in arbitrarily adjusting depreciation reserves where apparently insufficient depreciation had been set up in past years, providing sound value (presumably from appraisal) compared with book value. But the principle has not been extended to sales, and depreciation that should have been taken must be deducted from cost (Art. 156 and A. R. R. 3515).

These considerations by Congress and the Treasury Department have given rise to certain rules which will be stated in general terms first and amplified in this and following chapters.

(a) Cost of goods on hand at the end of an accounting period and also at the beginning thereof may be the market price in the beginning inventory if the lower of market or cost for inventory valuation was then followed (Sec. 202(a) (1)).

(b) Where property is exchanged for other property no taxable profit will arise unless the property received (1) has a readily realizable market value or is (2) essentially different from the property disposed of (Art. 1564 and Sec. 202 (c)). Under the 1918 act a similar rule existed except that "fair" was used in place of "readily realizable," although the Treasury Department's interpretations have been similar. The Department has held that the term "readily realizable" value excludes values which would be realized upon forced sales or sales in different quantities (Art. 1564).

(c) Where one or more persons transfer property to a corporation and thereupon acquire control (defined as an ownership of at least 80% of the voting stock and 80% of all other stock) of the corporation, no taxable profit arises if the ownership continues in substantially the same proportion. The cost of the property is merely transferred to the stock acquired by such transfer (Sec. 202 (c) (3) Art. 1566(c)). Under the 1918 act, such an exchange was looked upon as a closed

transaction, giving rise to income, doubtless because the stock was regarded as being essentially different from the property transferred (Art 1566, Regulations 45).

(d) Exchanges of stock in connection with a reorganization, merger or consolidation do not ordinarily result in profits to the stockholder. Under the Revenue Act of 1918, the rule was that a taxable profit was realized in such cases to the extent that (1) the par value of the new stock exceeded that of the old or (2) the fair market value of the new exceeded the cost or March 1, 1913, value of the old, whichever was the lower (Act. 1569 of Regulations 45). By provision in the 1921 act the exchange of securities in connection with a reorganization does not give rise to taxable income, but it is specified "a person receives in place," thus indicating that the stock surrender must be complete under a reorganization as defined in the act Section 202 (e) (2) and Article 1566(b)).

(e) Upon a subsequent sale of property acquired as described under (b), (c), and (d) above, the cost to be taken will be that of the property given in exchange. If more than one kind of non-taxable property is received, (1) the cost is to be distributed in proportion to the relative market value of the property received; (2) where only part of the property received has a "readily realizable" market value, such ascertainable value is to be applied in reduction of the cost or March 1, 1913, value of the property given (Art. 1568 and Sec. 202(e)); (3) a fair apportionment of the original cost should be made, or if impracticable, (4) the original cost should be reduced by subsequent sales of any of the property received until such original cost is exhausted; at that point any additional sales must be reported, in their entirety, as taxable income (Art. 1567(a) 1568 and Sec. 202 (e)). The 1918 rule was similar.

(f) There are thus three classes of non-taxable exchanges in which the property received may have a fair or readily realizable market value: (1) exchanges of like property, (2) formation of a corporation with an 80% control thereof, and (3) ordinary corporate reorganizations. Frequently the stock or property has no market value; in that case cash or other property also received in exchange is applied in reduction of the original cost as in (e) (2) above. If the otherwise exempt property received in exchange has a market value and is accompanied by cash or any other form of nonexempt property the whole transaction, for 1923 and succeeding years, becomes taxable. The profit will be the excess of the fair value of all the property received over the cost; the portion thereof subject to tax is not to be in excess of the cash or fair value of the other property received. Previous to 1923 the rule in (e) (2) applied to all cases. The reason for the changed rule is not difficult to see; the non-taxable exchange might in certain cases be easily availed of to cloak the distribution of real income (Art. 1566-8, and T. D. 3468).

(g) A fourth class of non-taxable exchanges existed during 1921 and 1922; exchanges of stock of one corporation for stock of another and of bonds for bonds. Cash paid or received in the exchange was an increase or decrease in the cost carried forward. This was made possible by a rule of the Treasury Department and was not in the law; Congress on March 4, 1923, excepted securities from the list of exchanges of property of like kind (Art. 1566(a) and Sec. 202(c) (1)) so that such exchanges are now measured for their profit possibilities in the usual way.

(h) Capital gains (i. e., gains from the sale of property other than stock in trade-held by the taxpayer for profit or investment for more than two years) are

taxed under the 1921 act at a rate not exceeding 122% of such gain (Sec. 206). The precedent for the twoyear period was found in the old Civil War acts and the act of 1894; profits from the sale of property held longer than two years was then looked upon as not being taxable at all.

The application of the 122% rate is optional with the taxpayer; that is, may be applied by him if a lower total tax will result thereby. On the tax return form it will be noted that where the taxpayer desires to take advantage of the 122% rate, the income on which it is based does not appear on the face of the return at all. See Figure 4 on page 230.

INTANGIBLES

Sales of intangibles (patents, copyrights, franchises, goodwill, and so forth) give rise to taxable income if the selling price exceeds the cost or March 1, 1913, value adjusted by depreciation if any has been sustained and deducted in past tax returns. Good-will at March 1, 1913, may be proved though not set up on the books at that date or previously purchased. The sale of the business or that portion of the business to which the good-will pertains must, however, be complete (Art. 40 and 41).

March 1, 1913, values of intangibles may be proved according to the facts of the case. Three rules were suggested:

(a) Where merchandise (e. g., liquor) was sold under a brand name and without the brand name, the difference in price, capitalized at 20% and based on the yearly income attributable to the difference in price, would give a fair value for the brand.

(b) Comparison of the volume of business done, profits, and the selling price of other trade-marks or brands with the volume of business and profits of the trade-mark or brand under consideration provides a basis for ascertaining an approximate selling value of the latter.

(c) One means of arriving at good-will value is to allow

a return of 8% to 10% on net tangible assets over not less than a five-year period prior to March 1, 1913, and to capitalize the average excess earnings on a 15% to 20% basis (A. R. M. 34). In the case of individual proprietorships and partnerships allowances for salaries should be made (O. D. 937). In the average case a 10% allowance on tangibles and the capitalization of intangibles on a 20% basis was intended by the rule (A. R. M. 68); in a recent case, 7% and 10%, respectively (A. R. R. 2954).

(d) If the object is to arrive at the value at March 1, 1913, of good-will sold in a later year, the first step is to ascertain the actual value of the good-will at the time of sale by subtracting the value of the tangible assets from the selling price. A fair return on the average tangible assets for several preceding years is then subtracted from the average annual earnings during the same period and the balance compared with the selling price of the good-will. The resulting percentage may then be used to capitalize the excess average earnings for the period prior to March 1, 1913, the result being the fair value of good-will on that date (A. R. R. 252). It should be added that this method may justifiably be applied only in cases where the good-will producing factors have not varied between 1913 and the date of sale. In computing average earnings of a corporation income taxes should be deducted (A. R. R. 2954) but not in the case of an individual (A. R. M. 145) because there were no individual income taxes prior to 1913.

SALES OR PURCHASES OF OWN STOCK OR BONDS

If the original stock issue of a corporation is sold above par or below, the premium is not taxable income nor is the discount a deductible loss. The fair value of the property contributed by stockholders constitutes the paid-in capital of the business (Art. 543). Stock donated for working capital purposes is additional capital only when sold (Art. 544). A corporation repurchasing and retiring or reselling its stock realizes no taxable income or allowable loss (Art. 543). If a stockholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution of capital to the corporation (Art.