X

TAX-FREE INCOME-SUMMARY

Insurance. Illustrations of exempt interest. Property acquired by gift, bequest, devise, and inheritance. Dividends and interest from building and loan associations. General summary of income.

CERTAIN items of tax-free income have already been touched upon. Others are referred to under this heading for the first time. The following list summarizes the principal exclusions from gross income applicable to both individuals and corporations.

(a) Insurance. In the discussion of the involuntary conversion 1 it was stated that no part of the proceeds of insurance covering property losses were subject to tax if such proceeds were invested at once in replacements costing at least a sum equal to the proceeds realized. It has also been indicated on page 97 that additional compensation accrues to an officer or employee if premiums are paid by the corporation on a policy (unless a group insurance policy) covering the life of the employee and the beneficiaries of the policy are subject to the determination of the insured.

Proceeds of life insurance policies paid on the death of the insured are non-taxable to corporations as well as individuals. Under the 1918 act, without specific exemption of such income, it was held that corporation beneficiaries were not exempt on the excess of the amount received over the premiums paid (Art. 541; Sec. 213(b) (1)). Amounts received during the life of the insured representing returns of non-deductible premiums paid under endowment contracts are also ex1 See page 56.

empt (Sec. 213(b) (2)). Should such amounts received be in excess of amounts paid, the excess has been regarded as ordinary income. Distributions on paidup policies coming from the earnings of a taxable insurer are taxable as dividends (Art. 47).

Both instalment payments and dividends received by the beneficiaries or the estate of the deceased are tax-free (O. D. 433); this rule applies also to an income of 6% per annum paid an income beneficiary under the terms of a will (O. 995). But if the beneficiary has the option of receiving the face value of the policy or interest thereon until the beneficiary's death, the interest is taxable (O. D. 66 and 612); and this rule was extended to a case where the option of the beneficiary was dependent on the payment of interest of at least 42% (O. D. 1010). Dividends from a life policy issued by the Bureau of War Risk Insurance was regarded as a return of premiums and therefore not taxable (O. D. 1037).

Use and occupancy insurance received covering the loss of profits due to a fire was ordinary income (O. D. 645). Under the 1918 act, the proceeds of an insurance policy on the life of an officer were taxable in full if the premiums had been paid by one other than the corporation itself (A. R. R. 335). When a life policy on an officer is sold for less than the aggregate premiums paid, neither profit nor loss for tax purposes arises (0. D. 724).

(b) Salaries of State Employees.1

(c) Interest. Liberty bond exemptions have already been outlined.2 Liberty bond interest is subject to surtax only, if taxable at all; consequently, after 1921, Liberty bond interest received by any corporation was exempt. Just as compensation from a state or political subdivision thereof has been regarded as non-taxable, so all interest on state, county, or municipal obligations, has been held tax-free (Sec. 213(b) (4)). Interest on Federal Farm Loan securities are also specifically exempted by the same section. Annuities paid by religious, charitable, and educa1 See page 97. 2 See page 89.

tional corporations are not taxable, unless paid on devised land or unless the total exceeds the original sum paid by or for the annuitant (Sec. 213(b) (2); Art. 47).

Interest on obligations of the Philippines (O. D. 34 and 922) and Porto Rico (O. D. 368) and its municipalities if approved by the executive council (O. D. 637) is tax-exempt, but not obligations of Santo Domingo (O. D. 420). Interest on state irrigation district bonds is exempt (O. D. 544); also interest on city deferred assessment bonds (O. D. 447), park fund and condemnation bonds (O. D. 491), including interest on deferred condemnation proceedings (O. D. 591) or on deferred payments on a contract (O. D. 999). Interest on securities issued by utilities owned by states or subdivisions of states, such as a railroad (O. D. 250) and a water, light and power company (O. D. 328) was tax-free; but dividends thereon were taxable and could not be applied as a credit for normal tax purposes since the corporation itself was tax-free (O. D. 328).

