be deducted by corporations as an element of loss, and by individuals as a separate deduction. This is an actual physical loss which can not be escaped or diminished by bookkeeping; consequently, it is not necessary that there be any reserve fund created or maintained. Corporations, however, must charge depreciation upon their books, or the deduction will not be allowed. 189. An individual may deduct depreciation only when it arises out of the business or trade, as in the case of losses, and may not deduct depreciation which is incurred in personal affairs. The depreciation of home property may not be deducted by the owner. But a physician may, for instance, deduct part of the depreciation of his home property, if he uses part of it as his office and for other business purposes. The owner of property leased as a source of income may deduct an allowance for the physical depreciation of such property arising out of its rental purposes. A farmer may deduct the depreciation of farm buildings other than his dwelling, and the depreciation of machinery and of stock purchased for breeding purposes. Actors may deduct depreciation of costumes purchased for stage wear only, and not adapted for personal use. A manufacturer may deduct the depreciation of his machinery. But the depreciation of a pleasure automobile, or household furniture, or personal jewelry may not be deducted. 190. Physical Exhaustion. Depreciation applies only to physical exhaustion, and not to decreased value. The language of the law is clear, but there are many attempts to include in the deduction for "exhaustion'' what is really nothing but a shrinkage of value. For instance, the good will of a business, stocks and bonds, and unimproved real estate, not being subject to wear and tear, cannot be the basis for any deduction under this heading. Patterns, drawings, lasts, tools, jigs, dies, and other equipment secured for special work may be included in the cost of the product manufactured, where the residual value of the equipment is small. 191. The amount of depreciation should be computed from the estimated life of the property. The deduction in each year is intended to represent the amount of loss in the value of the property which has accrued during the year by reason of its exhaustion in the business. To determine the amount, the cost of the property, less its value, if any, when discarded, should be divided over the estimated number of years for which it can be used. If, at the end of the period of its estimated life, property continues in use, no further depreciation may be claimed. If the property is actually exhausted before the estimated period, that part of its value which was not previously deducted as depreciation may then be deducted as loss. 192. Rates of Depreciation. The following rates of depreciation are not given as the rule, but only typical: Horses, automobiles, patterns, office furniture, books, instruments (surgical, etc.), at 20%; wagons, trucks, standard machinery, tools, sheet iron buildings at 10%; frame buildings at 3%; mill type and brick buildings at 2%; reinforced concrete and brick-steel buildings at 2%; the following, all at from 5% to 10% boilers, steam-piping, engines, heating and ventilating systems, turbines, generators, wires, motors, batteries, mine and mill equipment, farm, textile, and printers' tools. Where machinery is run overtime, depreciation is greater than where the equipment is used only during regular working hours; this last statement merely indicates that all of the facts must be considered in arriving at the amount of depreciation. The general rule is that repair expenses and depreciation charges, or reserve, together must not exceed the deterioration of the property. 193. Repairs. There cannot be a double deduction for exhaustion made good by repairs. If the exhaustion of a building or other property is completely made good by repairs, during the year, there can be no allowance for depreciation, but the cost of the repairs may be deducted as expense. On the other hand, if the loss by exhaustion has been deducted in a previous year as depreciation, expenses incurred in replacing it cannot be deducted. The theory of depreciation is that, at the end of the estimated life, the owner will have no property, but he will have its value set aside. Therefore, if he replaces his property, he is considered to have used some of the reserved money. He is not entitled to end the period with both the value of the property and the property itself. 194. In the case of machinery and possibly other property, as for instance, pipe lines, it is conceivable that repairs and the replacement of one section after another will result in entirely displacing the original equipment and leaving a new article. If such repairs resulting in an actual replacement are charged to expense, there should be no allowance for depreciation. The cost of incidental repairs which do not add to the value of the property or especially prolong its life, but merely maintain efficiency or keep the property in operating condition, may be deducted from gross income as an operation expense or charged against the cost of manufacture. 195. Patents. Depreciation of patents may be deducted. It has been held that the disappearing value of a patent may be accounted for by a deduction as depreciation. The actual cost of the patent, either the price paid for an assignment of it, or the cost of securing it from the government, making model and drawings, etc., should be pro-rated over the seventeen years of its life and 1/17 deducted in each year. If it was pur chased when only part of the full term remained, the price then should be pro-rated by the purchaser over the number of years remaining. 196. Depreciation of Buildings. The Return must state the cost of the property and the rate at which depreciation is figured, and a rate higher than 3% upon a building will seldom be accepted by the Treasury Department. It has been held in one court case that an allowance of 3% upon an apartment house did not appear to be unduly low. 197. The depreciation of a building does not include its diminished rental value because of a change in neighborhood, the erection of more modern buildings in the vicinity, or changes in style, but should be based upon the number of years the building will remain habitable for the purpose for which it was constructed and used, not merely the number of years which it will stand before collapsing. The probable life should be estimated on the assumption that the building will be kept in ordinary good repair by the owner. 