must be duly and properly made. This means that Intangibles and inadmisslbles must be completely adjusted, and such Items as good will, franchises, and so forth, as may have dis- appeared or first appeared at the time of Incorporation must be adjusted so as to make the accounts of the two MATTERS PARTIALLY OBSOLETE 207 concerns reasonably conformable. All differences in the statistical methods of calculating the income and capital for the predecessor and the corporation, respectively, must be duly and properly explained so that a reasonable attempt at paralleling the two may be made. In all of the aforegoing cases the rules for computing the net income for the pre-war period are to be found by reference to the Regulations and the income tax laws of 1909 and 1913, respectively. There are a great many differences between the methods of determining income of corporations under the 1909 and 1913 laws, and the 1918 law. It is impossible to rehearse these in a brief text of this character. The substance is that the income for the purposes of pre-war periods should be taken as reported in the income tax returns for those years, except that income taxes paid during those years by the corpo- ration may be readded to the income. This is done to compare with the present restriction against the deduc- tion of income taxes as an expense. Where affiliated corporations are making a consoli- dated return, the entire group income as the group now exists, so far as that group includes corporations affiliated during the pre-war period, is to be taken for the pre-war period plus the incomes of those corporations not in the group at that time. As a phase of the general subject of businesses now incorporated which were conducted during the pre-war period by firms or individuals, it is required that any asset in existence both during the taxable year and the pre-war period must be valued on the same basis both for the taxable year and the pre-war period, or where such an asset is valued on a different basis in computing the invested capital for the pre-war period and the tax- able year, respectively, the difference resulting from this 208 INCOME AND PROFITS TAXES variation in accounting for the item shall be excluded in determining the difference in invested capital of which ten per centum constitutes the second item of the war profits credit. Where a corporation is organized since March 3, 1917, and fifty per centum or more of the assets of its predecessor business remain in any of the previous own- ers by reason of their ownership of stock in the new corporation, such assets for the purposes of determining the invested capital of the corporation must be valued, if the predecessor was a corporation, at the same amount as they were valued on the books of the predecessor, but if the predecessor was not a corporation they must be valued at cost to the predecessor plus improvements and minus depreciation and losses. We mentioned some while ago that the pre-war period must consist of even calendar years. We suggested that we would explain the practice of the Department with respect to cases in which the corporation returns and calculations of income were based on a fiscal year differ- ent from a calendar year. The procedure is as follows : We assume as a base the invested capital of the cor- poration at the beginning of the fiscal year which ends during the pre-war period. A corporation having a fiscal year ending July 1st would take as its base for this com- putation the invested capital at the beginning of the fiscal years ending on June 30, 1911, 1912, and 1913, re- spectively. To each of these items of invested capital, dated July 1, 1910, 1911, and 1912, respectively, must be added the accrued profits of the corporation for the period between the beginning of such fiscal year and the first of the following January, and any additions to cap- ital during such period in each following year. From the total thus obtained must be deducted all distributions MATTERS PARTIALLY OBSOLETE 209 by way of dividends made during the period from the beginning of such fiscal year to the first of the next suc- ceeding January, all diminutions of capital by way of liquidation or retirement, or all losses of capital which occurred In such period. This method of calculation results in the adjustment of invested capital from the beginning of the fiscal year of the corporation to the beginning of the calendar year of the pre-war period in which that fiscal year closes. The three respective totals thus found will be used as the average and divided by three to obtain the average invested capital for the pre- war period. Where a corporation was in existence dur- ing only two or one of the calendar years, the process would apply only to the fiscal years ending in those calen- dar years during which such corporation was In existence throughout the whole calendar year. Returns for the purposes of the war profits tax are made on the same form as that provided for the excess profits tax for the year 1918. Where a corporation accepts the minimum war profits credit, no data as to the pre-war period are required. A foreign corporation naturally has no interest In any of this provision, as it is to compute its invested capital on the average as explained In a preceding chapter. Now you will recall the limitation on the excess profits tax for the protection of all corporations. The limita- tion in that case provided that the excess profits tax should not exceed twenty per centum of the amount of the net income in excess of three thousand dollars and not in excess of twenty thousand dollars, plus forty per centum of the remainder. In similarity to this provision the limitation on the 1918 tax, which applies to both excess profits and war profits taxes, is that the said tax in its entirety shall not exceed thirty per centum of the 210 INCOME AND PROFITS TAXES amount of the net income in excess of three thousand dollars and not in excess of twenty thousand dollars, plus eighty per centum of the remainder of the net income. The operation of railroads under federal control ne- cessitated some special provision for their taxation under the Revenue Act of 1918. At the time of this control the Revenue Act of 1917 was in force and the contract made for the control of these railroads by the Federal Government was assumed to have been made in the light of the tax laws then existing. In order to meet this con- dition it was stipulated that the agreement should make due and proper provision for the adjustment of income and other taxes as between the transportation corpora- tions and the operating governmental bureau. The re- sult of this is that for the year 1918, five-sixths of an income tax computed by the ordinary method in respect to net income of the railroad should be considered as a tax levied under the Revenue Act of 1917 payable by the corporation owning the railroad, and that one-sixth of the tax so computed should be paid by the federal operators out of the operating income of the railroad during the period of federal control. For the year 1919 the proportion was four-fifths payable by the corporation and one-fifth payable by the federal operators. This provision applies only to the income tax on corporations and is intended to cover the fact that the two per centum as levied under the 1916 Act is all that the Federal Gov- ernment is required to pay out of the operation of the railroads. The excess profits tax of the corporation owning a rail- road was payable by the corporation. The next item which may be said to come under the heading of obsolete provisions in the Act relates to the subject of the amortization of war plants and equipment. MATTERS PARTIALLY OBSOLETE 211 In order to understand the real meaning of this subject let us first consider what constitutes the kind of assets meant by the provision. Where a plant consisting of machinery or other equipment, or buildings to house the operations involved in the manufacture of munitions or other articles intended for the prosecution of the war were installed, built, or purchased by a taxpayer, the said plant, equipment, machinery, or building are gen- erally comprehended under the name of war plant and equipment. The amortization provisions were designed as an inducement to manufacturers to engage in the manufacture of those articles needed by the Government for the prosecution of the war without necessitating the bearing of losses by these manufacturers on account of the investment they might be compelled to make in the equipment necessary for producing the desired goods. Of course, a reduction of tax does not replace the prop- erty, that is not the intention of the provision, but it was designed that instead of compelling the manufacturer to capitalize permanently the amount required for the investment he would be permitted to charge the same in reasonable instalments against the expenses of pro- duction. It is impossible to estimate to what extent this provision might have continued had the war lasted longer, but the war terminated before the actual passage of the Revenue Act of 1918, and as a result the provisions for amortization are limited to the fact that by the termina- tion of the war a very early and rapid loss in value of especially installed assets was to be expected. Amortization in this case is similar to depreciation in its ordinary sense, except that instead of being intended to cover actual wear and tear in usage, as is the case of depreciation. It is designed to permit the complete charging off of the value of the property at a very much 212 INCOME AND PROFITS TAXES more rapid rate. The provision for amortization, how- ever, includes depreciation which might otherwise be claimed and there is no possibility of using both claims with respect to the same property. At this point let us suggest that the definition of a government contract for the purposes of the Revenue Act of 1918, wherever that term applies to the provi- sions of the Act, is limited to those contracts made by the United States, its agents, or subagents between April 6, 1917, and November 11, 1918. The provisions and application of government contracts in respect to amorti- zation, however, are not quite so restricted, because those institutions or manufacturers which engaged in the manu- facture of any article directly or indirectly intended for the prosecution of the war, whether or not directly made with the Government or its agents, would be still entitled to avail themselves of the provisions for amortization if the article were intended for such use. Included under the heading of articles intended for use of the Govern- ment for war purposes is also the construction of vessels intended for the transportation of troops. The basis of the amortization is the cost of the prop- erty installed after April 6, 1917. Where property was partially installed prior to that date only so much of the cost as represents the installation after that date may be used in computing the amortization. From this cost, however, must be deducted the value of the property for sale, or the value of the property for continued use in the business of the taxpayer under stable post-war conditions, or the scrap value of the property if the same is to be completely abandoned. If any depreciation in respect to the property has been claimed in previous returns such depreciation must be de- MATTERS PARTIALLY OBSOLETE 213 ducted from the cost before its application to the pur- poses of amortization charges. To reduce these three principles for the determination of the amount which is to be covered by amortization claim to simpler expression, let us say firstly that where the property was erected for and of use only for the pur- poses of the production of war material and the same has been permanently discarded or the manufacture of war material has been permanently discontinued at or prior to the date of the return, the salvage value at the time of its discard deducted from the cost less any previously claimed depreciation constitutes the total for amortiza- tion. If the property is still in use at the date of the return by reason of the fact that the contracts with the Government are not then completed, but would not be useful in the ordinary business of the concern, the residual value to be considered is the salvage or scrap value at the time when it will be discarded. Where the property may have some permanent value, the basis which is to be considered as residual for this purpose is the estimated reproduction cost as of April, 1919. This amortization is merely a tentative claim. It is not a permanent charge to expense but will be reviewed in every case at some later date. Such claim as is made for amortization, therefore, is merely a temporary abate- ment of tax liability and will result when the ultimate disposition of the property determines a true loss, if any, in an adjustment of the taxes for those years in which the amortization claim was included in the return. By an amendment to the Regulations all returns made in the calendar year 1919 were limited to the inclusion of not more than twenty-five per centum of the cost of such property as an amortization claim. The claim for amortization must be distinctly and sep- 214 INCOME AND PROFITS TAXES arately shown in the return and not merged in any other item. Where by the terms of the contract under which the production of war material was conducted, the manu- facturer was allowed as a part of the contract an amount to cover amortization of a specially constructed plant, such an amount must be included in the income and also by separate reference and not merged in other items. In- cidentally, let it be remembered that having permitted these allowances for the purposes of reducing taxes, at least temporarily, the amount of these allowances cannot be considered as reserves which can be included in the invested capital of the corporations. However, when the ultimately adjusted amortization loss is determined the capital will be simultaneously adjusted by such portion of amortization as is not allowed in final settlement. The redetermination of the allowances for amortiza- tion may be made at any time within three years by the Commissioner at his own discretion, or on the request of the taxpayer shall be made. This means that the tax- payer may within three years after the termination of the war require the Commissioner to readjust these amortiza- tion allowances so as to bring them to a true statement of the facts. In connection with such claims and allowances, there is a certain amount of data to be furnished by the tax- payer covering the purposes of the plant, the processes of production, evidence of its purpose, and date of its construction or purchase as well as details of the methods by which the computation of the claim was based. All of these data are, of course, reasonable as information in order to enable the Commissioner to determine the rea- sonable allowance tentatively, and as a means of verifying ultimately the actual loss resulting from the entire situa- tion. MATTERS PARTIALLY OBSOLETE 215 As another special element placed in the law by reason of war and post-war conditions as anticipated when the statute was passed, it was provided that for any fiscal year ending in the calendar year 1918 where the tax- payer submitted his return on the basis of an inventory and prior to the making of the return learned or realized material reduction in the value of the inventory by reason of serious market changes, he might defer the payment of the taxes to the extent which such losses would ulti- mately justify, by making a claim for abatement based on the reduction In the value of his inventory resulting from such market changes. This same protection was ex- tended to taxpayers who might, under contract made prior to the close of their 1918 taxable year, have been com- pelled to make rebate to their customers with respect to the goods then sold. These could not be made a part of the regular income tax return but must be covered by claims for abatement and refund, the formalities for which have been explained previously. Besides this, claims based on rebate could not be given consideration unless in respect to sales of which the profits had been included in the 1918 taxable year income, and claims for losses in inventory could be made only where such in- ventory was used in determining the income for the 1918 taxable year. Now to consider the statistics of the loss. In the first place, assuming a physical inventory at the close of the taxable year 1918, a loss may be determined in two ways : first, by actual sale of the goods at less than the inventory price plus reasonable selling expenses; or second, by a reinventorying at the close of the succeeding taxable year. While this latter loss is not realized, the application of the inventory method to accounting constitutes it a reali- zation for this purpose. In either event the loss ascer- 216 INCOME AND PROFITS TAXES tained must be an actual and substantial loss. The De- partment was authorized to and declines to consider trifling matters of this character. What amounts to substantial loss, however, might be very trifling in detail although heavy in aggregate result. Where there are a large number of items in an inventory, a drop in price although a trifling loss on single items amounts to a great deal for the entire group. Let us take a practical view of the method of dealing with a case of loss in inventory on goods sold. Where the inventory at the close of the taxable year 1918 dis- closed a then market or cost value for goods, and these goods were sold during the year 1919 at such a price that, when taken at the inventory price plus reasonable selling expenses, the result was an actual loss to the taxpayer, this loss constitutes the basis of the claim. In such in- stance the sales made after the inventory are considered in the order made until the entire quantity (not value) of goods in the inventory is exhausted. The aggregate of the sales at that point constitutes the selling price of the inventory. This provision was, of course, to be applied item by item to a class of goods or character of goods covered in the inventory and subject to the claim. If in such instance, however, the selling price of the goods merely amounted to a reduction of profits, that is to say the usual or average rate of profit on the goods handled by the taxpayer, it did not constitute a loss and could not be so considered. Where the goods listed in the inventory remained un- sold throughout the taxable year 1919 the inventory value of the same on the usual cost or market, whichever is lower, basis at the close of 1919 was to be compared with the inventory value at the close of 1918, and if the same resulted in a loss on those goods, the amount of that loss MATTERS PARTIALLY OBSOLETE 217 constituted the ultimately determined claim. In this case, of course, the selling expenses have no bearing whatso- ever. Such a loss when finally determined constituted a claim for the reduction of the tax liability for the taxable year 1918. In other words, a drop in the market resulting in such a loss during the taxable year 1919 was permitted to be carried back and made effective in reducing the tax- payer's liability for income and excess profits taxes for the year 1918. If the taxes for the year 1918 had been paid prior to the filing of such claim, the claim should be a claim for refund; if such taxes had not been paid, the claim should be a claim for abatement. The final adjustment of the loss by the determination of the ultimate result from the inventoried goods was to be settled not less than thirty days after the close of the taxable year 1919. To settle the same the taxpayer would be obliged to file a further statement setting forth the ultimate results of the hand- ling of these particular goods. A report for this purpose was necessarily complex in detail, consisting as it did of comparative figures concern- ing the items of the entire Inventory in so far as such inventory constituted the basis of the claim. It would be obliged to disclose the dates of the ultimate sale, or the inventory value of the goods at the close of the year 1918 item by item and in such manner as to be readily verified by reference to the books of the taxpayer. It was, of course, to be understood that any loss so allowed would naturally amount to a technical reduction of the inventory at the close of 1918, consequently the amount of such loss was necessarily a reduction of the invested capital for the year 1919. Where such a claim was filed simultaneously with the 218 INCOME AND PROFITS TAXES return of the taxpayer for the taxable year 1918, pay- ment of the tax could be based on the amended amount. There were two restrictive provisions in connection with such claim which probably deterred a great many from filing claims who might otherwise have done so. First, a bond had to be filed with the claim conditioned for the payment of the tax in so far as the claim was disallowed, and second, the amount disallowed under any such claim was to bear interest at the rate of twelve per centum per annum from the date the tax would have been due If not amended by such claim. Losses by reason of actual sales, or losses incurred by rebate, might be adjusted finally by the taxpayer Immedi- ately after the completion of the transaction which dis- closed the actual loss, but In the case of unsold goods no adjustment would be made under any circumstances until at the close of the taxable year 1919. The author categoried this as among matters obsolete because relating to a past year. As a matter of fact the author feels Impelled to remark that in view of the market conditions throughout the country during the year 1919, it Is probable that a great majority of those who availed themselves of this privilege were probably compelled In the last analysis to pay all of the tax they claimed to be abateable, as there were very few Instances of material reductions In market values during the year 1919. The provision would have been very Important had the market broken after the armistice, as was anticipated when the law was enacted, but the market did not break as most of you know who have any familiarity with the cost of living or business expenses during the year 1919. Our last provision relating to the effect of war condi- tions on taxes lies in the allowances made In the Act for the application of net losses In subsequent years to a re- MATTERS PARTIALLY OBSOLETE 219 duction of 1918 taxes. In effect the provision is that any business organization which in its ordinary operations or by reason of a loss on the sale of a war plant or building, in a fiscal year beginning after October 31, 1919, and ending on or before December 31, 1919, sustained an actual net loss on its entire year's business was privileged to apply such net loss in reduction of its net income for its previous fiscal year. It was then privileged to recom- pute its tax for the fiscal year 1918 and was entitled to an abatement or refund of the difference between the tax as computed on the reduced income and the tax previously returned as computed on the fiscal year 1918. Further- more, if such a concern sustained so much loss within the dates mentioned as to exceed its net income for 1918, it was permitted to carry the excess forward and use it in reducing its taxable income for the year 1920. The term taxable year for the purpose of the Act is defined as being a period of twelve months. The taxable year 1919 would be a period of twelve months corre- sponding to the calendar year of 1919 or ending during the calendar year 1919. The natural inference is that the net loss provision just described would apply only to a period of twelve months beginning and ending in the period of time between November 1, 1918, and Decem- ber 31, 1919, both dates inclusive. Whether the Bureau would have permitted an institution which was cognizant of a net loss to have changed its fiscal year which other- wise overlapped this period, so as to bring it entirely within the period and report a period of less than twelve months in order to bring such period entirely within the scope of the provision, cannot be answered at this writing. It is distinctly known, however, that in one instance, the Bureau did decline to permit an amended return to be filed on the basis of a change in the fiscal year in order 220 INCOME AND PROFITS TAXES to effectuate such claim. We are inclined to believe per- mission to change the fiscal year which would have re- sulted in such a net loss claim would have been denied. Such a claim being based primarily on a fiscal year al- ready closed and being applicable in so far as the recovery of taxes is concerned to a fiscal year closed a year prior thereto, it follows that the taxes in the previous year would under normal conditions have been paid in full. The claim, therefore, would take the form of a claim for a refund. Owing to the peculiar allowances concern- ing the payment of taxes for the fiscal year 1918, on account of the delayed enactment of the Act, it would have been entirely possible for a condition to have arisen where a fiscal year ended on October 31, 1919, or No- vember 30, 1919, might have closed before the last in- stalment of the 1918 tax had been actually paid. Under such circumstances, although an unusual condition, a claim for abatement of the remainder of the tax would have been a part of the procedure. The amount to be claimed, of course, was the difference between the tax as computed on the original return for the 1918 year and the tax as recomputed after deducting from the income of 1918 the net loss for 1919. We have used the term 1918 year and 1919 year rather indiscriminately for the sake of brevity. The actual possibilities in the case are as follows : The calen- dar ysar or fiscal year to come within the period would have to begin on October 31, November 30 or December 31, 1919. The previous year would have been closed on October 31, November 30 or December 31, 1918. Hence our reference to them as 1918 and 1919 respectively. Where we have suggested the possibility of applying any excess of the 1919 loss over the 1918 income in reduction of the income as shown by the 1920 return, such a situa- MATTERS PARTIALLY OBSOLETE 221 tion could arise only in the case of a fiscal year beginning after October 31, 1919, and ending before December 31, 1920. As a matter of administration, necessitated by the over- lapping of the Acts of 1917 and 1918 so far as public knowledge is concerned and its connection with withhold- ing of income at the source described in the previous chapter, it is provided that on payments made prior to February 25, 1919, where withholding was observed by the source of the income, in accordance with the Acts of 1916 and 1917, which were then still in force, so much only as was actually withheld in accordance with those previous acts was necessary to be returned by the source or withholding agent in conformity with the Act of 1918. In other words, where the withholding under the 1918 Act was at a higher rate with respect to any item than the withholding under the previous Acts, and items of income paid prior to February 25, 1919, were therefore allowed to escape the custody of the withholding agent prior to his knowledge of the additional requirements of the later act, his responsibility was limited to the duties described in the earlier act. Because the provisions of the 1918 Act were in some respects more generous in their treat- ment of foreign corporations, it was furthermore pro- vided that where amounts withheld under the 1916 and 1917 Acts prior to February 25, 1919, exceeded those re- quired under the 1918 Act, the withholding agent need return only the amount required under the later Act. In cases of payments subject to withholding, made sub- sequent to February 24, 1919, but accruing to the re- cipient prior to that date, the return according to the pro- visions of the 1918 Act must be computed on the basis of the entire payment and not merely of the amount accrued. 