for profit, and having a capital stock represented by shares, “upon the entire net income over and above five thousand dollars received by it from all sources during the year." The net income was to be determined by deducting from the gross income: necessary expenses of the business; losses actually sustained during the year not compensated for by insurance; reasonable allowance for depreciation of property; interest paid on bonded or other indebtedness; and all taxes paid during the year.

Strictly speaking, this tax would not be considered an "income tax" by many persons, but for our purpose it is of importance, because the phrase "net income" was used as the basis for determining the amount of tax. Net money receipts-gross receipts less necessary expense of operating the business was the definition underlying the corporation excise tax. Congress, in searching for additional revenue, selected the corporate earnings of the nation as an expedient source, in face of the inability to pass a general income tax law. The supporters of the tax claimed it was not a direct tax upon income, which would be declared unconstitutional, but asserted that it was an excise duty upon the privilege of doing business in a corporate capacity. This subterfuge was accepted by the Supreme Court. The law consequently remained on the statute-books, and constitutes one of the steps made in arriving at the present-day legal definition of income. We shall see later that its greatest importance for the purpose of this study rests in the judicial interpretation of the phrase "net income," which the law utilized as the basis for the measurement of the amount of tax corporations were required to pay "for the privilege of doing business in a corporate capacity."

4. INCOME TAX LEGISLATION SINCE 1913

The sixteenth amendment to the constitution of the United States, proclaimed February 25, 1913, declares: "The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” Just what the term "income" means was left an open question, 136 Stat. L. 113-18, C. 6, sec. 38. Flint vs. Stone-Tracy Co., 220 U.S. 107.

and it remained for Congress to formulate a definition, subject to the approval of the judicial branch of the government.

The act of 1913.-Under the authorization of the new amendment, an income tax section was inserted in the tariff act of October 3, 1913. This section provided for a tax on "net income arising or accruing from all sources," said net income being defined in the following paragraph:

That, subject only to such exemptions and deductions as are hereinafter allowed, the net income of a taxable person shall include gains, profits, and income derived from salaries, wages, or compensation, or personal service of whatever kind and in whatever form paid, or from professions, vocations, businesses, trade, commerce, or sales, or dealings in property whether real or personal, growing out of the ownership or use of or interest in real or personal property, also from interest, rent, dividends, securities, or the transaction of any lawful business carried on for gain or profit, or gains or profits, and income derived from any source whatever. . .

The exemptions allowed included: the value of property acquired by gift, bequest, devise, or descent; proceeds of life insurance policies paid upon the death of the person insured; payments by or credited to the insured, on life insurance, endowment, or annuity contracts, upon the return thereof to the insured at the maturity or surrender of the contract; income from tax-exempt government securities, whether national, state, or local; compensation of the president of the United States, federal judges, and the employees of any state or any political subdivision thereof. The deductions permitted included:4 all necessary business expenses; interest paid on indebtedness; national, state, and local taxes, except those assessed against local benefits; loss actually sustained and not compensated by insurance or otherwise; bad debts charged off as worthless; reasonable allowance for exhaustion, wear and tear of property arising out of its use or employment in business, not exceeding 5 per cent of the gross output in cases of mines. Permanent improvements and betterments were not deductible.

With these pertinent parts of the law before us, what may be concluded as to the definition of income in the minds of those who 138 Stat. L. 166–81, C. 16.

2

Ibid., sec. ii a, subdivision 1.

3 Ibid., sec. ii b.

4 Ibid.

formulated it? Several significant attributes of income are clearly indicated by the construction and wording of the law. In the first place, there remains no vestige of doubt that taxable income must mean net income. Not only are business expenses, losses, and similar items deductible, but we also find that receipts which are in the nature of encroachments upon capital investments are likewise to be excluded. Thus, the proceeds of insurance, endowments, and annuities paid on surrender or maturity of the policies are not taxable, since such payments represent, not additional income, but the return of savings capital. Interest accumulated on the premiums of these policies would be, of course, taxable, representing a new, additional income. Secondly, taxable income is restricted to actual receipts, in money or "in whatever form paid," that is, payments in kind are to be included. Income that does not customarily accrue in actual receipts, such as the food raised by a farmer and consumed directly by his family, the shelter of a dwelling-house occupied by the owner himself, and the services of housewives, would therefore not be taxable income. On the other hand, all payments in kind, such as a money salary supplemented by payments of goods, or operating a farm on shares, would be included as taxable income. Thirdly, income must be realized to be taxable. The old provisions for the inclusion of interest "paid or not, if good and collectible," and also corporate earnings, "divided or otherwise," no longer appear. If a reinvestment of earnings increases the market value of a corporation's outstanding stock, the increase is not income to the shareholders unless the stock is sold and the income realized. All income, including capital gains, must be realized to be taxable; realizability is not sufficient. Fourthly, additions to capital, such as new improvements and betterments to property, are taxable; savings are income. Finally, income must apparently arise out of productive activity. The law sought to tax the share of the national income received annually by each individual, and

