assessed as excess profits tax is to be credited to net income in computing income tax, so he will pay income tax only on $16,508.80.

246. Corporation Stock. Edward Hoover has the following property: $20,000 in Montana Utilities stock listed at par on January 1, 1917. It paid 4% interest in 1917 and sold on the market at 92 in December, 1917; $40,000 in Pittsburgh Interurban Bonds, paying 6% interest, selling at 94 in January and at 102 in December, 1917. Hoover did not sell either the stocks or the bonds. How shall he note them in his tax schedule? Answer: See paragraphs 50, 51, 76, 97. The interest and dividends received are to be included in gross income. Changes in value do not appear in the Return.

247. Law Clerk. Howard Johnson has an income of $60 a month as a law clerk. He owns United States Steel stock netting him an income of $500 a year. On July 1, 1917, he received $10,000 as a gift from his mother's estate, all of which he invested in United States Liberty Bonds, netting him 32% interest, payable semi-annually, June 15 and December 15. How shall Johnson make his Return for the year 1917? Answer: See paragraphs 5, 33, 89, 97. The gift from his mother's estate is not taxable and need not appear anywhere in his Income Tax Return. His gross income includes salary, $720, and dividends, $500, total, $1,200. The interest on the Liberty Bonds and the dividends are exempt from the normal tax. The personal exemption of $1,000 leaves no taxable income.

248. Bachelor. On June 1, 1917, Jacob Benson, a bachelor, living alone, borrowed $20,000 at 6% interest, buying therewith 333 shares of Atlantic Submarine Stock at $60 per share. During the year the stock went to $90 a share and on December 1, 1917, 7% dividends were declared from the earnings for the calender year 1917. How shall Benson make his Return on this stock, assuming that his salary is $10,000 a year? Answer: See paragraphs 5, 50, 111, 150. The increase in the value of the stock, not being realized by a sale, is not income. If the dividend on the stock is received in December, the income Return should show salary, $10,000, and dividends, $2,331. The seven months' interest paid on the loan may be deducted. This would amount to $700. Income subject to the normal tax is therefore $10,000, less $700, or $9,300; deducting the $1,000 and $3,000 exemptions, the normal tax will be $166 plus $126, or $292. Income subject to the additional tax is $11,631, and the additional tax is $123.93. The total tax due is therefore $425.93.

249. Political Subdivisions. Arnold Crandoll owns Chicago Improvement bonds worth $20,000, paying 4% interest; Kankakee River Drainage District No. 4 bonds worth $10,000, paying 42% interest, and Chicago Surface Railway Company bonds worth $30,000, paying 5% interest. On what part, if any, must he figure his income tax? Answer: See paragraphs 33, 36. The city and the drainage district bonds are exempt, so Crandoll will pay income tax only upon the $1,500 interest upon the Surface Railway bonds.

250. Timber Company. The Western Timber Corporation purchased standing timber in the year 1910 which on March 1, 1913, had a well established market value as follows: Oak, $9 per thousand feet; pine, $8 per thousand feet, and mixed timber, $6 per thousand feet. In 1917 the average market price of standing timber in the locality was as follows, per thousand feet: Oak, $12; pine, $10; mixed, $10. The corporation owned

its own saw mill and in 1917 cut one million feet of lumber of each of the above grades. The selling price of the lumber averaged 50% above the market value of the standing timber. How shall the corporation make out its Return? Answer: See paragraphs 49, 50, 51, 125. The difference in the selling price of the lumber and the value of the timber on March 1, 1913, should be reported as profit and expenses of manufacturing and selling are to be deducted in the general deduction for expense. The profit would be as follows: On the oak, $9,000; on the pine, $7,000, on the mixed timber, $9,000. It would be permissible, if the corporation books were kept on that basis, to report separately the profit made on the lumber as the difference between the value as of March 1, 1913, and the market value when used, and the profit on the operation of the mill, computed as though there had been a purchase of the standing timber at the market value.