222 INCOME AND PROFITS TAXES Of course, in cases of withholding under the 1916 and 1917 Acts on income paid after December 31, 1917, in excess of the necessity provided in the 1918 Act, the ex- cess would be subject to refund on a proper claim by the taxpayer. It was permitted that such refund should be itemized and submitted to the Commissioner or Collector on the annual return of the taxpayer and that would con- stitute the basis for refund. The student will now read, in the order given. Regu- lations 45, Articles 701 ; 712; 717; 771 ; 781 to 785 inclu- sive; 869; 931; 932; 801; 802; 933; 934; 941; 961; 962; 504; 181; 1510; 182 to 188 inclusive; 261 to 268 inclusive; 1601; 1602; 1603; 371 ; 372. CHAPTER XV THE CAPITAL STOCK TAX The capital stock tax is an excise tax levied on the doing of business under the corporate form organization. It was passed as an element of the Revenue Act of 1918. It follows that many of the provisions of the Revenue Act of 1918 even though not written within that section of the Act relating particularly to capital stock taxation yet nevertheless will apply to the capital stock tax, be- ing a part of the same general act. In discussing this tax we will follow the same broad outlines as have been used in setting up our discussion of the income tax. That is to say, we will first consider what is taxable and then who is taxable and then the rate of taxation, and the administrative procedure in respect to the same. The tax is levied fundamentally on the privilege of "doing business" under the corporate form of organiza- tion. The tax is, therefore, on the carrying on or the conducting of a business. We must first consider what constitutes "doing business." Fundamentally, corporations are organized for two classes of purposes. The first is that class of corpora- tions organized to conduct a business enterprise such as might be conducted by individuals for the purpose of earning their livelihood. On the other hand, corporations may be organized for the purpose of holding title to property and acting as intermediary between the owners and those persons from whom the income from said prop- erty is derived. In other words, the corporation may be organized to stand in lieu of those who own property whether real or personal for unity of action in dealing with those from whom the income is derived, whether 223 224 INCOME AND PROFITS TAXES rent, interest, dividends or other so-styled unearned in- come. The latter class of corporations is commonly called holding companies. A holding company is nor- mally not considered to be doing business. Its function is that of an intermediary between its stockholders and the tenants, borrowers or corporations from whom the income is derived. So much for the purposes actuating the organization of corporations. A corporation organized for one or the other of such purposes may for one reason or another change its function so as to enter the other class. For in- stance, a corporation originally organized for the purpose of conducting a mercantile establishment may close its business as a merchant and thereafter its activities would consist solely of collecting its assets, distributing the same to its stockholders, and otherwise going through the pro- cess commonly called liquidation. Such a corporation during the period in which it is merely liquidating would not be engaged in "doing business." Although not or- ganized as a holding company this corporation would have become a holding company from the change in its activities. On the other hand, a corporation originally organized as a pure holding company may from necessity change its position and become an active corporation. An ex- ample of this would be in the case of a corporation or- ganized originally to hold title to a parcel of real estate subject to rent. By reason of a change in the tenancy or in the conditions of the tenancy, such corporation might be required to act as a managing entity for the property and in such case it would be considered and construed to be doing business. The real test or division between the two classes of corporations would somewhat parallel the distinction be- THE CAPITAL STOCK TAX 225 tween an active and passive trust. If the functions of the corporation are purely those of a holder of title, whether the property be real or personal, and the entire activities consist of receiving and distributing the amounts arising from the property, it is a holding company. When it enters the domain of active conduct of or management of a business or property from which the Income is derived, it ceases to be a holding company. This would be so even where its activities in this respect were limited to the supervision of investment or the financing of the affairs of those subsidiary companies whose stock is held for its own stockholders' benefit. In the case of a corporation formerly actively engaged in business but now liquidating its affairs, however, the line is not drawn quite so finely against those administra- tive acts which would become necessary for the purpose of collecting its assets, exchanging them for cash or its equivalent, distributing them as liquidated A distributing them in kind. During the process of liquidation such a corporation would be fully entitled to the status of a holding company for the time being. The tax is levied on the privilege of doing business in corporate form for the period from July 1st to June 30th of each year. The tax is levied in advance. By a special provision in the Act the tax is not levied in the case of those corporations which were not in business during the preceding year. That is to say during the preceding year ending June 30th. This tax is limited to the year beginning on July 1st and ending on June 30th, and there is no application of any question of fiscal or calendar year in this particular instance. To illustrate this by an extreme example, a corporation which opened its doors for active business on the 30th day of June, 1920, would be liable to the tax for 226 INCOME AND PROFITS TAXES the year beginning July 1, 1920, and ending June 30, 1921. If said corporation had deferred its opening until July 1, 1920, it would be free from this tax until July 1, 1921. On the other hand, if a corporation discon- tinues active business and becomes a holding or liquidating company on June 30, 1920, it is not liable to tax from July 1, 1920, to June 30, 1921, but if it does not close its doors until July 1st so far as active business is con- cerned it is liable to the tax for the entire following year. An exception to this lies where one corporation suc- ceeds another. If the predecessor in such instance was engaged in business prior to July 1st, the successor is liable for the capital stock tax. The tax is based on the fair average value of the capital stock of the corporation. The use of the term fair aver- age value precludes any exclusive construction that the market value of the stock is the only basis on which the tax can be levied. It admits of the construction that the fair average value is made up of three principal elements, to wit: the book value or net worth of the corporation, the market value of its stock, and its earning capacity. The student will readily understand that, except for those cases in which the stock of the corporation is dealt with in the open market largely for speculative purposes, the triple basis stated in the foregoing paragraph in reality constitutes the true measure of the value of the capital stock of any corporation. Under the subject of invested capital in discussing in- come taxes we considered very broadly the question of capital and surplus. Any student familiar with business affairs generally will realize that the capital and surplus, including undistributed profits, represents the proprietor- ship or the aggregate interest of the stockholders in the assets minus the liabilities of the corporation. The com- THE CAPITAL STOCK TAX 227 bination of the capital and surplus truly presents the fair value of the entire stock. In other words, the capital stock outstanding if it has a par value may be entirely foreign to its true value on the balance sheet because of the ex- istence of a surplus or a deficit. Let us now consider the practical end of estimating the fair average value of the capital stock of a corporation on which is to be assessed its capital stock tax. First, we will consider the book value. Book value represents or means net worth. Net worth is, as the student will know, the difference between the assets and the liabilities of any business enterprise. It is, to those familiar with balance sheet construction, the assets minus the liabilities and equals the proprietorship group of accounts. It is very clear then that in constructing the net worth of a corporation as one of the elements for determining the fair average value of its capital stock, it is necessary to eliminate from the balance sheet all of those accounts which do not represent assets or liabilities. The general class of accounts which are thus eliminated consists of those elements generally described in the subject of in- vested capital as intangible and also of those items found in technically prepared balance sheets which are called deferred assets or gains, or deferred liabilities or losses. Having eliminated the intangibles and the deferred gains or losses, as the case may be, we must also eliminate any constructive liabilities which correspond to the general style of accounts eliminated under the heading of intangi- bles. This would largely be an elimination of reserves except where those reserves actually represented accrued reduction in value of assets such as depreciation. To present this still more concretely to the student, the author offers the following assets as those usually elimi- nated in preparing balance sheets for capital stock tax 228 INCOME AND PROFITS TAXES purposes: good will; franchises; patents and trade- marks, unless paid for in cash or its equivalent (other- wise they are merely another name for good will) ; those deferred debit items such as unexpired insurance, prepaid rent and taxes, unexpired advertising contracts, prepaid interest and discount, and deferred charges to operating or administrative expense. So much for the debit side of the balance sheet. On the credit side the items to be eliminated will con- sist principally of those reserves which are a mere allo- cation of surplus, such as contingent sinking fund re- serves, also such matters as unpaid wages, unpaid and accrued Interest, deferred Interest and discount liabilities, and deferred credits to income generally. Having eliminated these we now deal with the true assets and liabilities and set up as a result a true net worth, which constitutes the first element for the determination of the fair average value. Our next element is the market value of the stock. Of course, where the stock is dealt with on the public ex- change, the market value consists of the prices quoted on the exchange for the stock. There is no other possible answer to the question. Where the stock Is not dealt with on the public exchange but there is or has been some deal- ing In it, information as to the prices at which the stock has been transferred during the fiscal year will constitute the determination of a selling price for the stock. In small corporations it Is, of course, more often than not the case that there Is no general dealing in the stock. There being none whatsoever, the corporation cannot re- port any and the questions under this heading will have to be answered "none." Occasional sales of the stock where known to the corporation should be reported if the prices are known. If they are not known, the report can- THE CAPITAL STOCK TAX 229 not be made. Care should be taken that Influenced sales, that is to say, sales which are made for particular reasons such as the preservation or effectuation of a control in a corporation, or instances where stockholders in small cor- porations are compelled because of surrounding condi- tions to withdraw from the same, should be carefully ex- plained in the light of their surrounding circumstances so that no unfair opinion be created by the prices realized. The third element is that of earning capacity. To de- termine the earning capacity, the Department provides that the same shall be based primarily on the actual net earnings of the corporation for the preceding five years if it has been in existence for that length of time. If it has not been in existence so long, the average will be based on the period in which it has operated. As a starting point in the determination of this average income, the Bureau requires that there be listed for its information the net taxable income of the corporation as reported for in- come taxes during the preceding five years, or such number of years less than five during which it has operated. Realizing, however, that this net taxable income does not in any sense constitute the true earnings of the corpora- tion, it is provided that there must be added to this net taxable income all untaxable income, and deducted from the same all undeductible expenses. In other words, the same will be reduced to the actual increment to the cor- poration. For its own protction against overtaxation the corpora- tion will necessarily consider in determining this average all of any periods in which the operations resulted in losses. It is almost needless to say that unless these losses were considered, a very false impression would be created as to the average earnings during the period. Having determined the average or rather the aggregate, 230 INCOME AND PROFITS TAXES we now reduce them to an average by dividing the total by the number of years covered by the statement. Where a corporation returns for a full five years it is a simple matter of division by five. Where a corporation returns for a shorter period and any of the years covered by the return are periods of less than twelve months, it follows that in using this particular period in computing the aver- age it must be given weight in its fractional effect only. Let us illustrate this. We will suppose a corporation has reported in respect to its income history that during the two preceding full years it earned $10,000 each and having been organized during the third preceding year, it was in business only eight months in that period with earnings of $4,000. It would be entirely unreasonable to divide the total of $24,000 by three, and still more unreasonable to divide it by two. The proper action would be to divide it by two and eight-twelfths, or two years and eight months' earn- ings reduced to one year's average. For convenience in reporting income in order to com- pute this average, the Bureau permits that the same may be reported as of the close of the fiscal year of the cor- poration. That is to say irrespective of the fact that the return is made as of the 30th of June, the date of the last preceding five fiscal closings if annual may be used In com- puting the average earnings of the corporation. After determining the average annual income of the corporation on the above formula, the officers reporting are charged with the duty of placing what they consider a fair income rate on their stock. What is meant by a fair income rate is generally taken as that rate which the corporation would necessarily have to earn in order to maintain Its stock at par, other things not being consid- ered. THE CAPITAL STOCK TAX 231 It will be apparent that the determination of such a rate is extremely difficult. In the first place it is very dif- ficult to disassociate your mind from the other conditions surrounding the corporation such as book value and its market value for selling purposes. What constitutes a fair income rate for the purposes of maintaining the stock at par would not only be impossible of determination without knowledge of the book value of the stock, but it would depend on the book value of the stock in any in- stance. Two corporations earning equal income, having equal capitalization, would not find their stock selling on a parity if the respective book values A^ere widely variant. The corporation whose book value was actually depleted would necessarily be under the obligation of earning an enormously greater income in order to carry its stock to a par realization. The reason for this is that a purchaser in investigating the matter would realize that unless the return was suf- ficiently large to warrant his assuming the risk of loss in case of liquidation or cessation of the business, he would be foolish to invest his money in a concern which could never pay him dollar for dollar on the stock. On the other hand, a corporation with a large surplus would be able to sell its stock at par on a reasonably small income capacity because the purchaser would realize that even without a large income return he would still be entitled to his share in income already earned and represented by the surplus or undivided profits then existent. This last is especially so in the case of banking institutions whose stock commonly sells for far above a price which would pay the usual interest rate on the purchase. Another matter entering into the difficulty of fixing the rate lies in the fact that the risk of a business must be duly considered. Money as such may be worth six per 232 INCOME AND PROFITS TAXES cent, but very few persons would entrust their money in a corporate enterprise for a mere six per cent return when they could do equally well so far as Income is concerned by lending the money on securities and avoid all risks of business. The risks in some businesses, as the student will know, are enormous and in order to induce capital it is apparent that an enormous income ratio must be pos- sible else capital cannot be invited with any hope of ac- ceptance. Again, the earning capacity of a corporation, especially in the case of small corporations, may depend largely on the personnel of its management. The risk of the disorganization of this management must necessarily be considered in determining what would be a fair rate of income for the corporation. It is apparent that in many businesses no persons will invest their money unless they either have an experience and interest in that busi- ness or have a high degree of confidence in the persons who happen to be at the head of it. And even in the latter case, it is furthermore apparent that the possibility that these persons may sever their connections would have to be considered before the investor would feel any interest in the proposition. Of course, this discussion of the difficulties does not relieve the fact that an estimate must be made. It is only added to our text in order to show the student that he must be careful neither to overestimate or underesti- mate the income which has been actually produced. It must be considered in the light of all the surrounding con- ditions, such as the nature of the business, the condition of its assets, the personnel of its management, and the possibilities of serious calamity or heavy fluctuation in its activities. Having arrived at a decision which may be better ex- pressed by stating that we arrive at the determination of THE CAPITAL STOCK TAX 233 what rate of Income would induce a disinterested investor to place his money in the corporation's stock, we will use this as the rate. We have the problem of finding the principal (capital in this case) having given the rate and the interest (income in this case). The student will re- member the formula : divide the interest by the rate and multiply by one hundred. That is the method to be em- ployed. Divide our Income by the determined rate and multiply the quotient by one hundred, or if the rate is expressed decimally, merely divide the income by the rate so expressed. The answer will give you the hypothetical capital which Is to be considered the earning capitaliza- tion of the company. Although the Regulations require three views on which to base their estimate of the fair value, they specifically prohibit the use of anything less than the book value of the stock. The author Is compelled to state that in his opinion this Is an unfair view and In his opinion It Is not founded In the spirit or letter of the statutes; however, such is the practice of the Bureau of Internal Revenue. To explain the author's opinion by an Illustration, If we take the case of a corporation with a book value of one hundred and ten on its stock due to a surplus, but whose affairs are in such condition that It must Inevitably lose money for some time to come. It Is perfectly reasonable to say that no one will put money in the corporation at its book value. Its book value can in no sense, therefore, be considered the fair average value of the stock because, assuming that there Is no possibility of the corporation's winding up its affairs, the book value is positively merely an indication of a condition which cannot continue. To cite a specific example of this sort, the author is per- fectly familiar with the case of a corporation now in ex- istence which formerly conducted a very thriving business 234 INCOME AND PROFITS TAXES and has on its books a surplus which is equal to nearly fifty per centum of its capitalization. The book value of this stock is, therefore, not less than a hundred and fifty per centum, but by reason of circumstances surrounding the affairs of the corporation, it is inevitable that this cor- poration will lose from five to ten per centum of its entire capital per annum for the next eight or ten years. This condition is unavoidable and yet on the constructive methods of the Bureau, the company would be unable to place any value on its stock predicated in any degree on the losses either already incurred or due in the future. The basis for the taxation of foreign corporations is on the capital employed in the United States. This is held to be the capital employed in the operation of that busi- ness from which the corporation derives its income from sources in the United States. The definition is limited, however, to those corporations which are doing business in the United States and does not include those that are merely investors in stock or