Second: The capital asset sold must have been acquired and held by the taxpayer for profit or investment, and does not include an asset held for the personal use or consumption of the taxpayer or his family. The reason underlying the "two-year" holding rule is to indubitably establish the capital nature of the transaction and the rule as formulated bars from capital classification numerous capital transactions in securities, a fair number of capital transactions in real estate and other miscellaneous transactions that as a matter of common sense should not be barred. The statutory intent would be served as effectively if a shorter period of holding were in effect. trate: A question of "tacking" may arise under the statute; to illus A acquired Greenacre in 1910 and died in 1921, leaving Greenacre to B, B selling the land in 1922; shall B be allowed to "tack" A's period to his own period of holding to secure the statutory period of two years? If the reason for the rule is observed, B should be allowed to "tack"; if the phraseology of the statute is literally applied, B cannot "tack." The second qualification—that a capital asset must have been acquired and held for profit or investment, but does not include property held for the personal use or consumption of the taxpayer or his family-seems a somewhat illogical qualification and has no practical common sense reason underlying it. The first of two questions, however, very clearly arises under the foregoing rule: (1) Can there be a change in the state of mind of the taxpayer; or is the original state of mind legally imputed to cover the entire period of the holding? To illustrate: In 1910 A purchases a dwelling house for himself and family; in 1919 he determines to sell and does so in 1922. A sensible interpretation of the statute should allow the transaction of the foregoing nature to be classified as a capital one. (2) Can there be two states of mind: the superior state of mind that comes within the statute, the subordinate state of mind that is without the statute? 5. Stock dividends logically should not disrupt the "two-year" holding period, although received and sold within two years, if the original acquisition of stock qualifies as a capital transaction. Exchanges seemingly and logically follow the same rule. To illustrate: A acquired real estate in 1915 and in 1922 exchanged for other real estate and in 1923 sold the last acquisition. To illusrate: In 1918 A purchases a residence for his personal use but with the object in mind of selling at a profit at the very first opportunity; or A purchases a two-flat building, using one flat for himself, leasing the other flat; A sells the residence or flat building in 1922. Seemingly the logical interpretation should be that the major state of mind that induced the purchase by the taxpayer determines whether or not the transaction is a capital one under the statute. A donee of property may in some instances be placed in a somewhat difficult situation of intent in determining whether or not the property sold by him will take a capital classification under the statute. The Determination of the Base and Disposal Amount. Under Section 206 the statute lays down the rule determining what transaction shall be classified as a capital transaction; Section 202 and the related sections deal with the capital transaction, within or without Section 206, but only in so far as determining what constitutes the basis and what constitutes the disposal price in the sale of a capital asset; the disposal price less the basis is the amount considered by the statute either as a capital increase taxable at a preferential rate or as ordinary income taxable at the ordinary rates. As a practical proposition, the legal questions presented in business transactions of a capital nature are as follows: 1. The March 1, 1913, rule of valuation. 2. The status of the gift: (a) inter vivos; (b) by will or descent. 3. The status of exchanges: (a) definition of readily realizable market value; (c) corporate organization or reorganization. 4. The status of the compulsory conversion. 5. The status of the instalment contract. 6. The status of the sale and repurchase. 7. The status of the stock dividend and of stock. 8. The status of the corporate liquidation dividend. I THE MARCH 1, 1913, RULE OF BASE VALUATION Under the preceding revenue acts, those of 1913, 1916, 1917, and 1918, the basis of a capital asset acquired prior to March 1, 1913, was the fair market price or value as of March 1, 1913, irrespective of its valuation history prior to March 1, 1913. The group of cases contesting the constitutionality of the March 1, 1913, rule of valuation in its application to certain facts revised the rule and the rule as set out in the new act follows the before-mentioned decisions. The rule under the present act is divided into three parts and is summed up as follows: 7а A. If there be a gain on the acquisition basis and a gain on the March 1, 1913, basis, the gain more favorable to the taxpayer is the returnable gain. To illustrate: Land acquired in 1910.... Basis March 1, 1913.. Sold in 1922... The returnable gain is.. 7b $10,000 11,000 12,000 1,000 B. If there be a loss on the acquisition basis and a loss on the March 1, 1913, basis, the loss more favorable to the government is the deductible loss. 6. The leading case is Goodrich v. Edwards 255 U. S. 527. See related cases in the various tax services cited in conjunction with the principal case. 7. The principles outlined herein are particularly important in the sale of a business. A nice question may arise how a contract of sale should be drafted-whether to specify items in details or in bulk. To illustrate: In a situation such as the foregoing the business should be sold in toto and not itemized in detail as to sales price in reference to assets sold. The accounting formula for the valuation of good-will is the one obtaining in the practical administration of the revenue act. 7a. The best evidence on the valuation of real estate for any specific date, in so far as Chicago real estate is concerned, is the valuation certificate of the Chicago Real Estate Board. 