251. Reorganization. The P. & A. Corporation had been unable to pay any dividends to its stockholders for several years and in 1916 and 1917 failed to earn the interest on its bonds. The following scheme of reorganization was proposed by a bondholders' committee and was adopted by the consent of all parties. The company had outstanding stock amounting to $500,000, par value, $100 a share; first mortgage bonds amounting to $300,000 in denominations of $1,000 each, and second lien debentures amounting to $200,000, also denominations of $1,000. The plan was to exchange all of the outstanding stock and bonds for a new issue of stock in the same amount as formerly, and to sell new bonds for cash to be used in restoring the business. The first mortgage bonds were exchangeable for an equal amount in par value of the new stock, the debentures for one-half of their par value, and the old stock for one-fifth of its par value, of five shares for one new one. All of the securities were exchanged on this basis. Walter Harmon owned ten of the bonds for which he received 100 shares of the new stock, ten of the debentures for which he received 50 shares, and 500 shares of the old stock for which he received 100 shares of the new stock. He also bought ten of the new bonds at 96. How shall the transaction be reported in the income tax Returns of Harmon and of the P. & A. Corporation. Answer: See paragraphs 39, 49, 50, 62. As to Harmon, the transaction may be considered as closed and the par value of the securities taken as the basis of profit and loss. As to the first mortgage bonds there is no loss unless Harmon bought them at a premium, and he must show a profit in his Return if the price he paid for them, or their value on March 1, 1913, was anything less than par. On the debentures there has been a loss of $5,000 as a debt ascertained to be worthless. On the shares of stock there has been a profit or loss equal to the difference between $20 per share and the value as of March 1, 1913, or, if purchased since that date, the cost. The bonds purchased at 96 are an investment upon which there is no profit or loss until they are sold or paid off. The corporation has been relieved of $500,000 of indebtedness, but this is not income. The debt was in part paid by giving each creditor a shareholder's interest in the assets of the corporation; the balance was, if anything, a gift. Neither the cancellation of some of its capital stock liability nor the creation of other capital stock was gain or loss to the corporation. The issue of the bonds at 96 involved a loss of 4% of the amount issued, to be pro-rated and deducted in annual installments during the life of the bonds.

TITLE II. WAR EXCESS PROFITS TAX

I. APPLICATION OF THE TAX.

1. In addition to all income and capital stock taxes, a tax is imposed upon profits in excess of those earned during the period immediately preceding the war, or in excess of a fair return upon capital. Individuals, partnerships, and corporations are subject to this tax, which applies to all net income with the exceptions to be stated. Merchants, farmers, agents, and salesmen working on commissions, salaried officials, professional men, capitalists, business corporations, insurance companies, banks, in short, every one who receives taxable income is required to pay a tax, if such income exceeds the standard of pre-war profits and is at least 7% of the capital, or exceeds 9% of the capital invested in the business, or exceeds $6,000 if there is no capital, or no more than a nominal capital. The tax applies to income of the calendar year 1917, and to the applicable proportion of the income of the fiscal year ending in 1917.

2. Rate of Tax. Where the income is derived from an investment of capital, the rate is graduated as follows:

20% of the amount of net income in excess of the deduction and not in excess of 15% of the invested capital;

25% of the net income between 15% and 20% of such capital; 35% of the net income between 20% and 25% of such capital; 45% of the net income between 25% and 33% of such capital. 60% of the net income in excess of 33% of such capital.

3. Where the income is derived from no more than a nominal capital, or not from any capital, as salary, for example, the rate is 8%, and the deduction is a fixed sum, $3,000 for a domestic corporation, $6,000 for a citizen, or resident individual, or a domestic partnership.

4. Net Income Determined. The net income upon which the Excess Profits Tax is levied is the amount shown as net income in the Income Tax Return, except that the amount received as dividends from domestic corporations subject to the income tax may be deducted by individuals, partnerships, or corporations. While there is room for doubt, it would appear that, for the Excess Profits Tax, net income is not to be credited with the amount of tax assessed upon excess profits, but this credit is allowed for Income Tax only. Income which is exempt under the Income Tax Law is, of course, exempt from this tax, and the law expressly excludes, in addition, (1) compensation or fees received by officers and employees of the United States, (2) income derived from the business of life, health, and accident insurance combined in one policy issued on the weekly payment plan, (3) the income of persons and partnerships carrying on the same business or coming within the same description as corporations which are exempt from the income tax. It is expressly provided in the law that the income of all trades or businesses of whatever description, whether continuously carried on or not, shall be subject to the tax, and that all of the income

of a corporation or partnership shall be deemed to be received from the trade or business of the corporation or partnership; the law does not exclude income of any character from its operation, except as above stated.

II. INCOME FROM CAPITAL.

5. The Deduction. The "excess" income to which this tax applies, is that net income in excess of a sum known as the Deduction. In the case of income from capital, the Deduction is always the sum of two amounts, one a variable amount and the other a fixed exemption of $3,000 to a corporation, or $6,000 to an individual or partnership.