other securities. In the latter case, of course, so far as the foreign corporation was related to the United States affairs, it would be merely a holding company. If, however, a foreign corporation is doing business in the United States, directly or indirectly, its investments constitute a part of the capital employed in the United States. This is so even where the corpora- tion's entire activities are conducted by subsidiary com- panies and stock is held by the foreign corporation. In the case of mutual insurance companies, it is proper to mention at this point that the fair value of its stock, if not having any stock at all, is taken to mean the sum of its reserves both for the protection of policies and for general use in the business. Where a mutual insurance company is foreign the combination of the two items is to be taken in that proportion which the reserve on poli- THE CAPITAL STOCK TAX 235 cies or business within the United States bears to the en- tire policies or business of the company. The tax applies to corporations and the student will remember that corporations for the purpose of this Act include joint stock companies and associations. We have differentiated between associations and corporations in our discussion of the income tax. It seems unnecessary to reiterate here. Those limited partnerships mentioned in our previous discussion, which are enabled to limit the liabilities of all of their stockholders and the interests of which stockholders are transferable without consent of the others as is not the case in partnerships, will be treated as corporations for this tax as well as for the income tax. The same corporations which are exempt from income taxes are exempt from the capital stock tax. In the cases of stock insurance companies, the basis of taxation is on the capital stock alone. The reserve of stock insurance companies are not included. The student will recall the provision in a previous chapter concerning the possibility that an institution incor- porated before July 1, 1919, to succeed to the business of a partnership or individual would be permitted to elect to be taxed as a corporation from January 1, 1918, such taxation to be based on the invested capital and income of the predecessor from the date named. In such case, the corporation is required to make the return from Jan- uary 1, 1918, as if it were incorporated. The tax is at the rate of one dollar for each one thou- sand dollars of the fair average value of the capital stock of the corporation in excess of a prescribed deduction of five thousand dollars. Fair average value in the case of a foreign corporation means the fair average value of its capital invested in the United States, and in the case of mutual insurance companies of its reserve, both contin- 236 INCOME AND PROFITS TAXES gent and policy. The five thousand dollar deduction is allowed mutual insurance companies, but is not allowed foreign corporations. Of course, this fair average value at the time of the return is based on the fair average value during the pre- ceding year according to the balance sheet and during the preceding five years according to the income capacity. In the case of a foreign corporation it is the fair average value for the next preceding fiscal year. The fair average value in the latter case is determined by dividing the in- vested capital at the beginning and end of the fiscal year by two. In some instances, however, where there are wide variations in the use of capital, the average may be necessarily figured with due regard to the period between the variations. The tax is efFective from July 1st of each year and is payable in advance. The tax is actually due and payable when assessed by the Commissioner and the assessment notified to the taxpayer within ten days of the notice and demand. For the consideration of this subject the student must bear in mind that all of the general provisions concerning methods of payment, filing of returns, penalties both spe- cific and ad valorem, and the administrative provisions concerning collection, review, enforcement of payment, litigation, and so forth are in force as much for the capi- tal stock tax as for the income tax. The provisions concerning affiliated corporations do not affect the capital stock tax. Each corporation makes its own return on its own responsibility and for its own tax. In this case corporations reporting separately are not permitted to adjust inter-company items, which for the purposes of consolidated tax returns are compelled to be adjusted. THE CAPITAL STOCK TAX 237 Where for administrative or other reasons a perfect return is not possible, a tentative return may be filed and will as a rule avoid the penalty for delinquent filing of the actual final return. The tax will be levied on the basis of the tentative return but the final return when filed will call for an amendment of the tax assessed. Returns are due within thirty days after July 1st of each year. When a corporation believes itself exempt under any provisions of the Act it should nevertheless file a return and disclose the facts on which it bases the claim for exemption. Returns by foreign corporations are called for in such detailed data as will disclose the amount of capital employed in the United States. We have men- tioned that the penalties for failure to file returns and so forth are applicable to the capital stock tax in the same degree and with the same technicalities as in the case of the income tax. It is not deemed necessary at this point to review the details. A specific penalty applicable to the capital stock tax is, that where a corporation is doing business without having paid the capital stock tax it is liable to a penalty of not more than one thousand dollars. Matters of claims for refund and abatement of capital stock taxes identically parallel the provisions for the same claims in respect to income taxes. Overpayments of taxes or overstatements are both subject to this form of correc- tion, and the forms used in the correction of capital stock tax errors are identical with those for the income tax. These are forms 46, 47, and 47A. While there are many other sorts of taxes in the Reve- nue Act of 1918 it might seem peculiar to the casual student that we should have selected the capital stock tax as the only one of these to include in this discussion of income taxes. Let it be borne in mind that the capital stock tax is based on business as such and is for this reason 238 INCOME AND PROFITS TAXES similar to the excess profits and income taxes. The others are specific licenses, specific commodity taxes, or taxes of that character, which do not concern business as a thing in itself. The capital stock tax is so closely related to the income tax that we have deemed it advisable to make this short explanation in connection with our discussion of in- come taxes. The regulations for this tax are set forth in Regula- tions 50, which the student should now read. CHAPTER XVI PRACTICAL DISCUSSION We have now completed the discussion of the general subject of income taxes with their intricacies in respect to income and invested capital, and capital stock taxes more briefly. As a termination of this course the author deems it well to say a few words to the student concerning those things not naturally included in the interpretational part of the instruction. To begin with, the person who under- takes as a matter of profession or because it concerns his own or his employer's business to advise or deal with the general matter of income taxes must bear in mind certain general rules of conduct. It is admitted that the subject in its entirety is an ex- tremely complicated and technical one either from the standpoint of a lawyer or an accountant. Both lawyers and accountants taken separately have their part In the proper assistance of the public in this matter. The Bu- reau of Internal Revenue is organized for the collection of the tax. It is, therefore, primarily the creditor of the taxpayer. Under the terms of the Revenue Act it is also the final judge in the matter of interpretation and admin- istration of the law, unless the taxpayer's situation Is of sufficient Importance or of sufficient value in his mind to justify his attempting to deal with the matter through the courts. The practitioner of income taxes has, therefore, a two-fold function to perform. His first, and in the minds of many his greatest duty, is to protect the taxpayer from an overpayment of taxes. With this position the author is inclined to disagree. For the present let us say that in so far as it is our duty to protect our clients from overpayment of taxes, we must 239 240 INCOME AND PROFITS TAXES be guided by an Intelligent understanding of all the phases of the law as it may affect the taxpayer. While errors consisting of or resulting from overpayment of taxes can be rectified by a proper presentation of the case to the Department, such a recourse is burdensome, the correc- tion is usually long delayed by reason of the enormous congestion of business in the office of the Commissioner, and we are compelled to admit that it frequently seems that a blunder once committed is very reluctantly ad- mitted to be a blunder by those who have in charge the administration of the tax. We say this without attempt to cast reflection on those who have charge of this important part of our govern- ment service. We do not mean to suggest that once the money is in their hands, they use any unfair or unjust means of retaining the funds. But it is human nature to hesitate, especially as an officer of the Govern- ment, to authorize a return of money once collected. It is perfectly reasonable when one places himself in the position of an examiner of income tax returns to be very sure that one is absolutely right without possibility of differing in opinion from his superiors, before he author- izes the return of money which a taxpayer has appar- ently overpaid. These things make it imperative that the practitioner of income taxes as a profession must guard against the overpayment to the best of nis ability in the first place. With this in mind we wish to say that the student after reading our text and after reading the Regulations and the statute will find much that is doubtful therein. The general tone of the Regulations is inclined to the nega- tive rather than to the positive. By this we mean that the Regulations are made up principally of those cases which do not constitute exemption or relief from taxa- PRACTICAL DISCUSSION 241 tion and give far less space to statements announcing instances where relief is warranted. In interpreting the Regulations, therefore, the student must be sure for his clients' sake that he does not con- strue too strongly against himself those expressions in the Regulations which seem to weigh against him. The matter under consideration should be weighed with care, analyzed from every possible angle and decided with all of the doubt resolved in favor of the taxpayer. We believe we have mentioned once before in our discussion that the interpretation of a tax statute under all the ordinary rules of procedure, which have formed the basis for the consideration of such matters in the courts of our country, has been that a taxing statute must be construed most strongly against the Government. This justifies the position that the taxpayer Is entitled to the benefit of any honest doubt, which means that unless the Act specifically places him In a position of liability or specifically places his situation so as to make it render him liable, the result should be resolved In his favor and the practitioner is charged with the duty to see that this is done. A still greater duty according to the author's opinion is that of seeing that your client does not become sub- jected to penalties by reason of wilful, neglectful, or otherwise erroneous understatement of the facts reported. The penalties are sufficiently drastic to warrant the be- lief that In many Instances, unless the doubt is substan- tial, the taxpayer would do well to consider carefully, before making a statement of his income, whether or not the penalty involved did not outweigh the possibility of saving in taxes. The Bureau of Internal Revenue absolutely refuses to discuss hypothetical cases. There is, however, a right 242 INCOME AND PROFITS TAXES on the part of any taxpayer to lay the facts before the Bureau prior to the making of the return and to obtain a decision in advance as to whether or not the stated situation constitutes a taxable one. This is not always practicable in the short space of time usually elapsing between the close of the year and the time for filing the return. To meet this unfortunate condition, the author believes he has adopted the right attitude in cases where doubt is so great as to be beyond an authori- tative or satisfactory conclusion, in taking the benefit of the doubt on the face of the return and accompanying the return by a letter of explanation made in advance. Where such a situation becomes necessary it is apparent that the only reasonable way by which the taxpayer can save himself from an accusation of bad faith without simultaneously incurring a liability for taxes which he honestly believes should not be his, is to make a frank statement to the officers of the Government, be they Commissioner, collectors, auditors, investigators, or what not, and let the matter be decided as a part of the review of the return. It is apparent that a taxpayer making a frank disclosure of his affairs and showing reason for his claiming an exemption or deduction, or for his elim- inating an item of income on which there was a reason- able doubt of his taxability, can certainly be immune from any charge of having willfully or neglectfully under- stated his taxes. Let the student beware that he be not influenced in adopting such practices where in his own mind the tax- payer's position is an unfavorable one. We realize that frequently a client in all sincerity will be so biased by his interests and so influenced by his feelings as to be unable to make a calm and clear decision with respect to his responsibilities in connection with a complicated PRACTICAL DISCUSSION 243 situation. In such cases it usually happens that in order to bolster up his purpose he will seek to influence his attorney or accountant into a frame of mind paralleling his own wishes. The practitioner of federal tax matters should be careful not to be misled into such a trap. By this the author means to say that where a taxpayer not- withstanding the honest advice and opinion of his counsel insists on claiming or eliminating some item, the only procedure is to let him have his way after giving him full and complete advice as to the risk involved. In letting him take the course he prefers under such in- stances, it is also proper to advise him that in order to clear himself from culpability he should make a state- ment to the Government disclosing the grounds on which he bases his action. If he declines to do this there is only one thing for the practitioner to do: decline to file the return except in a purely clerical capacity. Be par- ticularly careful, therefore, that when a client does per- sist in doing something which, if you do not absolutely believe to be wrong you feel is passingly doubtful, to see that your connection with the matter is so completely freed from responsibility for the decision as to leave no possibility of being charged with improper practices. So much for general advice to the student who an- ticipates engaging in this sort of work. What we have said is for his guidance from an ethical standpoint and also in order to warn him that his function is not merely a ministerial one but carries with it a responsibility that is real. Let us now divert our attention to a brief discussion of the practical side of tax practice. We have previously stated that the forms in use by the Government are sub- ject to such frequent change that we did not deem it advisable to attempt to relate any of our text to the detail 244 INCOME AND PROFITS TAXES work on the face of these forms. We do, however, believe that a discussion of the principles of form prep- aration will be of value to the student, and for that pur- pose we shall be compelled to use those forms which are now in vogue. In the use of forms generally the student should first know that the data from which the form is to be prepared are complete. Having a general idea of the necessities in respect to income tax requirements, he should be careful that before he begins the preparation of the return not only the figures but the facts on which he is to base his report are in his possession. Unless this is done the student will find himself correcting, re- vising, and remaking his returns over and over before they reach the degree of completion which his client has a right to demand. In order to illustrate our point in this regard, let us take the most complicated form now in use, the corpora- tion income and profits tax return known as Form 1 1 20. We will consider the revised form for the calendar year 1919, believing that by this discussion we can cover in a comprehensive way the necessities for a proper under- standing of both facts and figures before proceeding with any return. The form consists of both accounting or statistical data and general information. We will take up the matter from the beginning of the form and briefly go through the items involved. The question of reporting properly the name, address, and the nature of the business of the taxpayer is primarily essential. The student should be careful that the name, address, and the description of the business are made uniform from year to year unless actual errors or changes have occurred, and in such case errors should be explained. We have known cases where an error in reporting a name, or rather in spelling the PRACTICAL DISCUSSION 245 name, has caused double assessment with consequent seri- ous loss of time, trouble, and costly procedure on the part of the taxpayer in order to correct the error. The first element of the return from a statistical stand- point is the report as to income, which is Schedule A on the form we are now considering. This is virtually a revised and rearranged profit and loss statement. The rearrangement that will be found on this form will vary widely from the kind of statistical set-up that the usual profit and loss statement contains. The reason for this is that the Government requires specific knowledge as to certain items in which the importance from the tax view- point is greater than for an ordinary business report. The report should be prepared directly from the profit and loss accounts of the corporation. Where the statis- tics in the profit and loss accounts do not agree with the statistics required it Is necessary in advance to make a reclassification for this purpose. Again the person making the return should be careful that the profit and loss accounts under consideration have been properly analyzed so that it can be deleted of all those matters of untaxable Income and undeductlble ex- pense which are provided by the law and the regulations. Let us consider the items of the schedule with respect to their special importance and detail. The computation of the cost of sales for Item A-2 Is, of course, usually on the inventory basis. If any other method is used it must be properly described so that the Bureau can understand the method as well as its applica- tions. The item "other income, A-3," requires merely a list which should be completely reconcilable to the source of Income as shown by the books of the concern. It Is to cover the main income In other than trading concerns. 246 INCOME AND PROFITS TAXES For the information of the Department, Item A-4 must disclose a lot of data not normally a part of the item itself. That is to say, it must disclose the holding of Liberty Bonds, the application of the exemptions, the collection of interest, and so forth, in such manner as to identify and demonstrate the amount which is reported as not exempted. Two specific items are called for under Item A-5. First, as to whether the item "interest paid" includes any so-called interest on preferred stock, and second, whether the item includes any federal income tax paid at the source on tax-free covenant bonds. The item of rents is ordinarily self-explanatory. Although Item A-7 and Item A-8 do not require any schedule, the author has found it exceedingly desirable whenever it seems that an explanation is necessary to give the information in the return by attaching a schedule. The information concerning dividends is complete and detailed. As these dividends are not taxable, the reason for demanding the information in the statement is merely one of information, and the student will note that in Item A-25 below the same dividends are deducted so as to avoid their being taxed. As a matter of fact, this same information is repeated in Schedule M and it is a dis- tinct case of duplicating work to compel the corporation to report it twice. Schedule A includes in Item A-10 the gross income from other sources. This is merely a detailed list of such income as is derived. Item A-12, "Ordinary and necessary expenses," is a broad and sweeping heading which covers what is gen- erally known as selling, general, and administrative ex- pense. The only care necessary here is to avoid dupli- PRACTICAL DISCUSSION 247 cation and not to include any capital disbursements or expenses for assets. In case of the compensation of officers, the Depart- ment reserves the right to be informed not only as to the officers' salaries for the current year but as to their similar compensation for the preceding year. This is for comparative purposes. It is a part of the effort of the Department to restrict salaries to a reasonable basis. Under the head of repairs the student is warned against duplicating any of the items which properly be- long under the category of improvements and replace- ments. Bad debts are required to be detailed, not only as to the names and addresses of the debtors against whom the debt is definitely known to be uncollectible but also with respect to a division on the line of the acquisition of the asset in the first place, such as whether it arose from sales or services rendered, or from such other in- come as interest and rent, or from loans, advances, and so forth, not included in either of the first two. Depreciation, or, as it is called in the return, exhaus- tion, wear and tear including obsolescence, is to be defi- nitely explained by reference to the cost or fair market value of the property, its probable life, previous depre- ciation, and current depreciation, with, of course, the general information as to the time of its acquisition and the general nature of the property. The question of de- preciation, as the student will recall, was deemed of suffi- cient importance to justify a whole chapter of discussion together with the collateral one of depletion. The De- partment is also very particular about the accuracy of depreciation claims, and for this reason the data must be submitted so as to demonstrate that the depreciation is reasonable and equitable. 