7b. Carrying charges such as taxes, interest and other charges of an expense nature if considered as capital charges are part of the cost. Carrying charges on assets prior to March 1, 1913, are ordinarily capital charges inasmuch as no tax law was in effect that would determine the capital or expense option of the charge. To illustrate: A purchased vacant property in 1892 for $10,000 and sold the same in 1922 for $30,000. Taxes and other carrying charges paid to March 1, 1913, are part of the cost and taxes. Carrying charges paid after March 1, 1913, are part of the cost if not taken as an expense deduction in tax reports. Interest on the investment before or after March 1, 1913, is not logically a part of the cost. C. If there be a loss on one basis and a gain on the other basis, there is no returnable loss or gain. Under the preceding acts a capital gain, and consequently the tax thereon, could be avoided by the simple expedient of a bona fide gift inter vivos to a trustee or to a donee, the basis to the trustee or donee being the fair market value of the gift at the time the gift was made; and inasmuch as the sale of the gift in most instances was very close, in point of time, to the date of the gift, the sales price and the basis practically corresponded. The present acts departs from the preceding rule and is in effect as follows: that where an inter vivos gift is made after December 31, 1920, the basis of the asset to the donee is the basis of the donor; thus 8. Section 202 (a) (2). 9. The basis for the computation of capital basis should be distinguished from the basis used in determining depreciation for income purposes. To illustrate: A had real estate which cost him, in 1916, $50,000 for the land and $150,000 for the building. In 1921, A gave the property to B, the building at that time being worth $200,000; B sold the property in 1923. B's depreciation for 1921, 1922, and 1923 for income tax purposes is based on $200,000 valuation and not on a valuation of $150,000; B, in computing depreciation for basis on a sale, will charge against his donee basis the depreciation attributable to the donor, but not what the donee (B) has taken. To illustrate: On inter vivos transfers to trustees, the foregoing principle would obtain also. If A purchased 100 shares of stock in 1915 for $10,000, gave the stock to his wife, B, in 1921, the value of the stock at that time being $20,000, and B sold the stock in 1922 for $20,000, B has a returnable gain of $10,000. The basis to the donee of a gift made by will or descent is the same as under the previous acts, to-wit: the basis to the donee is the "fair market price or value" of the property as of the date of the gift, to-wit: the date of the donor's decease. The reason for the distinction noted in the preceding paragraph is obvious; however, there is a question as to the constitutionality of a statute that discriminates between the inter vivos gift and the gift by descent or will for the purpose of levying an income tax. III EXCHANGES 10 (A) Definition of market-value. The status of exchanges under the Revenue Act of 1918 was very unsatisfactory, due in most instances to the arbitrary construction given by the treasury department to the words "fair market value, if any." Under the treasury department regulations "fair market value, if any," was practically construed to mean "what a supposititious willing buyer and a supposititious willing seller would agree on as a fair price if the aforesaid supposititious buyer and seller had the present transaction under consideration"; therefore no exchange of properties, under the foregoing construction, was ever exempted under the old act, no matter how restricted the market might be for the properties exchanged. A judicial construction of the words "fair market value, if any," in the writer's opinion, would never be as narrow as the foregoing executive construction. The present act11 injects an element of practical business sense in the definition, to-wit: "readily realizable market value,"12 and 10. The question is yet an open one, whether or not a return should be made of an exchange transaction: Article 1564, Regulations 62: "Attention should be called in the return to each exchange effected during the taxable year about which there could be any doubt." 11. Section 202 (c). 12. "A readily realizable market" is an inflexible definition and should not shift to the particular subject matter under review; for instance, certain real estate may not from its very nature be saleable within 3 months, certain securities within one or two months, due to certain necessary investigation as to safety, etc. "Readily realizable" means cash realizability within a very short period of time and at substantially full value. |