NOTES ON THE REVENUE ACT OF 1918.

TITLE II-INCOME TAX.

Section 200. Extension of the class of personal service corporations.

The definition of the term "personal service corporation" contained in section 200 excludes from the class of personal service corporations all corporations in which capital (whether invested or borrowed) is a material income-producing factor. It has been suggested that this definition be amended so as to include all corporations whose principal stockholders regularly devote their chief time and attention to the active conduct of the affairs of the corporation, except (a) foreign corporations, and (3) corporations 50 per cent or more of whose gross income consists of income derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. If this change were made, it would be desirable to change the term applied to the class from "personal service" to some such term as "personal corporation," "close corporation," ," "corporation partnership," or "private company." It might also be expedient to require, if the proposed extension of this class were made, the principal stockholders to own a stipulated proportion of the stock, say 85 per cent, and to place a limit, say 10, upon the number of stockholders not regularly devoting their chief time and attention to the active conduct of the affairs of the personal corporation.

Among the arguments advanced in support of this proposed change are the following:

1. Under the legislation as it now stands, the stock of a corporation may be closely held or owned-except for qualifying shares-by one person; the owner or owners may devote themselves so effectively and exclusively to the conduct of the business that it is impossible to distinguish satisfactorily between the profits of the business paid to stockholders as dividends and the personal compensation paid to the officers as salaries; and the principal competitors of the corporation in question may be partnerships or sole proprietors. Nevertheless, if capital is a material income-producing factor in the operation of the corporation, the corporation takes its place with corporations rather than partnerships, and pays the war-profits or excessprofits tax in place of income surtaxes upon undistributed profits.

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The resulting differences are so arbitrary and in many cases so extreme that it is suggested that the class of personal service corporations should be extended to cover all corporations whether employing a material amount of capital or not, in the active conduct of whose affairs the principal stockholders are regularly engaged.

2. The treatment of partnerships and corporations under the present legislation is radically different. The ordinary corporation of a given size or class in a particular line of business may pay 50 per cent of its net income in income and profits taxes, whereas the members of the average partnership in the same line of business may pay only 20 per cent of their net income in normal and additional income taxes. The profits left in the business are subject in the one case to income surtaxes but not to profits taxes; in the other case they are subject to profits taxes but not to income surtaxes. This vital difference turns upon the mere form of organization, yet the two forms of business may be in close competition.

It is suggested that different treatment in the tax law should turn upon distinctions of fact and not of form, and that real distinction exists between the closely owned corporation whose stockholders give their principal time and attention to the business of the corporation, and those very large corporations whose stockholders are widely scattered and are in many respects investors rather than owners. It is suggested that the tax law should follow more closely this fundamental economic distinction.

3. The corporate form of organization is now used or abused by wealthy individuals who incorporate their personal business and investments and thus escape surtaxes upon that amount of their income which is reinvested or saved. Section 220 provides a remedy for this abuse, but it can be applied only by a troublesome special procedure which will necessarily restrict its use to a comparatively small proportion of cases. A large proportion of these cases would be automatically and easily dealt with if the law be amended as here proposed.

4. The suggested amendment would go far toward the solution of the difficult problem of determining what constitutes reasonable salary or compensation in the case of officers of a corporation who own all or nearly all of its stock. In such situations the natural elements or checks which keep salaries within reasonable limits are absent, and the department is forced to rely upon estimates which are as unsatisfactory to the Government as they are irritating to the taxpayers.

5. The present definition of a personal service corporation is exceedingly difficult to apply with precision. To decide in thousands of cases what circumstances make a given amount of capital "a material

income-producing factor," is an elusive and difficult administrative task which, other things being equal, it is highly desirable to avoid. It has been suggested that these changes could be accomplished by an amendment in substantially the following form:

Strike out the fourth paragraph of section 200, which is as follows:

The term "personal-service-eorporation" means-a-corporation whose-income-is-to-be-ascribed-primarily-to-the-activities-of-the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or borrowed)-is-not a material income-producing factor; but does not include any foreign corporation, nor any corporation 50 per centum or more of whose gross income consists either (1) of gains, profits or income derived from trading as a principal, or (2) of gains, profits, commissions, or other income, derived from a Government contract, or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive;

and insert in lieu thereof the following:

The term "personal corporation" means a corporation (1) whose principal stockholders (a) regularly devote their chief time and attention to the active conduct of the affairs of the corporation, and (b) own not less than 85 per centum of the capital stock of the corporation and (2) in which the number of stockholders not regularly devoting their chief time and attention to the active conduct of its affairs does not exceed ten;

Section 202. Gain or loss from exchange of property.