248 INCOME AND PROFITS TAXES Items A-22 and A-23 relate to losses or profits result- ing from the sale of capital assets. The Information required is virtually a complete history of the assets with which transactions result in loss or gain. In the case of a complete loss resulting from casualty or theft, the de- tails must be set out in full. As the problem of the amortization of war facilities Is probably obsolete in most cases, the use of Item A-26 would be rare. When necessary, however, the informa- tion required is very similar to that used for the pur- poses of depreciation, except that in addition there is re- quired the general history of the nature of the contract for which the plant or other asset was purchased or con- structed. Requirement Is made at this point that the taxpayer also prepare a complete history of any discount or premi- um amortized which affects the income of the corporation for the taxable year. We have now made a fair analysis of the requirements for Schedule A. The student, however, will not proceed to Schedule B, as the schedules will not be taken in that order. We will consider Schedule M. This constitutes a reconciliation of the loss and gain as shown by the books of the taxpayer, and the loss and gain as reported for income tax purposes. It will be easily recognized that these two will not be the same. Most corporations, for Instance, will charge to expense many items which are not deductible, such as donations, federal taxes, special assessments for improvements, additions and betterments to equipment. Insurance premiums on the lives of officers or employes, and interest where paid to carry securities not subject to tax. It is necessary to demonstrate by reconciliation on Schedule M the reasons for the discrep- ancies between these two items. PRACTICAL DISCUSSION 249 Additions to reserves and other segregations of profits usually found in conservative accounting will also need to be set out in order to demonstrate the differences required. All the above must be added to the book income. On the other hand, a corporation's untaxable income will have to be shown as a deduction in order to show the desired reconciliation. Interest on United States obligations exempted, on state and territorial bonds, on Farm Loan bonds, dividends of corporations, and also charges against previous reserves, which amount, so far as the return of the year's business is concerned, to profit and loss adjustment, will have to be deducted from the book income to equal that shown by the return. To consider this schedule now a little more technically, the first item Is the profit as shown by the books. To this In due order as indicated we add those Items which are not deductible expenses. Then we proceed to the other side of the statement and enter the untaxable In- come, the net balance In the final result being shown at the bottom of the page as the taxable net Income reported on Schedule A. Where the adjustment of Income is made in any respect outside of the books or where adjustments affecting the Income tax statement are not made in the profit and loss account of the corporation but through previous undivided profits or surplus, it will be further necessary to carry the amount of such Items either as a debit or credit as the case may be, debit in this sense being an addition to the book profit or a deduction from the taxable profit, and credits, the reverse. Next in order we prepare balance sheets of the corpo- ration in detailed form. The student who is at all famil- iar with accounting will realize that the balance sheet at the beginning of the year and the close of the year, re- 250 INCOME AND PROFITS TAXES spectively, will result in reflecting the net increase or decrease representing the actual loss or gain of the cor- poration. A study of the tabulated list of asset and lia- bility headings required under Schedule K will be suffi- cient for the student's purposes as the titles are all self- explanatory. The balance sheets must agree not only with the books of the taxpayer, but must demonstrate in themselves that the increase or decrease in the surplus account is equivalent to the loss or gain reported as Item 1 in Schedule M, except where items have been charged or credited to surplus which do not affect profit and loss. In such cases a reconciliation of the surplus is necessary to show that the balances at the beginning and close of the year are properly accounted for by the book loss or gain plus or minus the adjustments just referred to. The whole scheme of these three statements is to dem- onstrate the accuracy of the accounting used. The stu- dent must recognize that as in any bookkeeping or ac- counting study, balances are necessary, that is to say, figures which are in balance. No excuse can be offered for submitting reports in returns which do not demon- strate their own accuracy by being in balance. The analysis of the surplus account is called Schedule L, which comprehends the surplus at the beginning, the additions for profits, the deductions for dividends, and all other items that do not belong in profit and loss. An example would be the profit or loss on the sale of stock during the year which in no wise would be a proper part of the profit and loss account. Having now completed and accurately stated the his- tory of the business for the year, comprised of a balance sheet demonstrating the net worth at the beginning of the year, its transactions during the year, and its balance sheet demonstrating the net worth at the end of the year PRACTICAL DISCUSSION 251 with proper adjustments and reconciliations of the in- crease or decrease to the taxable net income as reported, we will now proceed to the elements of the return which do not appear on the books. These deal almost exclu- sively with invested capital. The first to be considered is Schedule E, being a state- ment of the capital stock paid up and actually outstanding at the close of the preceding year. This is divided into first preferred, second preferred, and common, and if other forms of issues are in use by the corporation they should be shown in detail. To this are to be added the surplus and undivided profits reasonably detailed as paid-in surplus, undivided profits, and reserves which are admissible as invested capital because additions to them are not deductible as expense. The capital stock account of the books may differ from the actual outstanding cap- ital stock by reason of the holding of treasury stock and provision is made for the deduction of this treasury stock at the bottom of the schedule. Where the amount and details are large and important, the student will do well to prepare these schedules on separate sheets instead of trying to use the very cramped form found on the return. We come to Schedule F, which presents those addi- tions to capital claimed by the taxpayer by reason of errors in his accounting. A review of the subject of invested capital will be necessary in order to understand these schedules generally and especially with respect to the adjustment of Invested capital with reference to Schedules F and G. The items are those items which the taxpayer desires to add either by reason of under- statement on the books, or by reason of actual facts con- nected with their acquisition which can be used as a basis for claiming a higher valuation. The contrary of this statement Is Schedule G, which 252 INCOME AND PROFITS TAXES presents those amounts which must be deducted from Invested capital by reason of either the overvaluation of assets or, in the case of intangibles, by reason of their being carried at a value in excess of their admissibility. This schedule is also used for those cases where the property paid for with stock is overvalued on the books or where any elements of appreciation have been per- mitted to drift into the accounting records. As will be understood, these two schedules are not supported by any records on the books, but in every case they must be supported by full detailed information of the reasons for the adjustments. Schedule H deals with changes in invested capital dur- ing the taxable period. These changes arise from divi- dends, income and profits taxes, sale or repurchase of stock, assessments against stockholders or otherwise paid- in surplus or contributions, or, on the other hand, liquida- tion of the assets in any way, shape, or form. The stu- dent will recall that these adjustments are all to be aver- aged by the number of days from the date on which the transaction occurred to the close of the taxable year, the number of days including the day of the transaction, being taken as the numerator of the fraction and the de- nominator being either 365 or 366, as the case may be. With respect to inadmissible assets included in the balance sheets, proper schedules must be prepared under the name of Schedule J, showing the nature of these obli- gations and their admissibility or inadmissibility and also the method of arriving at the average by comparing these with the other assets and liabilities of the corpora- tion, all of which has been explained in the chapter con- cerning the subject of invested capital. Having our five schedules, or so many of them as are necessary, under this adjustment of invested capital we PRACTICAL DISCUSSION 253 now turn to Schedule B for the first time. The total of Schedule E is the first item; the total of Schedule F, the second. A total is drawn at this point, and then Sched- ule G is deducted, leaving a remainder for the adjust- ment of changes in invested capital. If the result of Schedule H, changes in invested capital during the taxa- ble year, is an increase in capital there is an addition at this point; if a decrease, a deduction. The net result is then further reduced by the amount of Schedule J on account of inadmissible assets, and we have what is known as the invested capital for the taxable period. The remainder of the return is the calculation of the tax. The instructions are there and the student by this time should be familiar with the rate and methods, and need but little instruction. Schedule C calls first for the eight per cent of the in- vested capital and secondly the three thousand dollar specific credit to form the total excess profits credit. Schedule D carries the two brackets for the calculation of the excess profits tax, to wit, the first bracket for not over twenty per cent of the invested capital, which is to say twenty per cent of Item B-9 ; and the second bracket for the remainder of the income. The excess profits credit as determined by Item C-3 is to be deducted in the second column from these two brackets respectively, using so much in the first one as is necessary to cover the amount carried as income in that bracket, or all of the same if it is less than that part of the income. The balance subject to tax is carried in the fourth column, which is the third column for figuring purposes. The rate of the tax is shown in the fourth figuring column and the amount of the tax in the fifth. Having arrived at this point, we now find it necessary to determine whether or not the limitation which has 254 INCOME AND PROFITS TAXES been explained in the chapter on taxes is applicable to the corporation under consideration. The student will remember that this is the provision that the tax shall not exceed twenty per cent of so much of the income as is in excess of three thousand dollars and not in excess of twenty thousand dollars, plus forty per cent of the re- maining income. This should be shown on Item D-4 and the smaller of the two items, C-3 or C-4, should be used as the excess profits tax. Having computed the excess profits tax, the student knows that this is a deductible item in figuring income taxes. The excess profits tax for the year constitutes a credit against the net taxable income in computing said income tax. The income tax, therefore, or the second part of Schedule D, begins with the net income as orig- inally shown in Schedule A. Next we find the deduction for so much of the interest on United States and war finance obligations as is not exempt from excess profits taxes. This is in order to effectuate exemption from normal tax, and is Item A-4. Then we enter the amount of the excess profits tax itself. The fourth item is a spe- cial one in case of excess profits and war profits tax computed in respect to income derived from government contracts. Fifth we find the exemption or credit of two thousand dollars applicable to all except foreign corpora- tions. The total of these four deductions is carried out and subtracted from the income to find the amount which is subject to the income tax of ten per cent. To this must be added the excess profits tax which is the lesser of the two determined above and correspondingly the same as included in Item D-7. This is the total taxability. From it we now deduct such income or profits taxes as have been paid to foreign countries or possessions of the United States and are applicable as a reduction of PRACTICAL DISCUSSION 255 the tax liability of the corporation. This brings us to the final result, the actual net tax liability of the tax- payer. Let us now consider the so-called questionnaire of the return. The first element of the questionnaire is a statement of the business of the corporation. The second is called for as a matter of reference and comparison, and is an effort on the part of the Department to obtain lists of similarly engaged corporations in the same community. Next we find information as to the history of the corporation showing the date of its incorporation, the laws under which it was incorporated, and a narrative as to its being, if so, a reorganized concern. The next group of ques- tions, to wit, numbers 1 1 to 14, inclusive, cover the question of whether or not a consolidated return should have been made, and the student will recall that we ad- vised him the Department would require this informa- tion wherever fifty per cent of the stock of the reporting corporation was held by or in common with fifty per cent of the stock of any other corporation. The other infor- mation is largely collateral, being simply a general state- ment of the side lines of investigation which might be of interest to the Department. The student has now been carried through the subject of income taxes, excess profits taxes, administrative mat- ters, and lastly, a general instruction on the details of handling a return for a corporation. It is, of course, apparent that the same principles must be observed in the case of fiduciaries, partnerships, personal service cor- porations, individuals whether large or small in respect to their income, and all other persons who have to make a return. The detail required is complete and full, must be reconciled to the books, and it must be in every in- stance supported by proper explanation of any items 256 INCOME AND PROFITS TAXES which do not carry their own explanation on their face. We do not deem it well to prolong this discussion by including detailed remarks concerning the other forms of return, but have selected the corporation return as the most complex of the group. The one important overweighing factor in the handling of income and excess profits taxes lies in the necessity for accuracy in figuring and for completely detailed in- formation as to facts. If the student is careful to give this his best attention and at the same time avoid an overpayment by the taxpayer, he will have accomplished his duty. As most of the students who are interested in this subject will be those who will be responsible in some de- gree for the business affairs of their clients or employers, particularly with respect to the accounting, we deem it wise to add a few suggestions concerning the accounting necessities or advisabilities for the purposes of income taxes. Broadly speaking, the success of accounting as the student will know depends upon a proper arrange- ment and classification of the accounts. That is to say, it lies in the selection of a proper number of headings or names of the accounts which are to be used, and care and proper judgment in the allocation of items to these ac- counts. When it comes to the question of dealing with income taxes, much of the information not ordinarily found separately stated on a set of books or a set of statements from a large or small concern is called for specifically and separately by the Department. The author has made a common practice of insisting that the client in every possible instance carry separate ac- counts for those items which should be used separately in computing income taxes. The advantage of this is so great that it would seem to need no explanation whatso- PRACTICAL DISCUSSION 257 ever. It will mean that a properly taken trial balance of a concern at the close of the taxable year will enable the person called upon to prepare the return virtually to complete it with no further information except as to facts not shown on the records. We have mentioned in a previous discussion in this chapter that in our opinion the more important duty of the practitioner of income taxes lies in the protection of the client from penalties for understatement rather than the possibility of overstatement. We do believe that the latter outweighs the former. It is apparent, therefore, that if the accounting suggestions made herein are properly followed, the danger of an error which will result in an understatement is very usually avoided. The instances where understatements are made usually occur in those cases where the books contain accounts which are a composite of two or more different kinds of infor- mation, and which must be segregated for the purposes of the return. The necessity for detailed picking out of items is dangerous, it is time consuming, and it is unfair to everybody concerned. It is dangerous because it may work either to an under- statement or an overstatement of income by reason of an error in recapitulating properly a long list of items. It is time consuming for reasons which it is not necessary to explain. It is unfair to the practitioner that the client should expect him to undertake any such task and the responsibility for it. It is unfair to the client if the prac- titioner does not advise him of the better way by which the matter may be covered, and it is unfair to the Gov- ernment to ask it to verify returns derived by this method from poorly kept books. Let us recognize now in full that, notwithstanding we may have our opinion as to in- stances and practices here and there in the administra- 258 INCOME AND PROFITS TAXES tion of the income tax law which to our mind and to the minds of others are not always as fair and as equitable as might be, yet nevertheless the duty of the government employes is to collect the tax. It is the duty of the tax- payer to see that the tax can be collected with the least possible additional effort. It is not unreasonable to state that while the burden of collecting the income and excess profits taxes for the United States Government is a tre- mendous addition to the necessity for raising revenue, it would be very substantially reduced if the taxpayers themselves would undertake to see that their returns were properly made, fairly made, and fully supported by col- lateral information which could be verified from the actual records of each person. It is the student's duty when he becomes a practitioner to protect his client. In that respect he is the client's representative or attorney. But let him always remember that in the last analysis he is charged with the duty of not defrauding, annoying, or obstructing the administration of the tax. APPENDICES A. Questions, Chapters II to XV. B. A Problem. APPENDIX A Questions on Chapter II 1. Give an example of income as distinguished from return of capital. 2. Give an example of income as distinguished from acquired capital. 3. Would the proceeds of an endowment policy be taxable in- come? If so, entirely? 4. Does a sailor's mother receiving fifty dollars per month, one- half from his pay and one-half from the War Risk Bureau, have to report any or all of it as income, assuming she is taxable? 5. Would a debt for goods sold in 1912 and collected in 1920 constitute income? 6. Should a taxpayer report his earnings for uncollected salaries? If so, under what circumstances ? 7. Should a corporation ofBcer report as income the stock received for services in promoting the business? 8. Differentiate "Paid" and "Accrued"; "Paid" and "Incurred." 9. What is usually meant by "Inventories?" 10. What is the difference between maintenance charged to ex- pense and maintenance charged to depreciation? 11. What is a "fiscal year?" 12. Can a fiscal year be ended on July 15th? 13. Having usually closed my books on June 30th, I find it de- sirable to change to April 30th. What is necessary with respect to Income Tax Return? 14. I regularly engage in the construction of bridges. These jobs take from two to five years to complete in most cases. How do I determine my income? 15. If the cities for which I build these bridges pay me in town warrants worth about ninety-five cents on the dollar, what in- come do I report? 16. In 1910 I filed suit for ejectment from a tract of ground which had been preempted by a squatter. The ground was then 261 262 INCOME AND PROFITS TAXES worth $20,000. In 1920 I was awarded possession. The ground is now worth $50,000. Is there any income to report? 17. My employer, a large corporation, habitually credits my ac- count with a bonus equal to the amount I deposit in its custody. It is a part of my contract that after I have been with the com- pany for three years, the whole amount will be paid me with 6% interest. Is there any income to report? From year to year? Or after three years ? 18. Are uncollected Liberty Bond coupons income? 19. Define "Compensation." 20. If the President's salary is taxable would he include the rent value of the White House? 21. If a merchant permits his employes to get their marketing at a discount, is the discount income ? 22. If a mining company pays its help in store orders carrying a 10% purchase premium, would the employes report their wages at 100% or 110% of the amount so paid? 23. If a major's salary and allowances are $4,500 per annum, what is his taxable income? (Eliminate questions of personal exemptions. ) 24. If I sublet a part of a business building is the rent income? 25. If I sublet rooms in a home is the rent income? 26. To what extent are bonds of a county issued for road build- ing exempt? 27. If a Federal Farm Loan Bank made loans to farmers and subsequently sold the loans to private parties, would the interest be taxable? 28. What is the difference between United States Bonds issued in 1913 and United States Bonds issued in 1918 as to taxes? 29. Are Victory Bonds taxable at all ? 30. What is the difference between dividends from personal ser- vice corporations and dividends from ordinary corporations? 31. Would a dividend from an English Shipping Corporation be taxable ? 32. What is the difference between a Federal Reserve Bank and a "Member Bank?" 33. What is a "script dividend?" APPENDICES 263 34. What is the exemption of 4th Liberty Bonds? 3rd? 5th? 35. What is the exemption of 1st Liberty Bonds converted to 4th 's? 36. A mining company having sold half its property declares a dividend of 60% on its stock under an agreement for liquidation of that amount, and retires the said 60%. Is the amount received by a stockholder taxable income? To what extent? 37. A corporation with $2,000,000 capital had on March 1, 1913, a surplus of $3,000,000. Its business having ceased to be profit- able, the corporation declared in 1920 a dividend of 150% so as to distribute said surplus before changing its basis of operations. Is this taxable? 38. Is a stock dividend income? 39. A mining company charges ofi each year a depletion of thirty cents per ton on the coal mined and issues cash dividends for an equivalent amount aside from earnings. How are these taxable? 40. An incorporated mutual fire insurance company has several old policy holders whose annual return from savings exceeds the premiums they pay. Is this income ? Questions on Chapter III 1. What is your understanding of the "oldest owned stock" rule for determining profits from sales? 2. If stock was bought in 1912 at 135, 1913 at 145, 1915 at 160 (three equal purchases), and one-half of the lot sold in 1920 at 175, what is the gain? 3. What basis would be used in appraising the value of stock received as a bonus of one share for each $1,000 bond bought at $950 if the bonds were selling on the market at $900? 4. I bought ten shares of preferred stock at 90 and received five shares of common as a bonus. Neither stock had then a market value. Subsequently I sold the common for 40. Is there any income ? 5. What are "stock rights?" Are they income? 6. I hold one hundred shares of stock costing $75 per share. I receive a dividend of fifty shares and sell seventy-five shares for $60 each. Is there any gain or loss ? How much ? 264 INCOME AND PROFITS TAXES 7. What is the value of a patent taken out by the holder at a cost of $500 for costs and legal expenses? 8. If the above holder was offered $50,000 in 1912 for the same and sold in later years for $75,000, w^hat would be the profit? 9. What profit if patent in Question 7 had been taken out in 1915 and the first offer received in 1917? 10. What is nominal standard maximum cash payment permit- ting return of income on instalments to be based on collections only? 11. Selling price $100; cost $50; cash payment $10; collected on instalments $20. What profit is to be returned? 12. On facts in Question 11, if the purchaser fails, what is cost of goods repossessed and what is profit? (No depreciation.) 13. If land is bought and improved and then sold in parcels, is there any profit at the point where one-half of the land is sold for an amount equal to three-fourths of the cost of all? 14. If realty is sold for $10,000 subject to mortgage of $5,000 and balance payable as follows: cash $2,000, second mortgage payable in instalments for $3,000, what is the gain to be reported? 15. How, if cash payment is $3,000 and second mortgage is $2,000? 16. How, if cash payment is only $500? 17. Does a second mortgage amount to cash equivalent in realty sales on investment? 18. Cost of property in 1909, $3,000; value March 1, 1913, $4,500 (on account of improved condition of neighborhood) ; assumed depreciation at 5% per annum. What is profit if sold in 1920 for $6,500? 19. What is basis for determining gain on property descended from deceased relatives? 20. If crops are exchanged for household supplies, what is in- come? 21. If horse is traded for household supplies, what is income? 22. If automobile is acquired by trade for goods in a merchant's store, what is the effect on income? 23. If I barter a boat costing $500 two years ago for another boat on which I place improvements costing $300, and sell the APPENDICES 265 same next year for $1,000, is there any income or profit? In which year or years? 