II

METHODS OF ACCOUNTING FOR INCOME

Definition of certain terms. Capital and revenue expenditures. Methods of accounting. Permission to change the accounting period. The cash and accrual bases. Income not determined until a later year. Contingent liabilities. Constructive receipt. Income credited and made available.

IN the brief summary of income tax legislation appearing in Chapter I certain terms were used without much definition. It seems desirable before proceeding with a detailed discussion to indicate further the significance of some of them.

Perhaps no exact definition of "income" or "taxable income" exists as yet, owing to the fact that "income" is a composite resulting from the working out of a large number of economic laws. "All wealth which flows in to the taxpayer other than a mere return of capital" is the definition contained in Article 21 of Regulations 62, but this is hardly inclusive enough; nor does it indicate that portion which is taxable. A definition deserving commendation is that of Robert M. Haig: "Income is the money value of the net accretion to economic power between two points of time." "Gross income" is income from all sources, paid or accrued, and includes "distributive" income, i. e., income of a partnership, estate, or personal service corporation which has been credited to the individual's account but not necessarily distributed as a whole. "Net income," as the term is used in the law and regulations, is not the individual's actual net or residual income but his net income for tax purposes. The difference between gross and net income consists of "deductions," that is, amounts such as business expenses, by which gross income may be reduced. As compared with "income," "deductions" are much more restricted and are confined to

specific items described in the law and regulations. "Income" from all sources, on the other hand, is taxable unless specifically exempted. "Deductions" should not be confused with "credits" which are certain portions of net income not subject to tax, nor with "credits against taxes" which are subtractions from the tax payable.

"Taxpayer" is any person, trust, estate, association, or corporation subject to tax. The word is used generally throughout the regulations. Partnerships as such were taxpayers only during 1917.

"Returns" are forms calling for details having to do directly or indirectly with income. They are of two kinds -tax returns and informational returns. Partnerships for the year 1917 filed tax returns; in other years they filed informational returns, i. e., returns showing the computation of partnership income and the amount credited to each partner's account.

1

"Invested capital" is, roughly, the net worth of the business and between 1917 and 1921, inclusive, was a factor in computing the tax payable in the case of corporations: the larger the invested capital the smaller the tax.

"Personal Service Corporations" were, as the name may imply, a class of corporations where actual invested capital was likely to be very small in comparison with the profits earned because of capital in the way of personal services invested by the principal stockholders. From 1918 to 1921, when invested capital was an important feature in the tax computation, these corporations were taxed as though the stockholders were partners and the corporations partnerships.2

A "taxable year" is a full 12 months ending on the last day of a month. A "calendar year" ends December 31; a "fiscal year" on the last day of any other month. A "taxable period" sometimes means a period less than a full year for which a return must be rendered, and may be occasioned by dissolution, formation of a new organization dur1 See Chapters XIX-XXII. 2 See Chapter XXVII.

ing any year, death, or change of taxable year. Other terms will be defined as used.

CAPITAL AND REVENUE EXPENDITURES

The distinction between capital and revenue expenditures for accounting purposes is, generally speaking, the proper differentiation for tax purposes. Additions and improvements, expenditures tending to lengthen the life of an asset or to increase, in the case of machinery, its output enhance the value of the property and are not revenue expenses except as depreciation on them may be taken. The cost of removing improvements on land purchased for other uses is a capital expenditure; the same reasoning applies to repairs on property purchased in a worn-out condition, to the extent they may be necessary to put the property into the condition contemplated at the time of purchase. Costs of defending or improving title to property are additions to the cost of the property itself (Art. 142 and 293).

Developmental expenses, rents in excess of accrued royalties and all other expenditures on a mine before normal output is reached should be capitalized; thereafter, only major items and items increasing the normal output need be so treated (Art. 222). Incidental expenses in connection with the development of oil and gas wells, such as labor, repairs, hauling, and so forth, may be capitalized or not, according to the preference of the taxpayer. Likewise, the cost of drilling non-productive wells may be charged off immediately if desired; but if the option is once exercised it must be adhered to (Art. 223).

Improvements made by a lessee whose license was of indefinite length and revocable were capital expenditures any balance of which, not absorbed through ordinary depreciation charges, could be deducted in the year of revocation (I. T. 1676). Buildings on leased land, originally intended to be rented, could be separated from the cost of the lease and treated as though the land were owned in fee; i. e., subject to depreciation and to deduction if destroyed (I. T. 1820). In the latter case the

lessee had intended to rent the building. If he had leased the land for other purposes the cost of tearing the building down would have been a capital expenditure (Art. 142), just as alterations on a new factory building purchased outright, even though not increasing the value of the building, were capital expenditures (A. R. R. 2688).

Payments made in acquiring or maintaining title to property have consistently been held by the Department to be additional costs thereof; recent examples are: attorneys' fees incurred in securing property under a will (I. T. 1689), annuities paid as a consideration for turning over an interest in a business (I. T. 1662), and costs of getting property back from the alien property custodian (A. R. R. 2318).

Taxes are a part of development expense and may, therefore, be capitalized in the case of mines and oil and gas wells but not otherwise, although applying to non-productive property and paid in years in which its owners were not subject to income tax (I. T. 1188, 1807).

Expenditures on mines and wells are subject to more rigid rules than expenditures in connection with any other kind of property; thus, the option of handling the cost of productive and non-productive oil wells may differ, but the policy, once adopted, must be adhered to for all future tax purposes (I. T. 1698). Machinery replacing mules to haul coal to the shaft of a mine was looked upon as a major replacement and therefore to be capitalized (I. T. 1688). Prepaid royalties must be carried forward to the year they are absorbed or to the year of cancelling the lease, although it may have been ascertained previously that the royalties accrued would never equal the minimum rental (A. R. R. 3699).

METHODS AND BASIS OF ACCOUNTING

The method of accounting followed by a taxpayer in recording his transactions should govern, in a general way, in calculating his taxable income. He must prepare his return on a fiscal year basis if his books are so kept. Changes from a fiscal to a calendar year or vice versa, or changes in the general accounting method must first be approved by the Commissioner, 30 days' notice being required. The 1918 act required that notice be given the Commis

sioner 30 days before the due date of the new return; the 1921 act requires a notice of 30 days before the close of the new taxable year. Form 1128 should be used in making application for a change in the taxable year. An individual not keeping books cannot render a return on the basis of a fiscal year or on an accrual basis (Art. 22, 23(3), 25, and 26).

Books may be kept on a "paid" or on an "accrual" basis. The distinction is not clear, from either the accounting or legal standpoint. Strictly speaking, the "paid" basis would seem to involve merely the collecting together of cash receipts and disbursements relating to income, but among the minimum requirements laid down by the Department for either method are (Art. 24):

(a) That where merchandise is dealt in, opening and closing inventories must be taken;

(b) That capital and revenue expenditures must be properly differentiated; and

(c) That where depreciation is claimed as a deduction, replacements must be charged to a reserve therefor. Technically, this means that the cost of the asset replaced must be charged against the reserve while the cost of the new asset is capitalized.

Perhaps no set of books exists in which all accounts are handled on a strictly accrual basis. Small items will invariably be found which, properly speaking, are not expenses, although recorded as such, and while their theoretically correct treatment might increase taxes payable by a small amount, the Department seems to have recognized that slight variations of method are bound to exist. Consistency, however, is necessary in the handling of all items, and the fundamental rule laid down is that "the computation shall be made in such a manner as clearly reflects the taxpayer's income" (Art.22).

In general, income should be included in the year re