Subdivision (b) of section 202 provides for the inclusion in the computation of income of gain or loss resulting from the exchange of property by the comparison of the fair market value (if any) of the property received in exchange with the cost or, if acquired prior to March 1, 1913, the fair market price or value on that date of the property relinquished. The only exception which the law provides to this rule is when in connection with the reorganization, merger, or consolidation of a corporation a taxpayer receives in place of stock or securities owned by him new stock or securities of no greater aggregate par or face value. The present law provides in such case that no gain or loss shall be deemed to occur from the exchange and that the new stock or securities received shall be treated as taking the place of the stock, securities, or property exchanged.

It has been suggested that there are other similar transactions in which it is difficult to determine the gain or loss in the absence of an actual sale and which should be treated in the same manner in connection with the reorganization, merger, or consolidation of a

corporation. The following four classes of transactions have been urged as proper additional exceptions to the general rule laid down in section 202 (b):

1. When the market value of the property received can not be satisfactorily determined.

2. When property is exchanged in return for all or substantially all the stock of a corporation.

3. When property is exchanged between corporations affiliated within the meaning of section 240.

4. When, in connection with the reorganization of a corporation or partnership, one corporation or partnership exchanges property with another corporation or partnership involved in such reorganization, or a person receives in place of stock or securities owned by him new stock or securities.

It has been suggested that these changes could be accomplished by an amendment in substantially the following form:

Amend section 202 by adding at the end thereof the following new subdivision:

(c) When property is exchanged for other property, the property received shall be treated as the equivalent of cash to the amount of its fair market value; but in the exceptional cases enumerated below no gain or loss shall be recognized and the property received shall, for the purpose of determining the allowances for depreciation, depletion, amortization, and other like purposes, be treated as taking the place of the property exchanged when the change is merely in form and not in substance:

(1) The market value of the property received can not in the opinion of the Commissioner be satisfactorily determined;

(2) A person or persons exchange property for not less than 95 per cent of the stock of a corporation;

(3) Property is exchanged between corporations affiliated within the meaning of section 240;

(4) In connection with the reorganization of a corporation or partnership, one corporation or partnership exchanges property with another corporation or partnership involved in such reorganization, or a person receives in place of stock or securities owned by him new stock or securities. The word "reorganization" as used in this paragraph includes a merger, consolidation, or a mere change in the identity or form or organization of a corporation or partnership;

The provisions of this subdivision shall be taken to declare and not to amend subdivision (b) of this section; and nothing herein shall be construed to modify the provisions of sections 330 or 331, or to authorize the direct or indirect exemption of any stock dividend or any capitalization of surplus tantamount thereto lawfully subject

to the tax.

Section 204. Net losses.

It has been suggested that section 204, which affords relief in the case of net losses sustained in "any taxable year beginning after October 31, 1918, and ending prior to January 1, 1920," should be made general or permanent, and that the definition of "net losses" contained in this section be amended to resolve in the affirmative the doubt as to whether, if a taxpayer sustains losses both from the operation of his business and from the sale of capital assets other than those constructed or acquired for the production of war essentials, both kinds of losses are to be recognized in computing the net loss.

In support of this suggestion it has been urged that as the legislation is now worded, it gives no benefit to a taxpayer whose business year runs from February, 1919, to February, 1920, although a taxpayer whose business year coincides with the calendar year 1919 and a taxpayer whose year runs from November, 1918, to November, 1919, receives the benefit provided by the law. It is also urged in support of this suggestion that it is desirable to go further than the mere correction of this discrimination, and that the right to spread a loss should be recognized as a permanent policy. It is said that the annual accounting period, the striking of a balance of gain or loss every 12 months, is merely an approximation resting upon convenience and fiscal necessity, and that the result shown is frequently unreal, for if a business concern makes $20,000 in 1918, loses $10,000 in 1919, and makes $5,000 in 1920, it has not earned profits of $25,000 in the three-year period, but only $15,000.

It has been suggested that these changes could be accomplished by an amendment in substantially the following form:

Strike out subdivisions (a) and (b) of section 204 and substitute in lieu thereof the following:

SEC. 204. (a) That as used in this section the term "net loss" refers only to net losses resulting from either (1) the operation of any business regularly carried on by the taxpayer, or (2)【the bona fide sale by the taxpayer of plant, buildings, machinery, equipment, or other facilities, constructed, installed, or acquired by the taxpayer on or after April 6, 1917, for the production of articles contributing to the prosecution of the present war; and when so resulting means the excess of the deductions allowed by law (excluding in the ease of corporations-amounts allowed as a deduction under except the deductions authorized by pargraph 6 of subdivision (a) of section 234 and losses of the kind excluded by the limitation hereinbefore prescribed) over the sum of the gross income plus any interest received free from taxation. both under this title and under Title III.