24. If I exchange bonds having a present value in the market of $1,000 for stock of indeterminable value, what basis fixes the gain or loss? What, if I subsequently trade stock for other bonds having a market value of $1,100? 25. What would be the gain if one share of stock, par value $100, were surrendered on reorganization in payment for two shares of new stock, par value $100, assuming the old company to have 100% surplus? 26. In the last question if market values are 195 on old com- pany stock, and 110 on the new company stock, what is gain or loss? 27. Which would you report as income? 28. Two members of a firm separate, each taking one-half of stock-in-trade and cash. No accounts are on the books. What is gain or loss? 29. What is "gross income" in case of a manufacturing concern? 30. What is meant by "deduction for redemption of trading stamps?" 31. How is it calculated? 32. How must inventories be used in connection with income? 33. What is "cost or market" rule? 34. If goods costing $100 are shopworn so as to be worth only $50, could the inventory reflect this loss? 35. Could goods bought but not received be included in in- ventory? If so, under what conditions? 36. Could goods received but not yet billed be included? 37. If goods are bought from time to time in carload lots and prices are continually rising during the year, what prices would be placed on an inventory at the close of the year amounting to two and one-half carloads in quantity? 38. Catalogue price, $100; trade discounts, 35%, 30% and 5% when bought; freight-in, $5; trade discounts at close of year are 35%, 40% and 5%. What is the inventory value? 39. Could the following items be included in determining inven- tory value of product? 266 INCOME AND PROFITS TAXES a. Factory rent b. General office rent c. Wages of superintendent d. Wages of company treasurer e. Depreciation of plant f. Depreciation of automobile delivery equipment g. Expense of New York sales office 40. On December 31st, I am offered $100 per share for certain stock in my vault which cost me $120. I decline because there is no stock in the market at less than $110. What price should I (a broker) use in the inventory? Questions on Chapter IV 1. What is meant by ordinary expenses of a business? 2. To what extent, if any, might inventories affect such expenses? 3. What repairs are deductible? 4. What is meant by "replacements?" 5. When are they not deductible? 6. What is the income of a professional man? 7. If a lawyer pays a Bar Association membership fee, may he deduct it? 8. Can a physician deduct the cost of printing his stationery? 9. Could an accountant deduct the cost of adding machines and typewriters ? 10. Could said accountant deduct his typist's wages? 11. If two members of a firm pay 90% of the profits to them- selves as salaries, could they be deducted? If not, why not? 12. How much could they so pay? 13. An employer agreed, that if his profits for the year exceeded $20,000, to give his credit man $1,500 on December 31st. Is this deductible ? 14. What would be the action of the Bureau in respect to the so-called salaries in Question 11? 15. I deeded my firm a building in which to operate. It cost me $10,000 but my partners were willing to let me have $15,000 APPENDICES 267 for it. Rather than have a profit to report I suggested their pay- ing me $2,500 additional salary for two years. Is this deductible? 16. Are annual Christmas gifts to the office force a deductible expense ? 17. My former superintendent's widow continues to draw 50% of his wages although he has been dead nearly two years. Is this a deductible item ? 18. Suppose in Question 17 the superintendent were still alive and, anticipating his demise, I set aside a sum of money to be used in paying his family after his death. Would this be deductible ? 19. I lease a building for ten years, paying $20,000 for the lease. Can I deduct the same? 20. On the land in question above, I erect an additional build- ing at a cost of $20,000. Can I deduct that cost? 21. I am sued in 1919 on a contract. In 1920 a judgment is rendered against me for $5,000. Can I deduct? 22. Could I have deducted this amount, had I foreseen it in 1919? 23. My cashier absconded in 1919. I did not discover this until 1920. In which year, if any, can I deduct it? 24. I owe $10,000 secured by a note bearing 6% interest. This note carries as collateral $15,000 in 3rd Liberty Bonds. Can I deduct the interest from my income? 25. Suppose the collateral were D. C. 3.65's, would your answer be the same? 26. My firm credits each partner annually with 6% interest on his capital account averaged for the year. What is the proper application of this item to income? 27. Can state income taxes be deducted ? 28. Can capital stock taxes be deducted ? 29. Can a broker deduct the annual license fee paid the United States? 30. I import silk. The duty is paid by my wholesaler and added to the price of the goods. Can I also deduct it as a tax paid? 31. Can benefits assessed for the widening of an adjacent street be deducted? 268 INCOME AND PROFITS TAXES 32. I am assessed biennially for re-surfacing the roadway in front of my property. Is this deductible at all ? 33. Why is the estate tax deemed non-deductible? 34. My dwelling was burned this year. The loss was appraised at $6,000. My insurance carried a reduced rate average clause and the company paid me only $5,000. Can I deduct the loss and, if so, how much? 35. Owing to the high cost of construction it cost $7,000 to replace the damage. Does that alter your answer? 36. In reconstructing, I added a larger front porch. Does that alter the answer? 37. When is the demolition of a building not deductible? 38. Define "obsolescence." 39. The low market on the Stock Exchange means a loss to me of $8,000 on my present holdings. Can I deduct this? 40. When are traveling expenses of a salesman a deduction? When not? Questions on Chapter V 1. What is depreciation? 2. What is obsolescence? 3. Can a merchant adopt the practice of reducing his inventories at each fiscal closing by a fixed percentage estimated to cover possible market fluctuations and shop wear and tear on the goods? 4. Can depreciation be claimed on one's dwelling? 5. What is the rule for the depreciation of patents? 6. A manufacturer purchases a competitive business, including a good will based on a trade name of the product. He decides to allow the trade name to become obsolete, discontinues the use of the same, and writes off the cost over a period of ten years. Can this depreciation be claimed ? 7. What is the amount to which a depreciation rate, once de- termined, is applicable ? 8. What effect has the March 1, 1913, rule on depreciation? 9. What method of depreciation is prescribed by the Bureau? 10. Under what circumstances may a method be changed? APPENDICES 269 11. Are the plans for a machine depreciable by the company which makes the machine as its selling product? 12. To what, besides ordinary equipment, may a farmer apply the principle of depreciation ? rS. What methods of bookkeeping are demanded for the record- ing of depreciations? 14. Upon the actual exhaustion of a machine, what must be done with respect to its value and the depreciation which has been charged against it? 15. What is the meaning of "depletion?" 16. To what kinds of assets is it applicable? 17. A^concern is engaged in the business of distilling chemicals from a certain impregnated natural spring. May it claim deple- tion? 18. What three possible bases of valuation may be used in com- puting depletion? 19. A dredging company accepts a contract for dredging a cer- tain stream, with the proviso that all extractions shall belong to the company. It finds a sand bar in the course of its work and estimates the same to contain 1,000 loads of sand. May it claim any depletion against the removal and sale of this sand? 20. What is the basis on which a lessee may claim depletion? 21. How would the "fair market value within thirty days of discovery" be determined in the case of a newly discovered coal deposit? 22. If the first estimate of ore in a mine proves erroneous, is there any remedy? 23. A leases a mine on a contract for 8 cents per ton royalty with a minimum of 5,000 tons guaranteed by him annually. In the first year he extracts only 2,500 tons, but is compelled to pay the full royalty guaranty of $400. May he claim the whole of this royalty or only the amount based on actual extraction? 24. If the above lease contained a further provision that any deficiency in extraction would be carried to his credit for five years from the close of the year of deficit, would that alter the answer? 25. What income would the owner report in Question 23? 26. What, in Question 24? 270 INCOME AND PROFITS TAXES 27. A owns a farm. B, while hunting thereon, finds an oil- bearing tract of land. He keeps his secret and buys the farm, but, not caring to appear too interested, awaits the foreclosure of a mortgage and buys at the sale. The cost to him is $4,500. After his purchase, he verifies the discovery and has the land surveyed and appraised, selling it shortly thereafter. The ap- praisal was $56,000 and the selling price was $65,000. Can he utilize the thirty days' discovery rule ? 28. The equipment of an oil well has an estimated life of ten years for normal usage. The well, however, has an estimated life of only four years, based on the present rate of extraction. Which life should be used in charging depreciation on the equip- ment? 29. A mine cost the owner $50,000, and is estimated to contain one-half million extractable tons of ore. The mine is leased at a royalty of 13 cents per ton. In the first year 5,000 tons of ore are extracted. The lessee has paid $5,000 for the lease at its execution. What is the allowable depreciation for the lessor? 30. Same, for the lessee? 31. A discovers a mine on an absolutely unclaimed parcel of ground. He files a claim with the state, obtains a title at a purely nominal cost and then organizes a company ostensibly to exploit the mine, making his announcements without disclosing too fully the true possibilities of the tract. The company realizes $50,000 from the sale of stock, and A accepts this cash as his price for the mine. Permitting the operations to lapse, he is en- abled to buy the entire stock of the company for $40,000. The organization expenses, etc., have cost him $5,000, which he pays out of his own pocket. Holding this stock, he negotiates a second sale of the mine to a newly organized company at $100,000, taking $25,000 in cash and $75,000 in stock. As he intends this new company to conduct no operations, he now secretly arranges a third sale by the second company to a dummy agent at $125,000, the minority stockholders being perfectly well satisfied with the profit on the sale. In this sale, he surrenders, through the dummy agent, his stock, $75,000 at par, and pays cash, $50,000 for the balance. Having now attained his desired purpose, he makes a bona fide sale of the tract at $150,000, all cash, and prepares his income tax return using the thirty days' discovery valuation at $125,000, based on the third sale and reporting a profit of only $25,000, the profit on the fourth sale. Is this correct? If not, what is his true profit? APPENDICES 271 32. In the above, what basis would be used by A if he undertook to operate the mine for himself after the third sale, in claiming depletion ? 33. In Question 31 and Question 32, assuming that his first dis- covery was incomplete, and that his later and higher valuations for sales were based on actual discoveries of additional available ore in the mine, to what extent would these facts be applicable in adjudging a true valuation? 34. In Question 23, above, what would be the effect on the in- come of lessee and lessor, respectively, if the lessee abandoned his lease at the close of the first year? .35. A leases a mine, unequipped, paying $5,000 for the lease, on a royalty of 9 cents per ton extraction, guaranteeing 8,000 tons per annum. It requires eighteen months effectively to equip the mine for operation. In the meantime, the royalty has been accumu- lating as a charge against future operations. The lease was for twenty years. What is the capitalizable value of the mine to A, as of the commencing of operations, eighteen months after the date of the lease? 36. May interest on money borrowed to erect improvements to a mine and paid or accrued during the course of construction be added to the capital value of the improvements? 37. Cutting rights on a timber tract are purchased on an esti- mate of availability of 4,000,000 feet. After one-half the tract has been cut for first grade timber, a demand for another grade is found and the difference adds 2,000,000 feet to the entire tract. Should the depletion rates be altered, there being no further cost for the cutting rights of the additional second grade timber ? 38. What is the meaning of "stumpage?" 39. Sawmills are erected on the tract in Question 37 at a cost of $30,000, also camps at a cost of $10,000. It is estimated that the time for cutting will be three years. The sawmills have a normal life of ten years under proper care. The camps have a possible life of twenty years unless abandoned. The cost of removing the sawmills to another tract after the completion of the present operation will be $8,000 and will add no value to the mills. How would you figure the depreciation? The camps cannot be removed economically. 40. In the last question, assume that the first estimate of three years to complete the cutting was made prior to the arising of the demand for second grade timber, and that to cut the remainder 272 INCOME AND PROFITS TAXES of the tract for both first and second grade will add one year to the time, while a recutting of the part already cut for first-grade will consume another six months. The change occurs eighteen months after operations are commenced. What changes in de- preciation on the equipment are necessary? Questions on Chapter VI 1. What is the gross income of a corporation conducting a manu- facturing business? 2. A corporation carries insurance on the life of its manager. He dies. What must it report as income with respect to the pro- ceeds of such insurance? 3. A corporation sells treasury stock which cost 90 for 110. Must it report a gain? 4. A corporation's stockholders agree to pay in 50% of their holdings in stock to be resold at par. Is this taxable income? 5. A corporation issues bonds at 102. Is this a profit? 6. A corporation buys its own bonds at 101 and resells them for 103. Is this a profit? When? 7. A corporation, having an old unused warehouse, agrees with another concern that it may use the warehouse provided it pays the stockholders a one per cent annual dividend. Who must report this rent ? 8. A corporation liquidates and winds up, as follows: Capital outstanding $100,000 Undistributed surplus 20,000 Gain on sale of its plant and other assets 30,000 Each stockholder receives $150 in settlement per share. What profit or dividend must a stockholder report as to stock which cost him 130 in 1918? 9. Can you suggest the most economical method by which the company might liquidate so far as a stockholder is concerned? 10. A company holds stock in B Company. What tax is paid by it on dividends from B Company ? 11. A corporation donates $10,000 to a hospital with the under- standing that its employes shall be given free beds therein for ten years. Is this deductible ? APPENDICES 273 ^2- A. corporation owning the patent on a fire escape donates $5,000 to a local board of trade for use in disseminating propa- ganda against unprotected school buildings. Can there be any deduction allowed? 13. A company pays its employes partly in orders on the com- pany store calling for purchases at a discount of 10% from cash prices. How does this affect income? Or the company pay- roll? Or the accounts of the store as a subsidiary business? 14. A company pays a dividend of $10 per share in 6% notes due in six months. It pays the notes in due course. Can it deduct the interest as an expense ? 15. A company after issuing dividend certificates at $6 per share, buys them back at $4 per share. Is there gain or loss and how much? 16. The banks of a certain state are required to maintain with the state auditor a fund equal to 1% of deposits. Each year, the depositors' losses by reason of failures of banks in the state are paid out of this fund and each bank is called upon to restore its 1 % balance, these losses being distributed proportionately over each bank. In this taxable year the C. D. Bank is called upon to pay $2,000 of which $1,000 is its share of losses and $1,000 due to increase of deposits. Can it deduct either or both items? 17. In the above, E. F. Bank in the taxable year received a refund due to a shrinkage of deposits in excess of one hundred times its share of losses. Is this income or expense or both ? 18. The X Company buys 30% of the stock of Y Company at 50 cents on the dollar. It enters into an agreement with the other stockholders guaranteeing them dividends of 6% if X Company be permitted to operate Y Company. The profits of Y Company will not justify the 6% dividend. Can X Company claim any deduction for the deficits made good ? 19. What credits are allowed a corporation? 20. Would a relief association, organized among the employes of a railroad but financed and maintained solely by its members, be taxable if not incorporated ? 21. The G. Ins. Co. collects $1,000,000 in premiums, pays $200,000 for reinsurance of extra hazards in cases where gross premium was only $280,000, and grants dividends to policy 274 INCOME AND PROFITS TAXES holders of 10% omitting extra hazardous policies. What is its gross income ? 22. By reason of unusual conditions, a life insurance company pays a dividend which equals the annual premium in all cases of policies older than ten years and for each additional year adds 1% of the annual premium to the dividend. Must a holder of an eighteen-year-old policy report the dividend, and how much? What is the income of the company from this policy? 23. What is meant by deductible "additions to reserves?" 24. Does a sum of money set aside for protection against con- tested claims constitute an "addition to reserves?" 25. A mutual fire company, receiving policy deposits, invests these funds at 5% and pays the policy holders 4%. What can it deduct from income, if anything? 26. A company pays its bondholders $20,000, being interest at 5% on $400,000 outstanding. In addition to this, under its tax-free guarantee, it pays a state income tax of 1% on $1,500 against which no exemption is claimed, and withholds 2% on $12,000 according to federal tax requirements. Can these be deducted as taxes paid? As additional interest? 27. B Company has a machine which cost $13,000. Depreciation against this machine has been charged for 12 years at $1,000 per annum. The machine is virtually worn out. Another concern buys the article for $2,000 and the company pays $18,000 for a new unit. Is any portion of this deductible as an expense or loss? 28. Does any portion constitute gain? 29. In its incipiency a company incurs the following expenses: Legal and charter fees $5,000 Installation of books and accounts 3,000 Preparation of drawings and specifications for manu- facturing processes 12,000 Installation of machinery 65,000 Fees and commissions to brokers negotiating promotion and purchase of manufacturing rights 15,000 $100,000 What part, if any, constitutes deductible expense ? 30. Does a corporation pay income taxes on Liberty Bond inter- est in excess of exemptions? APPENDICES 275 31. A corporation has: Assets, current $100,000 Assets, fixed $300,000 Depreciation 100,000 200,000 $300,000 Liabilities, current $100,000 Capital 100,000 Surplus 100,000 300,000 Desiring to curtail its activities it sells one-half its fixed assets at $150,000 and liquidates $75,000 par of its capital stock with the proceeds, paying $200 per share. Is there gain or loss in the transaction ? 32. On what dividends must the stockholders pay taxes? 33. Following this, the company distributes $50,000 of its current assets, being bonds received in trade contracts, taking up the re- mainder of the stock outstanding and issuing two hundred fifty shares no par value stock in the settlement to perpetuate the charter. What gain or loss to the stockholders? 34. Under what circumstances might interest on preferred stock be a deductible expense? 35. The cost of a machine unit, twenty years ago, was $30,000. The estimated life was twenty years with no scrap value. The cost of replacing this unit has steadily risen. With each known raise, the company has increased its depreciation, thus: after the first ten years, 5%; after the eleventh year, 2% additional; after the thirteenth year, 3% additional; and thereafter, to date, an additional 1% each year for four years, and a further additional 2% in the nineteenth and twentieth years. The machine is re- placed at a cost of $35,400, which is the value on which the last year's rate was based. What is the amount chargeable to expense? 36. In 1920, the P. Company paid excess profits taxes of $35,000 on 1919 earnings. In computing its 1920 taxes it finds its excess profits tax to be $20,000. Which may it deduct for the purpose of computing 1920 income taxes? 37. On what basis would you advise an accident insurance com- pany to set aside reserves, there being no specific requirement in law? 38. A marine insurance company (mutual) refunds 50% of all premiums on completed voyages in 1920, and pays interest at 6% for the time held. This is an adjustment of unrealized loss 276 INCOME AND PROFITS TAXES expectancies. What is its possible deduction in reporting income for tax purposes? 39. May A. B. Company (ordinary) deduct dividends from B. C. Company (personal service) in making its income tax return? 40. Dividends received by an individual are subject to surtaxes but not to normal taxes. Are dividends received by corporations correspondingly subject to excess profits taxes but not to income taxes ? Questions on Chapter VII 1. What is a person? 2. What is a foreign partnership? 3. What is a "non-resident alien ?" 4. Who are "citizens?" 5. When is an alien seaman a resident? 6. What constitutes "residence?" 7. When would an Englishman naturalized in the United States cease to be a citizen if he removed to Mexico ? 8. What income of non-resident aliens is taxable? 9. A. B., a Scotchman residing in Paris, is employed as a sales- man by the C. D. Co., an American corporation, having an office in Paris. Is his salary taxable? 10. What is the exemption of Fourth Liberty Bonds owned by John Smith, an Englishman living in London? 11. If Italy, in collecting an income tax allows an exemption of 1,000 lire to single men and 2,000 lire to married men, but no additional exemptions for dependents, these exemptions claim- able by American residents having income from Italy, what could Tonio claim, living in Rome with a wife and two children under eighteen, and having an income from the United States of $3,000 per annum? 12. An alien residing in Spain has income from the United States of $10,000 and from Spanish sources of $6,000. His expense for interest during the year is $800 dollars. How much can he use as a deductible expense in his United States tax return? 13. In the above, the alien lost $500 on a stock deal in New York. Can he claim the same or any part of it? 14. When is a citizen of Porto Rico taxable? APPENDICES 277 15. What credits may a resident of the Phihppine Islands claim? 16. What credit for taxes paid to Porto Rico may an American claim in respect to income from that island? 17. Who must make a return for the estate of a deceased per- son? 18. Distinguish between "fiduciary" and "agent" in respect to the responsibility to make returns and pay taxes. 19. How are estates taxed? 20. What differences may be named between income of an in- dividual and income of an estate? 21. What is meant by "capital disbursements" in relation to estates? 22. If a certain property is conveyed by A to B, in trust, to con- vey to C at A's death unless A elects to sell or otherwise dispose of the property prior to his death, who would report the income of the property? 23. What is the period of administration for the purposes of the income tax? 24. What is the effect on the taxability of a trust if it is granted for the benefit of the heirs of a person still living? 25. If a will provides that the income from certain specified prop- erty is to be paid to a son of the deceased, who should pay the tax on this income? 26. In the above case would it alter your answer if the provision read, "provided, in the judgment of my executors, his income from all other sources does not suffice for his maintenance?" 27. If a residual legatee is an orphan asylum would the estate be taxable? 28. A. B. dies leaving an estate consisting of stocks and bonds, and several buildings, all rented to good paying tenants. Who is to report the (a) dividends, (b) interest on the bonds, and (c) rents ? 29. Does the accumulated income of an estate, having been taxed during administration, constitute income to the residual legatee on winding up the estate ? 