There is one exception to this statement. If a corporation is formed for the purpose of, or fraudulently availed of for the purpose of preventing the surtaxes to be imposed on wealthy shareholders, by permitting the surplus to accumulate subject only to the corporation taxes, such gains are taxable income for purposes of the said surtaxes.

therefore did not tax mere transfers of wealth already existing. The words used in the definition-business, professions, trade, profits, compensation-indicate this intent. Additional evidence is given in the provision for the exemption of gifts and inheritances. When a gift is made, the national income stream is not thereby increased in volume. Likewise the acquisition of property by inheritance is simply a transfer in title to property, if viewed socially. Perhaps the irregularity of these items also had weight in formulating the decision for their exclusion, but the inclusion of other irregular gains, such as a profit obtained by the purchase and sale of a single share of stock, would not tend to support this explanation.

Generalizing on these observations, we can arrive at the income definition upon which the income tax of 1913 was constructed. Income was understood to mean receipts by the taxpayer of money or of money's worth, growing out of the productive process, and actually realized after deducting all necessary cost of acquisition. This definition differs in two ways from that of the Civil War legislation. The first and most important change is the elimination of accrued gains from the income concept. Income is secured only when it is realized in a definite, separable form. The second modification is the limitation of the income concept to gains growing out of the productive process. The early laws included all gains with very few exceptions, but the act of 1913 definitely ruled out such items as gifts and inheritances.

Such was the definition of income under the act of 1913, and, in substance, the same definition was woven into the subsequent federal income tax legislation down to the present law. As the successive acts of 1916, 1917, 1918, 1921, and 1924 were placed upon the statute-books, many changes appeared regarding the rates of taxation, administration of the tax, credits, and similar topics, but the income definition suffered but slight modification. It would not be difficult to insert here the mass of additional data found in these laws as to new details in exemptions, deductions, methods of determining gain or loss, and other features, but there would be little gained by that burdensome array of facts. We shall therefore point out only those new developments that are

of importance in their bearing on the income definition, and shall leave to the reader the duty of filling in the details by turning to the laws which are so readily available.

The acts of 1916 and 1917.-The 1913 law remained in force until the passage of the act of September 8, 1916.1 The new law taxed "net income," and defined it verbatim as in the previous act. The exemptions and deductions also remained unchanged. The one new development meriting attention is the privilege extended by the law to the taxpayer, permitting the use of an accrual basis of bookkeeping in the computation of his net income:

An individual keeping accounts upon any other basis than that of the actual receipts and disbursements, unless such other basis does not clearly reflect his income, may, subject to regulations made by the Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury, make his return upon the basis upon which his accounts are kept, in which case the tax shall be computed upon his income as so returned.2 While it would appear on the surface that a very significant modification of the income concept had been made, in fact the old basis still held. If the books are accurately kept, the measurement of net income by the accrual method and by the receiptsand-expenditures method should give the same results over a period of years, provided the method selected is consistently adhered to. Should this fail to be true, the law provided that the commissioner of internal revenue could insist on a change of the method used, thus insuring that the true income would be ascertained. For any single year, however, there might exist a wide discrepancy between net income measured on an accrual basis and net income measured on an actual receipts-and-expenditures basis. To that slight extent, the law may be said to revert to the early practice of including some gains not realized, but realizable.

Following the entrance of the United States into the worldwar, an additional "war income tax" was passed October 3, 1917.3 The definition of income in the act of 1916 remained

2 Ibid., sec. 8 (g). This privilege is also extended in each of the enactments since that of 1916.

3 40 Stat. L. 300-38, C. 63. This act was not in lieu of the act of 1916, but was in addition to that act. The taxpayer was paying two income taxes, but they were administered as one. The purpose of this arrangement was, no doubt, to furnish an easy way to return to the pre-war rates of tax when the emergency had passed.