6. Income Over 15% Taxed Without Deduction. The total untaxed net income can not in any case exceed 15% of the capital, as all income in excess of that rate of return is taxable at the higher graduated rates, without any deduction. This is very important in a small business. For example, Charles Mellin has $5,000 invested in an ice cream parlor, from which he received a net income of $1,700 in 1917. The applicable deduction will, of course, be equal to $6,000, plus the variable amount, so there is no income taxed at the 20% rate. But the income in excess of 15% of the capital, or $750, amounts to $950, which is taxed as follows: $250 at 25%, $62.50; $250 at 35%, $87.50; $400 at 45%, $180; the remaining $50 at 60%, $30; total tax $360. This is apparently contrary to the spirit and intent of the law and it is possible that an interpretation will be made by the Treasury Department, so that small incomes of the nature herein indicated will not be subject to the tax in this manner.

7. The Variable Deduction. That part of the deduction which is variable consists of an amount representing a fair return on the capital invested in the business during the taxable year. The rate of return which fixes this amount is (1) a maximum of 9% of the invested capital, or (2) the rate earned during the prewar period, if less than 9% and more than 7% of the invested capital, or (3) a minimum of 7% of the invested capital, or (4) 8% of the invested capital of a business which was not in existence in the prewar period.

66

8. Prewar Profits. The law defines, as the prewar period," the calendar years, 1911, 1912, and 1913, or such of those years during the whole of which the particular corporation or person was engaged in business. That is, if a corporation was organized in July, 1912, the prewar period, as to it, is the calendar year 1913. The profits of the prewar period are to be determined, in the case of corporations, for 1911 and 1912, according to the corporation excise tax law then in effect, and for 1913, according to the income tax law then in effect, except that, as to all those years, federal income taxes paid are not to be deducted, and except that dividends received from other corporations subject to the income tax are to be deducted from profits of 1913. For partnerships and individuals, profits of the prewar period are to be ascertained upon the same basis and in the same manner as net income is ascertained under the present Income Tax Law, except that dividends received from corporations subject to the Income Tax Law are to be deducted. The profits are to be ascertained for each year of the prewar period, and the average of the three figures represents the average annual profit of the prewar period. The invested capital for the prewar

period is then to be determined, according to the same rules and standards used to compute invested capital for the taxable year. From these sums, the rate of return upon invested capital during the prewar period may be computed, and the amount which is the variable item of the Deduction is then to be figured upon the capital for the taxable year at this rate, except where it is more than 9%, or less than 7%.

9. Maximum and Minimum. If the prewar profits were more than 9% of the capital then invested, the variable sum to be deducted shall be 9% of the present capital. If the prewar profits were less than 7%, the minimum rate of 7% is to be used.

10. Business Not in Existence in Prewar Period. If there were no prewar profits because the business was not in existence during the prewar period, then 8% of the present capital should be taken as the variable amount of the deduction. If a business was carried on, whether continuously or not, during the whole of any one calendar year, that is, from January 1 to December 31, during the prewar period, the standard of prewar period profits applies; but if it was in existence for anything less than an entire year, for instance, if it was organized on January 5, 1913, the 8% basis should be used.

11. Prewar Operations Unprofitable. Where a business was in existence during at least one entire year of the prewar period but (1) had no net income during that year, or (2) if the percentage of return on invested capital was low as compared with the income of others engaged in similar businesses during the same period, or (3) if the Treasury Department is unable to determine to its satisfaction the amount of such net income, then the percentage of return on capital to be used in the deduction shall be the same rate which is found by the Treasury Department to apply to representative persons and corporations engaged in a similar business or trade. A claim must be filed by the taxpayer at the time of filing the Income Tax Return if the benefit of this method of computing the deduction is desired.

12. Business Continued Under Different Form. If a corporation, partnership, or individual carries on a trade or business which is substantially a continuation of a trade or business theretofore carried on by another person, such trade or business shall be regarded as the same business, for purposes of the Excess Profits Tax, and the income and capital of such business for the prewar period shall be deemed the prewar income and capital of the successor business. This would apply to the organization of a corporation to take over the business of an individual or partnership, even though the amount of capital invested was materially increased, and likewise to a consolidation of corporations, to a change in a partnership organization, or to the sale of a business by one individual to another. If there is an identity of business, the prewar profits are to be the basis for determining war profits, notwithstanding a change in the identity of the proprietor, the form of the organization, or the amount of capital invested. In the same manner, where a reorganization or change occurs during the taxable year, the income and capital of the original business shall be deemed the income and capital of the successor business.

13. Capital Invested. The capital upon which the profits are to be measured is the capital invested, not the value of the capital employed.