30. When should an estate make its returns? 31. What exemption or credit is allowed an estate? 32. How are partnerships taxed ? 278 INCOME AND PROFITS TAXES 33. What returns must be made by a firm? 34. What differences exist between the computation of income of firms and the income of individuls? 35. As of what date should a partnership make its return? 36. A firm closes its books on June 30th, and its three members make their individual returns as of April 30th, June 30th, and August 31st, respectively. On what dates would each of these members include the profits shown by the firm books on June 30th, 1920? 37. Must the individual pay taxes on dividends received by the firm of which he is a member ? 38. Distinguish between "associations" and "partnerships." 39. Who is responsible for taxes in the case of a syndicate of persons owning a mine which is leased, and the title to which is held by trustees who collect the royalties and remit the same to the members of the syndicate in proportion to their invested inter- ests? 40. Under what circumstances is a limited partnership taxable as a corporation? Questions on Chapter VIII 1. Are all corporations taxable? 2. How should an exempt corporation act with respect to its returns? 3. Define agricultural organizations. 4. Why is a mutual savings bank not taxed ? 5. What is essential to constitute a fraternal benefit society ? 6. What would be the effect on taxability if the matured stock became permanent capital? 1. Would a cemetery operated by a stock company on an invest- ment basis be taxable ? 8. Is a Y. M. C. A. taxable? If not, why not? 9. Would an exchange center operated by the druggists of a city be taxable? If not, why not? 10. Would a city club operating a cafeteria for its members be taxable ? APPENDICES 279 11. Would a dramatic club which gave paid-admission entertain- ments be taxable? 12. If a mutual insurance company has an accumulated surplus of half a million dollars would that bear on its taxability? 13. What is the status for taxation of the mutual purchasing agencies among government employes? 14. Name the six elements of the definition of a "personal service corporation." 15. To what extent may a personal service corporation employ capital ? 16. If the principal owner of a personal service corporation gave his son, engaged in another business, one-half his stock, would it have any bearing on the taxability? 17. Would an incorporated organization of London patent attor- neys having a large practice in the United States be taxable? As a corporation ? In any other manner? 18. Would a stock brokerage house whose dealings with its cus- tomers were all transferred to another house for split commissions, but in its own name, be a personal service corporation? 19. Would an incorporated commission house which bought a load of wheat from a farmer who was in need of immediate cash rather than keep him waiting for a brokerage sale be a personal service corporation ? 20. Three stockholders of a purely brokerage corporation are active, the fourth having retired owning one-half the stock. Is this a personal service corporation? 21. If the members of an incorporated auction house employ a special man to conduct the sales is this a personal service corpora- tion? 22. If one member of a personal service corporation dies, may his estate continue its interest permanently without changing the status of the company ? 23. Would uncollected fees of an incorporated law firm consti- tute "invested capital" so as to preclude the personal service status ? 24. If a commission house commonly advances 50% of the market on goods consigned, can it claim personal service status? 25. What is the tax on a personal service corporation ? 280 INCOME AND PROFITS TAXES 26. To what extent are dividends of a personal service corpora- tion paid January 1, 1918, taxable? 27. If a personal service corporation owns $20,000 in 3d Liberty Bonds would the interest be taxable? How would a one-half owner report the matter if he had exhausted his exemption on personal holdings? 28. A corporation organized by the heirs of an estate with the idea of allowing the income to accumulate, except for agreed annual allowances to each, until the present tax law is repealed, is taxable under what method ? 29. Would the above be justification for any special action by the Commissioner ? 30. If the funds accumulated by the above were used in making extensive enlargements of the properties, would your answer be the same? 31. What is the taxable gross income of a foreign corporation? 32. If a foreign corporation derives one-third of its income from the United States, what would be its deduction for interest on bonded liability? 33. What constitutes the invested capital of a foreign corporation? 34. Who must make a return for an English insurance company having an agency in Baltimore? 35. Why does the foreign corporation have to return only its income and balance sheets? 36. What was the method of computing invested capital for a foreign corporation in 1917? What bearing has this on 1918 and 1919 tax computations? 37. Is a Porto Rican sugar company a foreign or domestic cor- poration ? 38. If the English Government invested large sums in American stocks, would the dividends be taxable ? 39. If an American citizen acting as Consular Agent in New York for the Swiss Government receives $4,000 in the year as fees, must he pay a tax? 40. If the city of Detroit operates a street railway is the income taxable ? How, if the city received a percentage on the net income from a private corporation operating said railway? APPENDICES 281 Questions on Chapter IX 1. Aside from personal credits, what is the normal tax on an income of $4,000? 2. What is the tax, normal only, on an income of $12,000, if the personal credit is $1,000? 3. What would be the taxes in the above question at 1918 rates? 4. Which of the following persons are subject to taxes? A Frenchman residing in America ? A Swede, naturalized in the United States and living here? An Italian, naturalized in the United States and now living in Great Britain having been there for three years ? An Englishman, holding Liberty Bonds, residing in London? 5. Is an estate subject to normal taxes? To surtaxes? 6. What principal items of income are subject to surtaxes but not to normal taxes? Are there any which are subject to normal taxes and not subject to surtaxes? 7. A man, insane, is incarcerated in an asylum. His wife and two small children live in the same town so as to be with him. Has he any personal credits? 8. I support an old family servant who is now decrepit. May I claim a dependency credit for her? 9. A father of two children, his wife being deceased, maintains one of them aged twelve at a boarding school, and the other aged fourteen in the residence of his brother. The father's residence is at a near-by hotel. What is his personal credit? 10. A wealthy bachelor maintains a large household, with several servants. The only occupant, besides himself and the servants, is the invalid husband of a deceased sister. The invalid has means of his own but lives with his brother-in-law for the convenience of having the servants to attend him. What is the personal credit of each of them? 11. Frank Lord and his wife occupy different portions of the same dwelling, pending a divorce and separation of their finances. What personal credit can either claim? 12. Carter's income is $25,000. He has two children, aged six and four years, respectively. His wife is living with him. The two children receive $100 per month each, from a deceased grand- mother's estate. What is Carter's personal credit? 282 INCOME AND PROFITS TAXES 13. Markwood files a return December 31st, claiming a per- sonal credit of $2,000 on account of marriage. His wife, at that time is visiting, ostensibly, her mother, who lives in a rather distant city. On May 1st, following, the wife enters suit for divorce, not having returned home in the meantime. Markwood contests the suit. On December 31st, following, what credit should he claim? Was his first claim $2,000 a correct one at that time? 14. What are the personal credits against surtaxes? 15. The following formula will suffice for quick estimation of surtaxes on incomes up to $100,000: Divide the income by 4,000, disregard the fractional part unless 2,000, that is, one-half. Subtract IJ^ from the quotient and take the result as the rate, average, on the greatest amount in even $2,000 multiples. With this rate, find the tax on the even $2,000 multiples and add $10. The result is the surtax on the whole. Example : Income $49,000 Divide by 4,000 12 Remainder, disregarded . . $1,000 Subtract 1^ Rate average 10^ 10y2% of $48,000 $5,040 Add 10 Surtax on $48,000 $5,050 For the additional $1,000, the rate is the number of even two thousands, minus one. In this case: Even $2,000's in $49,000.. 24 Minus 1 Rate for additional amount 23 23% of $1,000 $230 Surtax on $48,000 5,050 Total surtax $5,280 Using this formula, find the surtax on : $8,000 $33,500.00 20,000 47,550.00 25,000 63,756.00 27,000 99,999.99 16. Gillis discovered oil on his farm. The farm was a family site, and had been in the family for generations. No value was APPENDICES 283 ever placed on the farm for matters of his father's estate. In 1912, being short of funds, be obtained a loan of $5,000 on the place and at that time was told that the bank was loaning 50% of what it estimated as the fair value. Gillis sold the farm, includ- ing the oil rights, for $150,000. His other income was $1,200 net. What is his surtax? 17. In the above, modify the figures by the following statement of income and expense, other than sale proceeds: Sale of farm products $6,500 Labor on farm $1,400 Surveyor's fee for locating well 1 ,600 Taxes and interest 400 Lumber, for temporary structure at well 600 Construction labor 1,000 Auctioneer's fee, for sale of land 300 5,300 Net income $1,200 Sale of land 150,000 Total income $151,200 18. Knight and Long are partners. Their profit for the fiscal year ended August 31, 1919 was $57,000. WJiat is Long's tax, he having a one-half interest in the firm and being a single man with no other income? 19. In the above, what is Knight's tax, he being one-half owner, a married man with one child aged six years, and other income from dividends amounting to $5,000? 20. In the above two questions, recompute the taxes on the basis that of the firm profit, $7,000 was dividends. All other figures the same. 21. Zellers has an income of $35,000 net. He is a single man. Of this income, $25,000 is clearly taxable at the rates for 1916. Compute the tax. 22. Viers owns an interest in a personal service corporation. He receives dividends in 1919, as follows: From surplus earned prior to December 31, 1917 $35,000 From earnings in 1918 15,000 From earnings in 1919 25,000 The actual earnings of the company for 1918 were $65,000, of 284 INCOME AND PROFITS TAXES which Viers is entitled to 8/13 and he so reported in his 1918 return. The actual earnings in 1919 were $91,000. What income must he report in 1919, and what are his taxes? 23. What is the normal tax on corporations? 24. What is the normal tax (disregarding excess profits taxes) on the income of a corporation which closes its books as of Octo- ber 31, 1919? 25. Invested capital, $1,000,000; income, $450,000. What is the tax if a calendar year return, 1919? 26. The same, if a fiscal year May 31, 1919? 27. The same, if a return for the period from January 1, 1919, to August 31, 1919? 28. The same, if a return for the period from September 1, 1918, to May 31, 1919? 29. The same, if a return for the period from July 15 to Decem- ber 31, 1919? 30. What is the excess profits credit in case of three affiliated corporations having invested capital of $56,000, $73,000, and $4,700, respectively? 31. Compute the excess profits tax if the invested capital is $22,- 000 and the income, $4,900. 32. Compute the tax under Section 302 (Limitation) where the income is $53,742.98. 33. Same as Question 32, if the return is for eight months. 34. What is meant by the provision that income from govern- ment contracts is taxable differently than that from ordinary sources ? 35. Compute the tax on the figures in Question 25, assuming that $250,000 of the capital was utilized in the performance of a government contract from which the net income was $150,000 included in the total given in the question. 36. A company started business December 15, 1920. It earns $56 by the end of the month and makes a return on the calendar year basis. Must it cover the excess profits data in its return? 37. A company keeps its books in single entry, with tabulations of income and expense not used as a part of the system. It has, as is known, a large net worth but no record of the same has been maintained. By what method should it compute its tax? APPENDICES 285 38. A company engaged in mining derives net income as follows : From gold mining $50,000 From other mining and trading 40,000 Net gain from sale of a mine during year (sale price, $175,000) 140,000 $230,000 Its average mvested capital for the year is $550,000. What is its tax? 39. A company derives income as follows: From trading $45,000 From personal service 55 QOO $100,000 Its invested capital is: For trading $250,000 For personal service 25,000 $275,000 What is its tax? 40. What is the minimum applicability of the partly personal service method of computing taxes? Questions on Chapter X 1. The tax being on incomes, why do we discuss the matter of capital ? 2. What is the difference between "invested capital" and "out- standing capital?" 3. Is a lease "tangible" property? Stock in another corporation? 4. Is stock of the corporation under consideration, held in the treasury and not canceled, which has been acquired by purchase from the estate of a deceased stockholder, "tangible" property? 5. The A. B. Co. is organized to conduct a manufacturing busi- ness. As an adjunct to its activities, it purchases a large block of stock in one of the companies from which it purchases raw materials. The said stock is purchased with stock of A. B. Is this "admissible" and at what value? 6. The same company issues stock, par value $70,000, for an old plant and building worth probably $100,000, but the reason for the sale at the lower figure was because the new company 286 INCOME AND PROFITS TAXES owned the patents controlling the manufacture, and these patents were deemed to make its stock worth about 150% par. At what price would the plant be included in invested capital? 7. The following assets were purchased for the aggregate listed beneath : Inventory $2,500,000 Plant and Equipment 3,500,000 Accounts and Notes Receivable 2,000,000 Unfinished Contracts, aggregating $10,000,000, on which the value is placed 3,000,000 Good will of predecessor, not carried on his books 5,000,000 ~$1 6,000,000 Accounts and Notes Payable, assumed by new com- pany 4,000,000 Bonds of new company 5,000,000 Cash, raised by borrowings of new concern 2,000,000 Stock, Common 3,000,000 Stock, Preferred 8%, retirable at option of new com- pany without premium 2,000,000 ~$r6,000,000 Besides these items, the new company also sold $2,000,000 in common and $3,000,000 preferred (same as above) for par and 10%, paying a 5% sales commission out of the premium realized, or 105 net. How would you allocate the assets for purposes of admissibility ? 8. A firm incorporates its business. Under D. C. law, a com- pany must have 10% of its capitalization paid in in cash and all stock subscribed for before a charter can issue. The firm, having paid in enough to qualify, signed a subscription list for the re- mainder of the stock and accounts were opened against the several members for the amounts of their subscriptions not covered by the cash payment. What is the admissibility of these accounts for invested capital? 9. A company sold an issue of bonds, as follows : Sold on open market, at 85 $100,000 Sold to stockholders with a one share ($100) bonus on each $1,000, at par 100,000 What paid in capital shall be claimed with respect to this? 10. The W. W. Co. issued $100,000 stock for a going business. This was its entire capitalization. The vendor returned $40,000 APPENDICES 287 to be used in raising working capital. Of the same, $30,000 was sold at 75. The remainder is still in the treasury. What is the invested capital? 11. Finding the market favorable, the directors of the B. G. Co. authorized the treasurer to purchase so much of its stock as was offered at not more than 110. Under the order, 500 shares were purchased. Subsequently, the said stock was sold for 120. As- suming this stock at one-tenth of the entire capitalization, all outstanding, and no other surplus to consider, what is the in- vested capital? 12. A bank is organized and sells its stock, par value $10, $15 per share. It pays commissions and underwriting expenses amount- ing to $2 per share. What is its invested capital, using the per share unit? 13. A company operated for four years at a loss while develop- ing its plant and market. The aggregate loss is $40,000. Its capital is $100,000 fully paid in. After this period, it begins to earn a profit. In the third year, it has accumulated an undivided profit of $35,000. What is its invested capital on this showing? 14. A company has never charged off depreciation. Its assets consist principally of a building and contents. The value of the building and ground has advanced, according to the tax appraisers, at an average of 5% per annum. This appreciation has never been entered on the books, but is understood as being more than an offset to the depreciation which would normally be chargeable. What effect does this have on invested capital, if any? 15. If, in the above, the company had been charging 5% per annum on this building, including the ground value when making the charge, what might be done to correct invested capital? 16. The B. D. Co. purchased a going business for cash. In said purchase, $35,000 was paid for a good will. This was written off over a period of seven years. Can you suggest anything that might be done in the matter as a benefit to the invested capital? 17. A company owns many patents. Those held in one group are annually depreciated at one-seventeenth cost. Those in another group, because of their peculiar nature are not depreciated at all. It desires to standardize the two for the purposes of its income tax returns. May it do so? 18. The F. H. Co. paid an income tax in 1920 of $73,200. What is the deductibility of this with respect to invested capital, using the calendar year basis? 288 INCOME AND PROFITS TAXES 19. Donovan owes the H. K. Co. a bill of $5,700. He gives the company a mortgage on his property for the amount. After six months, he finds he cannot meet the interest and agrees to let them take the property in if the company will permit him to purchase goods at a selling value of $3,600 and accept the said property as full payment. The rate of interest on the mortgage is 5% per annum. The property is taken in, and the company places a value of $14,000 on it for tax assessment. At what value may it be included in invested capital? 20. S. K. Co. issued bonds, par $100,000, for 85. The bonds were for fifteen years, and the straight line method of amortization was applied to the premium. The bonds have now been out for seven full years. Can the remainder or any part of the premium be included in invested capital? 21. Is a reserve for interest not due admissible as invested capital in the case of an investment note broker who collects his interest in advance and retires it in semi-annual adjustments? 22. A mining company operates at a loss for several years, creating a deficit of several thousand dollars. Subsequently, it leases the mine on a royalty basis, and distributes the royalties collected, annually to its stockholders. The company is engaged in other business. What effect have these two matters on the invested capital ? 23. Would debenture stock, entitled to a 110% of par settlement on retirement or liquidation of the company, be admissible as a part of the invested capital? 24. Would it make any difference in your answer to the pre- vious question if the option of retirement were in the stockholders on a sixty days' notice basis? 25. Three stockholders of a small corporation, owning all the stock, agree among themselves to leave all profits and salaries in the business for a period of five years. Can either the profits or salaries be included in invested capital ? 26. A bank, whose stock is selling at 175 on the exchange, used a block of its stock to purchase the entire business of another bank, paying one share for two of the one bought. The other bank, so purchased, was insolvent and its stock had a book value of only $50. To cover the facts in the books, the purchasing bank opened an account with "Charter Purchased" for $75 per share issued, the assets and liabilities of the retired bank amount- ing, of course, to the par value of the stock issued only. The said APPENDICES 289 $75 per share was then credited as paid-in surplus. Is it admis- sible to invested capital? 27. The District of Columbia is a federal jurisdiction. Its acts are done strictly under authority of Congress. There is out- standing an issue of bonds called D. C. 3.65's. Would these be admissible as invested capital on the theory that they were to all intents and purposes United States obligations? 28. January 1st, D. H. Company held $30,000 H. County 4's, had $70,000 other and tangible assets, all admissible, and $20,000 liabilities. On March 1st, the company borrowed $20,000 against these bonds, at 5%. This loan was carried for six months and the bonds were then sold for $32,000. On December 31st, the company had assets, all admissible, of $85,000 and liabilities of only $8,500. Determine the deduction for inadmissibility. (Use eight months' accrued interest on the bonds.) 29. Are deferred charges to operations admissible assets? 30. What is the addition to inivested capital in case of a sale of stock for $100,000 on November 1, 1920, if the corporation uses March 31st as the close of its fiscal year? 31. A company changes its fiscal year, then makes a return for the period from January 1 to August 31, 1920. Its invested capital January 1st is $350,000. What is its excess profits credit? What is the amount in its first bracket? 32. A bank declares its dividends quarterly at 2%. Its capital is $100,000, its surplus January 1, 1920, is $300,000. Its earn- ings in 1920 were $12,000. The dividend dates are February, May, August, and November 1st. It has no inadmissible assets. Which of the dividends must be deducted from invested capital, if any? 33. A company declares a dividend payable in cash with the option of stock at 110. Ninety per centum of the stockholders avail themselves of the purchase privilege. What effect has this on invested capital if the dividend is payable January 1st, and the company uses the calendar year? 34. Would the reserves for ordinary policy protection in case of a fire insurance company be admissible as invested capital? (Such reserves are usually figured on unexpired premiums only.) 35. In the previous question, what of reserves for known but unadjusted fire losses? 290 INCOME AND PROFITS TAXES 36. Figure the invested capital of the following group: A Co. B Co. C Co. D Co. Tangibles $30,000 $50,000 $65,000 $35,000 Good Will .... 40,000 20,000 none 15,000 Stock in A Co 5,000 15,000 Stock in B Co... 25,000 25,000 10,000 Stock in C Co... 15,000 none none Stock in D Co.. . 10,000 10,000 10,000 $120,000 $85,000 $115,000 $60,000 Liabilities $100,000 $5,000 $50,000 $20,000 Capital 20,000 65,000 15,000 30,000 Surplus none 15,000 50,000 10,000 $120,000 $85,000 $115,000 $60,000 37. The following is a condensed balance sheet of the G. B. Co.: Cash $60,000 Accounts 150,000 Plant 250,000 Good Will 400,000 $860,000 Liabilities $360,000 Stock 400,000 Surplus 100,000 860,000 38. In the aforegoing, assume that the D. B. Co. purchases the said 95% of the stock for its own stock, paying eight shares for seven. What is the valuation of the assets? 39. A company in computing the profit from a sale of part of its real estate, valued the same, as of March 1, 1913, at $700 per acre. This valuation is admitted as reasonable by the Bureau of Internal Revenue. The said real estate actually cost, in 1910, $550 per acre. Which should be used in determining invested capital? (Prior to sale.) 40. A company is permitted to place a sound value, as of March 1, 1913, of $3,5OO,0OO on its plant, for the purpose of adjusting depreciation. The rate is 6% per annum. The plant was pur- chased in three sections, as follows : APPENDICES 291 March 1, 1908 $1,000,000 September 1, 1909 1,500,000 March 1, 1912, 500,000 Total purchases $3,000,000 Additions and better- ments, 1910 to 1912 1,000,000 Total cost $4,000,000 What is value for invested capital? The additions and better- ments were made equally in the three years 1910, 1911, and 1912, and it is agreed that no depreciation shall be charged on the same for the year in which made. Questions on Chapter XI 1. John Doe is a widower with three small children. His in- come is $1,500 per annum. Must he make a return? 