198. Tenants Building. Where a tenant erects a building on leased ground, the cost of the building may be included in expense, as we have seen. But where the estimated life of the building is less than the duration of the lease, the tenant should deduct an annual depreciation for the building, without regard to the length of the lease. There can not be a deduction of the cost as both expense and depreciation. 199. Trust Estate Depreciation. When the terms of a will, trust, or court decree provides for keeping an estate intact, a deduction may be made for depreciation incurred in business or trade. 200. Depletion of Mines, Oil Wells, and Gas Wells. In view of the special character of mines, oil and gas wells, the law specifically provides that the income may be reduced by deducting, in the case of mines, the market value in the mine of the product which has been sold, until the entire capital invested, or the value of the mine on March 1, 1913, if acquired prior thereto, has been returned to the owner, and in the case of oil and gas wells, the percentage of the cost or value as of March 1, 1913, which the reduction in flow or production during the year bears to the flow of the previous year. Since the sale of mineral product is in fact the sale to a certain extent of the capital investment, the entire price is not income, but only that part representing the productive operation, and it should be reduced by an allowance for the value of the mineral. This allowance is charged against the gross earnings of each year, and should be sufficiently large to cover the original outlay by the time the property is exhausted. 201. Obsolescence. Depreciation does not include obsolescence. There can be no advance estimate of the number of years in which a building or machine will become obsolete and the annual deduction for depreciation may not include any allowance upon that account. If the property is obsolete and worthless before its estimated life has expired, the amount of its cost not theretofore deducted as depreciation may be at that time deducted as loss. Contributions to Charities. 202. Contributions or gifts, made within the year covered by the Return to certain classes of charitable organizations, may be deducted by an individual to an amount not in excess of 15% of his net income as computed without the benefit of this deduction. This deduction is not allowed to corporations, but may be availed of by partnerships in computing their net income subject to the Excess Profits Tax. The contributions may be deducted, only if verified under rules and regulations which will be prescribed, and only if made to corporations or associations organized and operated exclusively for religious, charitable, scientific, or educational purposes, or to societies for the prevention of cruelty to children and animals, no part of the net income of which inures to the benefit of any private stockholder or individual. VII. TAX ON UNDIVIDED PROFITS OF CORPORATIONS. 203. In addition to the income tax upon corporations a further tax of 10% is levied upon the amount of the net income of any corporation which remains undistributed six months after the end of the calendar or fiscal year, and is not invested in the business. That is, if the dividends paid do not equal the amount of the profits earned, the difference must be employed in the business or it is taxed at the 10% rate. 204. Net Income. The net income referred to in this connection is the amount shown as the net income upon the Income Tax Return of the corporation, except that the amount of federal income tax paid within the year is to be deducted. Dividends are not to be deducted. If the corporation makes its income tax Return on the basis of the fiscal year, the tax on undistributed profits applies to the proportion of the undistributed income of the fiscal year ending in 1917 corresponding to the part of the fiscal year after January 1, 1917. In subsequent years, the whole of the undivided profit will be taxable. 205. Income Retained and Invested in the Business. The tax does not apply to any undistributed net income which is actually invested and employed in the business of the corporation, or which is retained for employment in the reasonable requirements of the business. If such in come is actually employed in the business, no question arises whether or not there was a reasonable requirement that it be so employed. 206. Income Retained But Not Employed. When the undistributed income which is not taxed as such, because it was retained for employment in the business, is not actually invested and employed in the business, the Secretary of the Treasury is to determine whether the amount retained is reasonably required in the business and, if he finds that it is not reasonably required, a tax of 15% is imposed upon the amount re tained, in excess of the reasonable requirements. 207. Income Invested in United States Bonds. The tax does not apply to income which is invested by the corporation in obligations of the United States, issued after September 1, 1917. VIII. INFORMATION AND PAYMENT AT THE SOURCE. 208. To prevent the evasion of the law and to assist in collecting the tax, the law establishes what is known as "Payment at the Source'' and "Information at the Source." A person making a payment which constitutes the income of another person, as, for instance, salaries or wages, is required in certain cases to render a statement to the government showing the name and address of the person receiving such payment and the amounts paid; the law also requires that upon the interest payable on "tax free" bonds of corporations, the corporation shall pay to the government 2% of such interest, representing that much of the normal tax imposed upon the owner of the bonds for such income. It is also provided that from certain payments made to non-resident aliens the person making the payment shall deduct and withhold an amount equal to the normal tax Payment at The Source. 209. Interest on Tax Free Bonds. Whenever bonds or mortgages of a corporation contain a contract or provision by which the corporation agrees to pay the interest upon such obligation, without deduction for any tax which the corporation may be required or permitted to pay thereon, or to retain therefrom under the Federal Income Tax Law, or by which the corporation agrees to reimburse the owner of the bonds, or to pay on his behalf any federal income tax imposed upon the interest, the corporation is required to pay to the government one normal tax of 2% of the interest. As there are many different forms of "tax free covenants," it must be determined in each case whether the language used covers the federal income tax. |