Interest on promissory notes of a political subdivision of a state or a territory is also exempt from tax (O. D. 817). If the notes were non-interest-bearing and were discounted by the holder, the discount given to the lender in lieu of interest is not tax-free as the transaction is between the lender and the seller (O. D. 870). In the same way discount on municipal securities realized by sale before maturity was not exempt even though discount was distinguished in the sale (I. T. 1187); but discount realized at maturity was tax-free to the extent of the discount sustained originally by the municipality (O. D. 647, 774 and 856).

Interest on bonds of joint-stock land banks organized under the Federal Farm Loan Act of 1916 were exempt from tax but dividends on their stock (I. T. 1349) and promissory notes (I. T. 1806), unless secured by a first mortgage (T. D. 3515), were taxable. By the act of March 4, 1923, Federal intermediate credit banks and their dividends are free from tax (T. D. 3515). (d) Stock Dividends."

1

(e) Property Acquired by Gift, Bequest, Devise, ana Inheritance. Profits from the sale of property thus acquired arise under the circumstances described on 1 See page 80.

page 58. The fact that a value is put on such property when received does not affect its taxable status to the donor or to the estate of the decedent. The recipient derives no taxable income unless he sells the property and then only to the extent that the selling price exceeds the original value (fair value at the time received in the case of property acquired by bequest, devise, and inheritance, or by gift prior to December 31, 1920; or cost to the donor in the case of gifts acquired after December 31, 1920). (Art. 1562-3).

Where a father made an absolute gift of property to his minor child, even though he continued to administer the property, the income need not be returned by the father (Sol. Op. 14). A taxpayer sold his undivided interest in property to his sisters for less than the appraised value for inheritance tax purposes and at less than the estimated forced sale value; the loss was not deductible, being in the nature of a gift to his sisters (O. D. 847). The fair market value of land conveyed to a corporation in consideration of the moving of the factory thereto is not a gift, but taxable income (A. R. R. 3513).

(f) Damages. Insurance and damages received on account of accident or sickness are not taxable (Art. 72; Sec. 213(b) (6)).

Damages recovered in a libel suit (S. 957), for alienation of a wife's affections (S. 1384), and for a threatened suit for breach of promise to marry, the last for the reason that the deprived benefits were merely anticipatory (O. D. 501), were looked upon as income and not a return of capital; but damages received for breach of promise to marry were not taxable because the personal right violated was not capable of being valued (I. T. 1804).

(g) Dividends and Interest from Building and Loan Associations. These are specifically exempted (up to $300 and made available before January 1, 1927), where such associations have been organized exclusively to make loans to members (Art. 89; Sec. 213(b) (10)).

The $300 exemption on dividends and interest received from

a building and loan association as defined in 213(b) (10) and not in 231 (4) applies to amounts received in any one year from 1922 to 1926 (I. T. 1193), notwithstanding the fact that a single payment may include accumulations for several years (I. T. 1608). Earnings paid or credited to holders of instalment stock are dividends, not interest, and amounts in excess of the $300 exemption are subject to surtax only (I. T. 1665). Each income beneficiary in the case of income from a trust (I. T. 1641) and each spouse in the case of community income (I. T. 1675) is entitled to an individual exemption of $300 from his portion of the dividends and interest from building and loan associations.

GENERAL SUMMARY OF INCOME

As has been seen, the receipts of an individual or corporation are conceived by the law and the Treasury Department as being either income or return of capital. A receipt of cash may be either income or return of capital, depending on whether the books are kept on the cash or accrual basis, or not kept at all. There may be constructive receipt of income-not "psychic" income, but income of more or less direct physical benefit ordinarily received by other individuals in the form of cash. Were it not for the idea of constructive receipt, taxpayers would be discriminated against: some, through having benefits paid for them by debtors, or through various possible forms of organizations, would be enabled to report little or no income.

Because of our present economic structure, there can be no unified concept of income. Money or money's worth and its proper differentiation between capital and revenue up to a given point of time offer almost insurmountable barriers to taxpayers whose complex problems are not accompanied by an application of proper accounting principles. Income, as a rule, must be accounted for in the year made available; any other method, such as that applied to dividends during the last five months of 1917,1 present such enormous difficulties that the computation would scarcely

1 See page 77.