2. Sam Simpson is a merchant. He is taken ill on March 1, 1921. His return for 1920 was not yet made. Might his bookkeeper make the return under such circimistances ? 3. An army officer has no income other than salary, which is $4,500. Must he make a return, if single? 4. A widow has her entire capital invested in Liberty Bonds. Her income is $2,500, but the Liberty Bond exemptions applicable to her holdings render them entirely exempt. Must she make a re- turn? 5. Would a sixteen year old girl, earning $1,100 per annum and living at home with her parents, be under any necessity for making a return? 6. Would it be lawful for a large stockholder to place his holdings in the name of an employe and let the employe pay the taxes on the dividends? 7. What is meant by "oath or affirmation?" 8. Is the use of the stereotyped forms necessary in making returns of income? 9. Is the Commissioner charged with any fixed responsibility in the matter of furnishing forms? 10. Three trustees of an estate have its affairs in charge. Must the three join in the filing of the return? 292 INCOME AND PROFITS TAXES 11. Who would make the return of income of an incarcerated lunatic? 12. Who should file the return in case of a person who dies on January 1st, having not yet filed his return for the close of the preceding calendar year ? 13. In the above case, could the additional day be included in the return or would it be necessary to file an additional one for the single day? 14. If such person was married at the time of his death, and had no dependents, might any personal credit be claimed in his case for the single day if such a return were filed ? 15. The guardian of a twenty-year-old young man asks what ob- jection, if any, could be made to his permitting the minor to make his own return. What would you advise ? 16. A. and B. are trustees under two deeds in trust, holding estates created thereby which are distributable of F., G. and H., share and share alike. A. and C. are trustees under another deed, the income from which estate is distributable to G. and H., only. The grantor is the same in all these cases. B. and C. are trustees under a deed from another grantor, but the distributees are identi- cal with those in the first three trusts above named. How many returns are necessary, all beneficiaries being of lawful age? 17. If the trust is for the benefit of one beneficiary, only, is it necessary to use the fiduciary form, as usual, or may the individual form be used? 18. Why is a firm required to render a return notwithstanding its exemption from taxes? 19. What must such a return disclose besides the usual infor- mation as to income, expense, etc. ? 20. May a partnership file as of the calendar year, if it so desires? Can you give a reason for your answer ? 21. Why must a partnership return disclose data as to dividends received ? 22. Should all corporations make returns on the same form? 23. A corporation opens its business on September 23rd. It is decided that September 30th is the most advantageous day for a fiscal closing. Having operated one year, it makes a return, merg- ing the business of its first eight days in September of the previous year with the annual accounting. Have you any criticism of this? APPENDICES 293 24. The A. B. Co., having become involved in a controversy with a customer, a receiver is appointed to hold the goods under dis- pute until an adjudication of the rights of the parties. The com- pany, shortly thereafter, becomes insolvent and a trustee in bank- ruptcy is appointed. Upon which is the responsibility for making the return ? 25. If the goods delivered to the first named officer are sold at a profit, and the funds invested, temporarily, at interest, who should make the return for these items of income? 26. Might an insurance company file a copy of the standard form insurance report in lieu of making a return ? 27. Would the return of a personal service corporation require any information other than that called for in the cases of ordinary corporations ? 28. A group of investors own, among themselves, 98% of A. Co., 97% of B. Co., and 99% of C. Co. Should there be a single return for all, or one for each of these companies? Which of the com- panies is responsible to make the return provided a single return is allowed ? 29. The X. Y. Z. Co., owns as follows: Stock in P. Q. R 75% Stock in S. T. U 98% Stock in V. W 97% Stock in the P. Q. R. is also held by Smith, Jones, Brown and Robinson, 6% each, and these men are the only holders of stock in X. Y. Z. In making a return must the consolidated form be used ? Must all four companies be included? Wiho must make the re- turn? 30. If, in the aforegoing, the remaining 25% of the stock of P. Q. R. were owned by persons not interested in X. Y. Z. would that make any difference in your answer? 31. S. owns 51% of the stock of two large companies which operate a joint enterprise. He also owns 95% of the stock of an- other company engaged in the same business but not connected with the above joint enterprise. Should a consolidated return be filed ? 32. What is meant by "apportioning the credits" in case of a return for a period of less than one year ? 33. When is the return due in case of a fiscal year ended October 31st, all previous returns having been filed on a calendar year basis? 294 INCOME AND PROFITS TAXES 34. The secretary-treasurer of the B. H. Co. died on February 10th. He was the ofScer in complete and exclusive charge of all accounting and financial matters. There is no officer with suffi- cient familiarity to prepare a return, and the board is obliged to employ an expert to examine the books for this purpose. The time estimated for the work is ninety days. What should be done ? 35. An American officer, with the Army of Occupation, has not yet filed any income tax return. Is he in default? 36. The Baltimore Collector maintains a branch of his office in Washington. May a resident of the District of Columbia file a return at that office? May he do so on March 15th if he uses the calendar year basis, without incurring penalties for delay, or must he file it in time to be mailed to Baltimore ? 37. Why are returns of information required of partnerships as to the distributions of profits, when the income return itself is merely a matter of furnishing information ? 38. If Smith's bookkeeper were taken ill a week before the in- come return was due, and died shortly thereafter, and Smith, in looking through his desk, after the death, found an unfinished re- turn, completed the same and filed it ten days later, would these facts probably be deemed reasonable cause for delay? 39. If not, what would be the penalty on Smith ? 40. If Smith, being somewhat familiar with the data from which the return was being prepared, made an understatement of income under the circumstances in the previous question, would he be sub- ject to any penalties? Questions on Chapter XII 1. When are income taxes payable? 2. If a company closes its books as of August 31st, when would its third installment of taxes be due ? 3. Can you suggest how the Commissioner might obtain infor- mation for preparing a return of income which had been neglected by a taxpayer? 4. Capital stock taxes are due in advance but payment is not required until notice by the Collector. When would interest be- gin to run against such taxes, and at what rate? 5. Green filed a claim for abatement. Three-fourths of the same was disallowed. The notice of disallowance came after the second APPENDICES 295 instalment of taxes was due, Green having paid the first and second instalments on the amount of his return minus the claim. What interest is proper on the amounts involved? 6. In the above question, if the Collector, not knowing of the claim, demanded payment of the unpaid portions of the first and second instalments, prior to the adjudication, would there be any penalties ? 7. Owing to rural mail service conditions, the time required for mailing from the Collector's office to that of a certain taxpayer is six days. What should the Collector do when sending out notices and demands for pajTnents ? 8. May a Collector of Internal Revenue sue for taxes? Under what circumstances ? 9. What is meant by "distraint?" 10. On search, no personal property was found belonging to Henderson, a delinquent taxpayer. It was learned, however, that he owned a one-half interest in a building, which was mortgaged for about two-thirds of its value. Can the Collector take any action to collect the taxes out of this real estate ? 11. If I pay my taxes with an uncertified check, may I demand a receipt? 12. I owe income taxes amounting to $6,235.98. I have on de- posit in the Richmond Reserve Bank, U. S. Certificates of Indeb- tedness of a par value of $7,000 (seven at $1,000 each). These certificates are bearing interest at 5%, and there are matured coupons uncut amounting to $350 attached to the same, besides accrued interest of $70. To what extent may I utilize these in payment of taxes? 13. In the above, if any taxes are due the Baltimore Collector, must I send to Richmond for the certificates? If not, how would I proceed? 14. Is the provision for "credit for foreign taxes" meant to per- mit the same to be deducted as an additional expense in reporting net income? 15. Jones is a member of a firm which derives a large income from France. There is an income tax paid by the firm amount- ing to $4,000. Jones owns a one-half interest in the firm. How must he utilize this item in his return? 296 INCOME AND PROFITS TAXES 16. The firm, in Question 15, failed to pay its taxes on time, and a penalty of interest amounting to $700 was added. Can Jones claim anything with respect to this interest? 17. If the Province of Quebec levies an income tax, may that be used with respect to income taxes in the United States where the same is paid by a person deriving income therefrom and resident here? 18. What form is necessary in order to substantiate a claim for tax credits? 19. In Question 15, the tax stated was reported before actual payment. When finally settled, it was found that the same was $4,400 intead of $4,000. What should Jones do ? 20. Can a corporation claim credit for foreign taxes? 21. What is a claim for "abatement"? 22. What is the difference between a claim for abatement and ■ an application for permission to file an amended return ? 23. What form is used for "abatement" ? 24. What is a claim for "credit"? 25. How does this differ from a claim for "abatement"? 26. What is the proper form for this claim? 27. F. having paid his taxes in full, finds reason to file a claim for refund. Subsequently, and before the claim is passed upon, his next year's taxes are returned and the first instalment becomes due. How may he avoid paying cash for this tax? 28. When may suit be brought for the recovery of taxes errone- ously paid ? 29. Smith was sued for unpaid taxes and paid his judgment. Believing himself unjustly taxed, has he any further redress? 30. What is the penalty for a willfully fraudulent return? 31. Can the Commissioner of Internal Revenue imprison a tax- payer who deliberately falsifies his books to avoid income taxes? 32. Johnson was sued for a large amount of taxes. Although fully satisfied that he was being wrongfully assessed, he agreed with the Commissioner to pay one-third of the amount if the suit were withdrawn. Can the Commissioner accept the offer if he wishes to do so? 33. In the above, after a settlement, Johnson files a claim for re- fund, setting forth the grounds of his belief that the tax was im- APPENDICES 297 proper. The agent agrees with him fully, and the refund is ad- mitted to be equitably due. How may Johnson obtain relief ? 34. An auditor of the Bureau finds certain errors in the returns of a corporation extending back over a period of seven years. He files his report assessing the additional taxes for all of said years. Can the Bureau collect? 35. If the corporation were your client, what would you advise, assuming the errors are admitted? 36. Why does the Commissioner declare the termination of a tax- able period, and under what circumstances? 37. What is the eflect of this in the case of a Greek, desiring to return to Greece in February, who has made a return for the year ended December 31st? 38. In the last question, if the Greek were a married man with two small children aged six and ten, respectively, what credit would he claim? 39. What is the "fractional part of a cent" rule? Explain this fully. 40. Must a taxpayer keep books ? In what manner ? Questions on Chapter XIII 1. Define a "withholding agent." 2. Why is the rate of 8% selected as the amount to be withheld in the case of non-resident aliens? 3. What rate is withheld in respect to foreign corporations, where the income is derived from rents in this country ? 4. What rate, where the income is from dividends of ordinary corporations in this country? 5. What rate where the income is from bonds of a domestic cor- poration? 6. What is a "tax-free covenant clause" ? 7. Would commissions on occasional sales of goods to foreign buyers be "fixed and determinable" income if the selling agent were a non-resident alien? 8. Should there be any withholding at the source in the case of dividends of personal service corporations, paid to a non-resident 298 INCOME AND PROFITS TAXES alien stockholder, actively engaged in foreign countries in the busi- ness of the said corporation ? 9. By what method may a non-resident alien, whose income from the United States would be less than his personal credits, protect himself from withholding in respect to the interest on tax-free cov- enant bonds? 10. Are ownership certificates necessary in collecting the interest by coupons from bonds of the City of New York? 11. What must the withholding agent require of a resident who claims no credit against interest on tax-free covenant bonds? 12. What certificates must be used by a non-resident alien indi- vidual in respect to bond interest? 13. Would a partnership be compelled to use a certificate when collecting interest on tax-free covenant bonds? 14. What certificate form is used where withholding is not re- quired ? 15. What may a bank do to avoid disclosing the ownership of bond coupons passing through its hands? 16. Does this same rule apply in the case of non-resident aliens where such aliens are the parties for whom the collections are made? 17. What is necessary when coupons are presented without the usual ownership certificates attached? 18. Who prepares the certificates in the case of registered bonds? 19. Can you state why, with respect to the proper answer to the last question ? 20. Taxes having been withheld, when does the withholding agent pay the same to the Government? 21. Are returns required in respect to taxes so collected, other than the return transmitting the funds? 22. Is the date of payment of amounts withheld the same whether it be interest or other income? 23. What is the procedure with respect to the filing of returns of certificates, when no actual withholding has occurred? 24. May an executor file one certificate, only, if the items being transmitted are to inure to the benefit of several participants in the income? APPENDICES 299 25. Three parties own a block of securities. Will one certificate of ownership suffice in collecting coupons on the same? 26. Where items are payable to the Alien Property Custodian, would certificates of ownership be needed ? 27. In making an income tax return, would the recipient of in- come on which tax had been withheld report the net or gross amount ? 28. What rights has the recipient in respect to the taxes paid on his income so received? 29. What income is subject to a tax withholding of ten per cen- tum in the case of foreign corporation recipients? 30. How may a foreign corporation, having a place of business in the United States obtain exemption from withholding? 31. In what cases is a return of information required with re- spect to income against which no withholding is necessary? 32. Name four kinds of income as to which information at the source would be necessary. 33. The A. B. Co. employs a great many men. They are engaged in work which requires these men to be removed from city to city at frequent intervals. The pay-rolls are kept on each job, separ- ately, and no central detailed pay-roll record is maintained. How would the company prepare its information returns in respect to the earnings of these men? 34. What form is used by a partnership in submitting its infor- mation as to distributions to the members of the firm ? 35. Would rent, paid to a corporation, have to be reported on an information return? 36. John Jones has a standing contract with the C. D. Co. by which that company ships him every two weeks four hundred bar- rels of flour, and Jones transmits regular payments of the price of this flour at the contract basis. Would Jones be under the neces- sity of making a return of information as to these regular payments? 37. Does the Navy Department file information returns with re- spect to the salaries of naval officers ? 38. What is meant by a "license to collect foreign items?" 39. Must dividends be reported on information returns? 40. Would the owner of a single share of stock in the United States Steel Corporation be permitted to examine its tax returns? 300 INCOME AND PROFITS TAXES Questions on Chapter XIV 1. Why do we style the war profits tax an obsolete element of the present law ? 2. What are the first two brackets of the 1918 tax? 3. What is the third ? 4. Tax under the first bracket is $24,300, under the second, $91,- 000, and under the third, $93,600. What is the total tax? 5. Tax under the first bracket is $24,300, under the second, $71,- 500, and under the third, $104,600. What is the total tax? 6. A corporation opened its business on May 1, 1912. Its income to December 31, 1912, was $35,000 net; for 1913, $58,000 net; for 1914, $75,000 net. What is its pre-war average annual in- come? If the dates above are advanced one year each, what is the pre-war average annual income ? 7. A corporation earns as follows : Calendar year, 1911, gain $45,000 Calendar year, 1912, gain 55,000 Calendar year, 1913, loss 5,000 Calendar year, 1918, gain 60,000 Its capital is as follows : January 1, 1911 550,000 January 1, 1912 575,000 January 1, 1913 610,000 January 1, 1918 750,000 What is its war profits credit ? 8. Substitute in the above : Calendar year, 1913, gain $65,000 Capital, January 1, 1918 650,000 What is its credit with these changes? 9. What is meant by the provision that the ratio of capital and income of representative corporations may be used in determining the war profits credit? 10. A. F. Co. purchases 80% of the stock of a new corporation, organized to conduct a by-product activity of the said A. F. Co., which latter has been in existence for twenty years. The invested capital of the A. F. Co. is $10,000,000. That of the new concern is $1,250,000. How would you compute the credit for the new APPENDICES 301 company, provided its remaining stock were widely held so as to prevent afSliation? 11. Three companies are affiliated. A. Co. has invested capital of $1,000,000, of which $200,000 is stock in B. Co. and $300,000 is stock in C. Co. B. Co. has $500,000, of which $300,000 is stock jn C. Co., and C. Co. has $1,000,000 of which $400,000 is stock in A. Co. Assuming all other assets to be admissible, what is the minimum war profits credit for the group ? 12. F. Co. and G. Co. were merged without reincorporation in 1910, and in 1913 purchased the entire stock of H. Co. which was organized in 1912. In 1914, these three were taken over by stock control by a new group of companies known as M. Co. and N. Co., respectively, both of which were organized in 1908 and affiliated in 19l4 for the purpose of taking over the first-named group. How would you undertake the computation of pre-war capital? 13. What is the application of "reorganization" as meant in the adjustment of pre-war capital and income? 14. A large department store, after being operated as a unit for some twenty or more years, was sold out in 1915 to three companies, each of them taking certain of the departments. There is no af- filiation. What would you suggest with respect to computing the capital and income of the companies, respectively, in 1918? 15. Jones, a manufacturer, sold out in 1915 to a corporation formed for the purchase of the business. Jones's pre-war capital will average $2,000,000, his income $1,600,000, which proportion is largely due to patents and unbooked good will developed by him during his personal management. In the reorganization, his pat- ents, which have no book value beyond the nominal, were taken over at $4,000,000, and his good will at $1,000,000, all other assets being just about equal to his pre-war average. The com- pany does not increase its invested capital at all, and declares all profits in dividends as fast as earned, so there is no change in the above up to 1918. Compute the war profits credit. 16. In the above, the company after taking over these patents and the good will, depreciates the patents at 7^^ per annum as an ex- pense. This item forms a part, therefore, of its income deduction in 1918. No other difference being considered except as cited above, what effect has this practice on the computation of the war profits credit? (All patents are to be taken as having existed during the entire pre-war period.) 17. In the above, assume that $300,000 of the income of Jones consisted of dividends on several small corporations operating as 302 INCOME AND PROFITS TAXES semi-affiliates of his business, none of his holdings, however, amounting to a control. The stocks from which these dividends are derived are transferred to the new company, which still re- ceives the same dividends. As these are exempt from taxation, so far as income and excess profits taxes are concerned, what must be done with respect to a war profits credit? (Recompute with this fact added to the above. ) 18. In Question 12, the M. and N. Cos. own all the stock of F. and G. Cos. which in turn own all the stock of H. Co. Be- sides, M. Co. owns 60% of the stock of N. Co. How would you compute the pre-war income for a war profits credit ? 19. A corporation is formed in May, 1919, to take over the busi- ness of a firm. The firm earned $800,000 in 1918 but only dis- tributed $200,000 by way of withdrawals, the remainder being left in the business. What income would the partners, two equally interested, have to report for 1918? 20. The net worth of the above firm at January 1, 1918, was $3,000,000. There is sold to the corporation, however, an un- recorded good will, at a price of $4,000,000, for which the partners accepted stock, $2,000,000, and bonds, $2,000,000. They re- ceived cash for the other assets minus the liabilities. The corpora- tion is capitalized at $5,000,000. All other stock is sold at par. Its bonded debt is $3,000,000. Compute its war profits credit on the minimum basis. 21. A firm sells out to a new corporation, taking 60% of the stock as a consideration for its assets, and another 25% for the good will. In reopening the books, the following changes are made : Firm Books New Value Inventory $300,000 $300,000 Equipment 50,000 50,000 Building 250,000 350,000 Good Will none 250,000 $600,000 $950,000 The equipment is at cost, no depreciation having been charged. The building is at cost, no depreciation having been charged. The good will was built up by the firm and no account for the same has been included in the firm's books. What is your opinion as to the invested capital of the company? 22. If a withholding agent has in his possession funds represent- ing interest due a non-resident alien, which have accrued during APPENDICES 303 the calendar year 1918, what should he withhold in remitting the same in March, 1919, i. e., under the 1917 law or the 1918 law? How, if he remitted in January 1919? 23. What form is used for the war profits tax returns? 24. What is the reason for the special provision with respect to the taxation of railroads and steamboat lines under federal control ? 25. What is the meaning of "amortization" as applied to war plants ? 26. What constitutes a war plant? 27. A steamer on a river line was remodeled so that it could be used in carrying soldiers and stores from a camp on the river to the near-by city and return, when needed. The boat had been originally designed as an excursion steamer, and the cost of conversion was $300,000. Could he claim any especial expense in respect to this remodeling? 28. Define "government contract" as used in the Revenue Act of 1918. 29. In Question 27, if the remodeling was started February 10, 1917, when the prospect of the location of the camp was first known, and completed April 1, 1917, would that change your answer ? 30. In Question 27, provided the work were all done within the time limit for government contracts, what would be the effect of the subsequent use of the steamer, after the abandonment of the camp, in its remodeled condition for general passenger and freight service instead of restoring it to the excursion trade? 31. B. claimed in his 1918 return, an amortization of 75% of the cost of a plant erected to manufacture shells for the War Depart- ment, the machinery being worth little or nothing as a unit for other products, and the possibility of re-sale in parts being remote and expensive. Is he correct ? If not, what was his proper claim ? 32. A. B. is a manufacturer of machinery. In 1917 he sold to C. D. a lot of specially built machines for use by C. D. in making parts of special trucks for the army. After the armistice, his con- tract with C. D. was canceled. He was therefore compelled to readjust his own plant and resume work on his regular line at a cost, for readjustment as well as for the abandonment and removal of several units specially installed to meet the contract, amounting to $50,000. He is allowed 60% of this expense in the cancellation agreement, and the remaining 40% was estimated as the salvage 304 INCOME AND PROFITS TAXES value of the discarded units. Has he any grounds for amortization claim ? 33. G. Co. in its fiscal closing of December 31, 1918, sets up a reserve for the amortization of a building erected to store sup- plies carried for sale and delivery under a government contract. The reserve is 20% of the cost of the building, it having previously owned the land. In 1919 another change was made and credited to the reserve of 40% of the building. In 1920 the building was razed and the ground used for other purposes. a. Can any further loss be claimed ? b. Can any part of these reserves be included in invested capital? 24. H. J. K. is a merchant. In his inventory, 1918 closing, he listed 3,000 pairs of shoes at $6, the same being a special line. In March, 1919, at the time of filing his income tax return, he knows that these shoes can be bought at $4. He files a claim for inventory loss. During 1919, 1,000 pairs of shoes were sold at an average price of $7.50. His selling expenses are 5%. By the end of 1919, the price of these shoes has risen to $8 wholesale, and his remaining stock is worth that amount. What actual loss can he claim ? 35. G. J. N. accepted in October, 1918, for spring delivery, an order for goods at $12 per dozen. In his return for 1918 he has not included this sale because he does not cover undelivered goods in his sales accounts. In March, 1919, however, when he attempts to deliver, the purchaser claims the present market price, $10 per dozen, and N. is obliged to rebate or lose the sale. Has he any grounds for a claim for loss from rebates? 36. A merchant inventories, using the "cost or market rule," at the close of 1918, a line of goods at $7 per case, that being the cost. The market value at that time was $9. In inventorying in 1919, the market value is $10, but as the goods are shopworn, he uses the cost less a reduction of shopwear. None of this lot has been sold during the year. His 1919 inventory price is $5.50. Can he claim a loss ? 37. Brown closes his books as of September 30th. His closing for 1918 showed a gain of $30,000. His closing for 1919 shows a loss of $10,000. What remedy has he? 38. Wihat happens if the net loss for 1919 exceeds the net gain for 1918? 39. Johnson has always made his returns on a calendar year basis, although closing his books April 30th. After the passage of the APPENDICES 305 1918 Act, he makes his first return for the period from January 1, 1918, to December 31, 1919, and another return for the period from January 1, 1919, to April 30, 1919, to adjust his affairs to the fiscal year requirement. The second of said returns shows a loss of $20,000. Can he use this in reducing taxes under the previous calendar year? Questions on Chapter XV 1. Define "doing business." 2. Distinguish between "doing business" and "not doing busi- ness" as meant in the capital stock tax law. 3. A corporation is conducting a dry goods store. Is it doing busi- ness? 4. Said corporation sells its business for cash, retaining the cash then in bank and the accounts receivable, and assuming to retain and be responsible for the liabilities. It is now engaged in the collection of its debts and the payment of its liabilities from the proceeds. Is it doing business? 5. Having completely settled its liabilities, the company now pro- ceeds to invest its further collections in Liberty and municipal bonds, until its assets can be distributed. It is still doing business? 6. A company is organized to hold the titles to several mining properties, contiguous but belonging to difEerent owners. The company pays for each of the properties in stock on an agreed value, and proceeds to leasing the properties in more advantageously di- vided sections. All its leases are on a royalty basis, and the stock- holders, who were the original owners of the tracts, receive divi- dends based on stock, regardless of the activities of the parcels they formerly owed. Is this company doing business? 7. One very desirable site, being unleased, the stockholders or- ganize another company to operate the same, the stock of which new company is conveyed to the trustees of the first one to hold and turn the dividends or profits over to the older company. Is this doing business ? 8. In Question 7, would either company have to make a return and pay a capital stock tax? 9. The lessee of one of the tracts fails. The trustees of the com- pany owning the title take over the entire equipment and continue to operate the mine, pending the negotiation of another lease. Would this be doing business ? 306 INCOME AND PROFITS TAXES 10. In Question 9, the failure was followed shortly by the grant- ing of a lease to a new tenant. State, under the following date situations, which cases would and which would not incur capital stock tax liability and for what years: (a) Failure, April 10, 1919; new lease, June 26, 1919. (b) Failure, June 26, 1919; new lease, August 1, 1919. (c) Failure, July 1, 1920; new lease, July 1, 1921. (d) Failure, June 30, 1920; new lease, June 30, 1921. 11. What definition can be suggested for "fair average value"? 12. Must the paid-in surplus be included in "fair average value"? 13. A company has outstanding capital stock of $50,000, but a deficit on its books of $20,000 due to bad years. What is the value of its capital stock, from this data only ? 14. Must a foreign corporation pay a capital stock tax? 15. A London company owns a large packinghouse business in Kansas. The company is capitalized at one million pounds and has a surplus of three hundred thousand pounds, invested entirely in British securities. The company's Kansas ofEce shows an invest- ment which represents the entire million pounds at pre-war ex- change, averaging $4.87. Exchange at the time of making the re- turn is at $3.87. What should be the value of the capital stock for this case? 16. An English insurance company, writing no policies in the United States, makes its reserve investments principally in Ameri- can railroad securities. It owns at this time $5,000,000 in such. Would it have to pay a capital stock tax on all or any of that amount ? 17. A mutual insurance company carries a reserve for losses of $2,000,000, a reserve for current expenses of $200,000, a reserve for unsettled claims of $100,000, and a reserve for shrinkage in securities investments of $50,000. What is its taxability? 18. If the above company was a foreign concern, and had $20,- 000,000 in force, of which $8,000,000 was in the United States, also shrunken securities were all British bonds, and the unsettled claims were $30,000 in the United States and the balance foreign, what would be its taxability? 19. A syndicate is formed to exploit a tract of real estate. The shares are twenty in number all equal. There is no restriction against a transfer of shares among shareholders, but no transfers to outsiders are permitted without the consent of two-thirds of the APPENDICES 307 remaining shareholders. Would the same be liable for capital stock tax? 20. Four men form a limited partnership. Three of them invest the entire capital, the fourth undertaking the operation of the busi- ness. The fourth man is the only general partner. Is this con- cern taxable? 21. Would a church owning a large endowment in real estate from which it derived a regular income be taxable? 22. The A. B. Company was organized April 1, 1919. After due consideration, it purchased the business of Smith, an old merchant of many years' good standing in the community. It decided for the protection of Smith, who insisted upon the same, that it would be taxed as a corporation from January 1, 1918. When is it first liable for capital stock taxes ? 23. What is the rate of the tax? 24. If the fair value, as determined, is $125,987, what is the tax? 25. If the fair value is $5,999.99, what is the tax? 26. When is the tax due? 27. When is it actually payable? 28. May it be paid in advance ? If not, why not? 29. The X. Y. Company sent its check for its capital stock tax immediately upon demand. It reached the Collector's office two days before the expiration of the notice. The Collector's office was some distance from that of the company and before the check reached the bank, the concern had been closed by involuntary bankruptcy. Does this constitute a delayed payment? If so, why? 30. Three affiliated companies, one a holding company and the others operating subsidiaries, filed a single return. Was this proper ? If not, what should have been done ? 31. Owing to the illness of the auditor, the D. V. Company was unable to close its books when its fiscal year ended June 30, 1920, and did not complete a proper balance sheet and profit and loss account until September. What should it have done with respect to capital stock taxes? 32. What is the last possible day for mailing a return, if the Collector's office is in another city, and the usual mailing time is thirty-six hours? 33. In the above, if the train was wrecked and the mail delayed 308 INCOME AND PROFITS TAXES twenty-four hours, what would be the situation had the corporation waited until the last practical moment for mailing? 34. A company finds the following : Profit, 1915 $12,546.87 Profit, 1916 4,675.98 Loss, 1917 5,675.43 Loss, 1918 5,482.88 Profit, 1919 926.75 What is its average income ? 35. In the above, if the assumed rate of earnings is 13%, what is the capitalized income ? 36. If the balance sheet shows a net worth of $22,548.63, which amount would you report as taxable? 37. In Question 22, the company paid Smith, as follows: Assets, fixed $3,500,000 Assets, current 2,500,000 Goodwill 4,000,000 $10,000,000 By Cash $3,000,000 Stock 2,000,000 Bonds 2,000,000 Liabilities of Smith, assumed.. . 3,000,000 10,000,000 The company raised the cash for the above by selling bonds at par amounting to $3,000,000, giving as premium for the same one $100 share of stock with each $1,000 bond sold, and sold the remainder of a full capitalization of $5,000,000 at par. What is its capital stock valuation, on this basis ? 38. Smith's net earnings, for the five years last passed, were $4,000,000, which he has drawn out as fast as earned to use in other ventures. The company estimates that with the additional working capital it can increase the average about 30%. What would you consider a fair rate at which to capitalize the income using all the facts and estimates at hand? The bond interest is 5%. 39. To what extent does the method of payment for the above good will affect the valuation to be placed upon it? 40. Had Smith accepted stock for the entire good will, and the company sold for cash so much less, what would be your answer as to both book and earning value ? APPENDICES 309 APPENDIX B The serial problem presented herewith is designed to test the ability of the student to apply his knowledge of the income and profits tax law and practice, as acquired by a proper study of the text preceding. There is no attempt on the part of the author to make this an easy example. Yet we can say without hesitation that the problem is merely within the scope of the ordinary experience of those who undertake this subject as a professional matter. To make the figures and facts comprehended in the problems more interesting, we have so framed the entire group as to make them one continuous and interrelated case. Reference from one to another of the detailed exhibits covering the test will be necessary for a correct interpretation of the whole. John Doe and Samuel Stiles, partners trading as "Doe and Stiles" are operating a department store, with the especial help of one Rogers, their financial manager. John Doe, realizing his health to be failing, decides to arrange his affairs so as to enable him to retire from active life. He establishes his son in business, and then organizes a corporation to take over the store. The transfer of the business from the firm to the store takes place as of July 1, 1920, and we find the firm to have operated for the first half of the year. In the organization of the corporation, both Stiles and Rogers continue active participation, Rogers in particular being dealt with by contract in substitution for his previous right of participa- tion in the profits of the firm. Doe, however, dies on October 1, 1920, and Stiles becomes the administrator of his estate. Following the organization of the new corporation, and as a re- sult of the fact that those who participated in this organization, outside the firm, were already owners of a competitive institution, there is a further reorganization as of the close of the year 1920. The competing concern, having less capital and finding, by compari- son, that a savings in taxes may be expected if a merger of the two is effected, agrees to a certain form of absorption and the same is consummated January 1, 1921. You, the student, are supposed to be called in to advise and assist with the preparation of the needed tax returns. For this task there are submitted the necessary statements of the entire his- tory of the whole affair, and it is your duty to cover the require- ments in the case. 310 INCOME AND PROFITS TAXES The statements presented are : Exhibit A, Balance sheet, Doe and Stiles, Jan. 1, 1920: Exhibit B, Profit and loss account of the said firm to October 1, 1920, with a supplemental statement covering the liquidation ; Exhibit C, Balance sheet of the firm, July 1, 1920, that being the date of the taking over by the new company ; Exhibit D, Statement covering the sale of the business and organization of the new company; Exhibit E, Doe's personal account to the date of his death ; Exhibit F, Stiles's personal account for the year 1920; Exhibit G, Rogers's personal account for the year 1920; Exhibit H, Loss and gain statement, Department Store Co., from July 1 to December 31, 1920; Exhibit I, Balance sheet. Department Store Co., Dec. 31, 1920; Exhibit J, Condensed profit and loss statement and balance sheet of the Emporium, Inc., for 1920; Exhibit K, Synopsis of agreement for merger and consoli- dated balance sheet after the merger as of Jan. 1, 1921 ; Exhibit L, Account of Stiles, as administrator of Doe's estate. With this data, you are to prepare all necessary income tax returns for the firm, the company, the individuals (both the members of the firm and Rogers, the manager) ; you are to com- pute the invested capital of the consolidated companies for the in- formation of those interested ; you are to prepare the capital stock tax returns of the two companies, which will be needed July 1, 1921 ; and you are to instruct as to all necessary information re- turns for every person involved, assuming that this is not necessary except where shown by the facts recited, or, in other words, that no one not named and described in the data is earning a sufficient sum to necessitate such returns. It is suggested that the student should not attempt to take these matters in the order given, but would do well to start with the simpler ones, such as the individuals. In this way the more diffi- cult phases of the work will be left until a greater familiarity with the detail methods is obtained. A PROBLEM 312 INCOME AND PROFITS TAXES o 0^ < < o o o o o o t^ o o o o o o u^ o M O c APPENDICES 313 o o o o o d <=> o o o_ ocT ■^ CO o o o o d d o o o o <3 O CD O O O O O O O O O O O O o o o < X .2 3 Oh ^ hflo •-loo O -J^ ^ W eft J'l m < <; H o H z <;z < j3 c 314 INCOME AND PROFITS TAXES C/3 w W O Q n X X w o 'A 09 e o o H O • S " A e 3 ^ I COHHbb c rt q a" o « 'e> o u -"-§ o o o o o o o o o o o o O O "^ o O O M O o o o o o o O O w> o o o o o o o o o o o o --^ n "a CO s o ■S o CO ^ o 73 Oh B tins a > tH « ■^ O 4) ■<|coK .2 5 S. Q 4J S 2 S 2 S| .. a, o* ." s.s t S « 3 &coQm Q u a ^ o a S(2 APPENDICES 315 o o o o o o o o O u-» OO tH o o o o o o o o o o o o o o o o O O O w-1 ca X w o o o o o o o o o o o o o o o o o o o o o o o o o o o ly^ O O vj-t O "^ O vn Th CO rh C^ rj- CO o t^ 1-1 W>- Cli M < S 9 Q S O i3 -d J C " u a 1 i-iW 2 » -o . o • c c mW § " S " « o. ;< s 03 C Q ^ 5 m en en Z3 O t-i (- V- iH t- u ^ u u M HH t~l CA )« Vl> c O 13 O > tt o o s -^ Ma) CO o " z 318 INCOME AND PROFITS TAXES u^ O ^0 ^ o o \n ^ oo O o>; d d oo o o to ^ en o h^ 1-1 oTo" ^0 Csl rj- '*• w^ <«■ o o o t^ o o ncu •o 3 •*^ *5 o w •a -a -^ S M c .a o o CD QO o «o > 3 S ^ *j .-H « S 2 .2 o < l> Oi Q "5 M cd i4 M .2 U T3 ^ 3 is 2-0 3 ■a -o -= •B «3 tl « .S o m (J ^ £ 5 APPENDICES 319 O O o o o o o o o m m o o o o o o o o o o^ o_ cT *i^ tH o o o o o o o o o o o o o'o" o o o o o o o o O O O C3 o o o o o o o o o o o ^ a S sag a S a e.2 •3.2 s- « so B .S-c 3 O cr-3 W.2 o o o o o o o o o o . o o . o o ■ "^-"^ ■ o o ■ CO r^ ■ ^ en o o o o o o o o o"o" a " c - ! OU ~ Q C B " c o CO o ^ o -d o " 3 1-1 <3 ►J rt flj < ^-S t- M -2 cn « p 0) o u So «: H O o-^ 320 INCOME AND PROFITS TAXES o CO W o o o o o o o o o »X" *n CO en o o O O o o o o o o o o d d d d d d o o o o o o o o o o o o O tn d'ln' d'o ^H O lo m ""^ fn 1-* o o o o o o 3 CI. < APPENDICES 321 o o o o o o o o o o o o o o o o o o o o o o o o o o o en s 5 W ■s'^ JO CO c rt o "no M--S o w ho (« « •- rt UOO a o o o o o o o o_o o_ o o'o" o o o W^ \0 ^-H H U) z j-M (J c o o o o o o o o o o o o" o o 5^ CO O 2 ■a" « ^ .t; — o o S-cghh >- 3 O • h h < w Q < O Q < o H S w o o o o 5i o o o o C) o o o o o o d o o o o O "^ o o o o o o o o o o o_ iX" «X" oo ^ en 2 a 2 ■= oj a. y til T3 T3 C C nt bo " u o o o o o o o o o o o o o C> O O CD o^o^o o O O*" vc (Sf o o o o o o o o o o o o OQ W o « 1 > G a» jj ^:^ -5 2 2 2 3 3 M ;w < en o " " ^ lU 0) 5l5 •r: w Q9. M o;i go APPENDICES 329 Exhibit I December 31, 1920 BALANCE SHEET DEPARTMENT STORE CO. Cash $466,500.00 Accounts Receivable $170,000.00 Reserve, Bad Debts 17,000.00 153,000.00 Inventory 300,000.00 Store Equipment 140,000.00 Depreciation 10,000.00 130,000.00 Delivery Equipment 30,000.00 Depreciation 2,500.00 27,500.00 Building and Ground 300,000.00 Depreciation 1,500.00 298,500.00 Deferred Expenses: Buying 1,200.00 Selling 3,500.00 Insurance 3,000.00 Taxes 2,600.00 Delivery 700.00 11,000.00 Organization Expense 10,000.00 Amortization 5,000.00 5,000.00 Contract, Rogers 100,000.00 Amortization 10,000.00 90,000.00 Good Will 413,000.00 $1,894,500.00 Accounts Payable 65,000.00 Notes Payable 250,000 00 Mortgage Payable 150,000.00 Accrued Expenses: Selling $2,150.00 Delivery 350.00 Interest, Mortgage 1,500 00 Interest, Notes 2,500.00 6,500.00 471,500.00 Net Worth $1,423,000.00 Capital Stock $1,200,000 00 Surplus (Earned) 223,000.00 $1,423,000.00 $1,423,000 00 330 INCOME AND PROFITS TAXES Exhibit J-1 December 31, 1920 BALANCE SHEET EMPORIUM, INC. Cash $185,000.00 Accounts Receivable and Acceptances 213,000.00 Inventory 250,000.00 Store Equipment $80,000.00 Depreciation 48,000.00 32,000.00 Building on Leased Land 50,000.00 Amortization 30,000.00 20,000.00 $700,000.00 Accounts Payable $65,000.00 Accrued Wages 1,000.00 Accrued Ground Rent 3,000.00 Income Tax Reserve for 1920 132,000.00 201,000.00 Net Worth $499,000.00 Capital Stock 50,000.00 Surplus 449,000.00 $499,000.00 $499,000.00 Exhibit J-2 PROFIT AND LOSS AND SURPLUS ACCOUNT, YEAR ENDED December 31, 1920 Sales: Cash $2,150,000.00 Credit 350,000.00 $2,500,000.00 Inventory, Jan. 1 $265,000.00 Purchases, 1920 1,950,000.00 2,215,000.00 Inventory, Dec. 1 250,000.00 1,965,000.00 Gross Trading Profit $535,000.00 Sales Wages 85,000.00 Advertising 23,000.00 Store Expense and Supplies 20,500.00 Taxes and Insurance 4,500.00 Officers' Salaries 50,000.00 Amortization and Depreciation 6,500.00 189,580.00 Net Gain $345,500.00 Income Tax Reserve 132 000.00 Credit to Surplus $213,500.00 Surplus, Jan. 1, 1920 410,500.00 Dividends, April 30, 1920 $75,000.00 Dividends, October 31, 1920 100,000.00 Surplus, December 31, 1920 449,000.00 $624,000.00 $624,000.00 APPENDICES 331 Exhibit K-1 CONSOLIDATED BALANCE SHEET AFTER AFFILIATION D. S. Co. Cash $253,000.00 Accounts Receivable 170,000.00 Inventory 300,000.00 Store Equipment 140,000.00 Delivery Equipment 30,000.00 Building and Ground 300,000.00 Building on Leased Ground.. Deferred Expenses 11,000.00 Organization Expense 5,000.00 Contract for Services 90,000.00 Good Will, Dept. Store Co... 377,400.00 Emporium, Inc. . . 213,500.00 Stock in Emp.., Inc 600,000.00 $2,489,900.00 Accounts Payable $65,000.00 Notes Payable 250,000.00 Mortgage 150,000.00 Accruals 6,500.00 Depreciation and Amortization 14,000.00 $485,500.00 Capital Stock $1,500,000.00 Surplus 408,800.00 Bad Debts Reserve 17,000.00 Income Tax Reserve 78,600.00 $2,004,400.00 $485,500.00 2,004,400.00 $2,489,900.00 Emp. Inc. Total $398,500.00 $651,500.00 213,000.00 383,000.00 250,000.00 550,000.00 80,000.00 220,000.00 30,000.00 300,000.00 50,000.00 50,000.00 11,000.00 5,000.00 90,000.00 377,400.00 213,500.00 600,000.00 $991,500.00 $3,481,400.00 $65,000.00 $130,000.00 250,000.00 150,000.00 4,000.00 10,500.00 78,000.00 92,000.00 $147,000.00 $632,500.00 $600,000.00 $2,100,000.00 112,500.00 521,300.00 17,000.00 132,000.00 210,600.00 $844,500.00 $2,848,900.00 $147,000.00 $632,500.00 844,500.00 2,848,900.00 $991,500.00 $3,481,400.00 332 INCOME AND PROFITS TAXES Exhibit K-2 AFFILIATION DETAILS 1. Department Store Co. pays Emporium, Inc., for its good will as appraised, in cash $213,500.00 2. Emporium, Inc., increases its capital stock and issues a stock dividend of 550,000.00 3. Department Store Co. adjusts its own good will for equalization by a reduction of 35,600.00 4. Department Store Co. sets up reserve for income tax of 78,600.00 5. Stockholders in Department Store Co. surrender stock (25% of their holdings) 300,000.00 6. Department Store Co. buys entire capital of Emporium, Inc., from Jones' Syndicate at par for par, issuing its own stock '. 600,000.00 Exhibit L STILES'S ACCOUNT AS ADMINISTRATOR OF JOHN DOE'S ESTATE The deceased left the following assets: Stock : City Bank, par $60,000, valued $102,000.00 G. H. Ry., par $225,000, valued 168,750.00 Crossroads Farm Loan Bank, par $20,000, valued 20,000.00 Bonds: County 4%, par $30,000, valued 30,000.00 1st Liberty 3^%, par $50,000, valued 50,000.00 2nd Liberty 4%, par $100,000, valued 90,000.00 4th Liberty 4>4%, par $30,000, valued 27,600.00 Accrued Interest: 1st Liberty 466.66 2nd Liberty 1,066.67 4th Liberty 587.96 County Bonds 303.33 Total Securities $490,774.62 Real Estate: Dwelling, valued 50,000.00 Leased Ground, valued 20,000.00 Improvements on Leased Ground $50,000.00 Less 8 yrs. unamortized reserve 20,000.00 30,000.00 Total Real Estate.. Personal Effects: Automobile, valued 2,500 00 100,000.00 Household goods, valued 3,500,00 6,000.00 Cash 22,675.00 Interest in Partnership of Doe & Stiles 701 070 83 Total Assets $1,320,520.45 APPENDICES 333 Exhibit L (Continued) Cash Account The administrator charges himself as follows: Dividends: Bank Stock $1,500.00 G. H. Ry 4,500.00 Crossroads F. L. Bank 500.00 Interest County Bonds 600.00 Liberty Ist's 875.00 Liberty 2nd's 2,000.00 Liberty 4th's 637.50 From Liquidation of Doe & Stiles 343,950.00 Total Receipts $354,562.50 The administrator claims credit as follows: Paid: Doctor's Bill 125.00 Undertaker's Account 350.00 Nurse 100.00 Household Debts 600.00 Income Tax, 1919, last instalment 3,995.40 Legal Services 1,500.00 Court Costs 500.00 Federal Inheritance Tax 78,935.00 Commission as Administrator 10,000.00 Total Disbursements 96,105.40 Increase in cash $258,457.10 Cash from decedent 22,675.00 Total Cash $281,132.10 The administrator also charges himself as follows: Stock received in liquidation of Doe & Stiles 360,000.00 and claims credit as follows: Interest in Doe & Stiles liquidated. $701,070.83 Accrued interest on bonds included in col- lections 2,424.62 703,495.45 Excess of credit over charge $343,495.45 Increase in cash 258,457.10 Net Reduction $85,038.35 Balance down 1,235,482.10 Equals assets from decedent $1,320,520.45 334 INCOME AND PROFITS TAXES Exhibit L (Continued) Balance down, consisting of and distributable as follows, by agreement between distributees: To John Doe, Jr., Capital: Leased Ground and Build- ing $50,000.00 Stock, Dept. Store Co 360,000.00 Cash 202,207.52 Total Capital $612,207.52 Income Cash 5,533.53 Total Distribution 617,741.05 To Mary Doe, Capital: Stocks, appraised $290,750.00 Bonds, appraised 197,600.00 Dwelling 50,000.00 Household Effects 3,500.00 Automobile 2,500.00 Cash 67,857.53 Total Capital $612,207.53 Income Cash 5,533.52 Total Distribution 617,741.05 $1,235,482.10