Income Tax Department

EDITED BY JOHN B. NIVEN, C. P. A.

In the July JOURNAL there was published a treasury department ruling on the question of losses arising from the sale of real estate; and this month THE JOURNAL contains a further ruling with regard to losses from both real and personal property and referring particularly to losses on the sale of and shrinkage in the value of bonds, stocks and like securities. The ruling is in the form of instructions to collectors for the purpose of enabling them to check up the returns both of individuals and corporations, and in effect the department rules that such losses are not deductible at all unless they are an incident of, connected with, and growing out of the business of the individual or corporation sustaining the loss and are ascertained, determined and fixed as absolute within the taxable year in which the deduction is sought to be made. The ruling will be found at the end of this article as T. D. 2005, to which reference is made for its exact terms.

The subject of the above rulings is of such practical moment to a great number of the larger taxpayers, more particularly on account of the recent violent fluctuations in the security market, that, if any flaw can be found in the department's reasoning, we may look for the matter to be carried into the courts for decision. To the profession generally it is of sufficient importance that a brief indication of some of the points involved may be of interest, and as the principle is the same for corporations as it is for individuals the following remarks deal only with the position of individuals in regard to investments.

In the first place the terms of the provisions of the law under which it would be possible to claim such losses as a deduction from the net income of an individual may be recalled. The act provides that in computing the net income there shall be allowed as deductions:

fourth, losses actually sustained during the year, incurred in trade or arising from fires, storms, or shipwrecks, and not compensated for by insurance or otherwise; fifth, debts due to the taxpayer actually ascertained to be worthless and charged off within the year; sixth, a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business

"

Taking these three kinds of deductions in their reverse order, it would seem that the provision for the deduction marked sixth is so specific in its terms that depreciation in bonds, stocks and like investments is debarred.

The deduction marked fifth is in a somewhat different position. Investments fall into two classes: bonds, mortgages, notes and other obligations in the one class and proprietory holdings in stocks and shares of corporations in the other. Investments in the former category might be held to come under the fifth deduction, as they are "debts due to the

taxpayer"; and, should the principal, or any part thereof, of one of these obligations not be paid at maturity and ultimately ascertained, determined and fixed to be an absolute loss, then there would seem good ground for maintaining that to the extent of that loss the taxpayer had a just claim to deduct the same from his net income for income tax purposes. A different situation would arise were the obligation sold before its maturity, for in that case the taxpayer would have sold the debt and he would then have no obligation outstanding. The loss so sustained would therefore fall into the same class as stocks and shares and other proprietary holdings and the only place where such a loss could be entered would be under the deduction marked fourth.

The right to enter these losses under this head turns upon the meaning to be applied to the words "incurred in trade" which are used in the provision for the deduction. Does the word “trade” mean business or does it merely mean a transaction? The department holds that it means the business which engages the time, attention and labor of anyone for the purpose of livelihood, profit or improvement. On the other hand it might be argued that even an occasional investment in securities by an individual is a transaction in trade by him quite as much as if he devoted his whole time to such a business. Whether the restricted meaning given by the department would be applied by the courts were the department's ruling contested remains to be settled in the future.

But apart from the exact interpretation of the words used one or two points arise for consideration from the general context of the provision.

In the first place it may be pointed out that losses arising from fire, storms and shipwreck are allowed as deductions, so that if an individual's investments include improved real estate he would be entitled to deduct in his return any losses sustained by fire or storm even though the property affected was not used in business; and similarly if his steam yacht were wrecked a deduction for the loss would presumably be open to him. Again, the law provides that the net income of an individual shall include gains and profits derived "from sales or dealings in property, whether real or personal, growing out of the ownership or use of or interest in real or personal property" and the general regulations provide that gross income "is held to include all income, gains and profits arising or accruing from all sources whatever." While the department has not yet specifically so ruled, there seems no doubt that the phraseology just quoted is sufficiently wide to cover all profits made through the sale of investments. It may therefore happen that a taxpayer will have to disclose all profits so made but nevertheless be debarred under the interpretation of the law by the treasury department from entering losses made in the same period. Such a condition would be indefensible and the only logical position for the department to take would be either to allow both the profit and the loss to be included in the return or to exclude both. In any case if it is the opinion of the department that all profit on the sale of investments should be included in the return, then it would certainly seem proper that before entering such

profit there should be deducted any loss which may have been sustained, and only the balance disclosed in the return.

Other possible situations which would create hardship on one taxpayer as compared with others will readily occur to the reader and enough has been indicated to show that the situation still requires some adjustment.

The other rulings printed are:

T. D. 2003 which advises collectors that the five per cent penalty is not to be demanded until the expiration of 10 days after serving demand and notice.

T. D. 2006 which gives further definition of "foreign corporation" and "fiscal agent."

(T. D. 2003 June 26, 1914)

Assessments

Demand and notice, form 17, to be served on July 1, unless payment of assessments is not made on or before June 30, or on the day following the termination of the 120-day period in the case of corporations which have designated fiscal years, held to apply in case of delinquents where their returns are filed prior to the date on which taxes are to be paid in the ordinary course.

LETTER TO COLLECTOR SECOND DISTRICT NEW YORK

This office is in receipt of your letter of the 16th instant, relative to the collection of the 5 per cent penalty against the Co. for failure to pay the income tax and 50 per cent penalty within 10 days after the service of demand and notice on form 17.

You were advised under date of June 12 that the 5 per cent penalty does not attach until 10 days after the service of the demand and notice and in no event until 10 days after June 30, and you call attention to mim. 991, under date of January 22, 1914, in which collectors are directed to issue promptly form 17 in cases of assessments for special excise and income taxes where the tax assessed is for overdue or additional taxes or where the required return is not filed within the time specified in the statute, as in such cases the right to 30 days' notice (form 627) has been forfeited.

You are advised that this office is of the opinion that the cases referred to in the law where the assessments should be made by the commissioner of internal revenue and paid immediately upon notification of the amount of such assessment relate to delinquent corporations who have failed to file returns until after the final day on which taxes should be paid in the regular course, viz., June 30. Under this construction, therefore, it will be seen that in cases of individuals and corporations whose delinquency was disclosed prior to July I or prior to the termination of the 120-day

period following the day when the return was due to be filed, the demand and notice on form 17 should not be served until July I or on the day following the termination of the 120-day period after the return was due and the 5 per cent penalty should not be demanded until the expiration of the 10-day period following the serving of such demand and notice. Where, however, such demand and notice has been served and payment of the 5 per cent penalty made before the termination of the 10-day period following June 30, the corporations by whom such payments have been made should be advised of their privilege to file claim for refund.

All rulings or decisions in conflict with the above are hereby overruled.

(T. D. 2005 July 8, 1914)

Instructions and rules for determining what amount is to be allowed as a deduction for loss in a return of income. Depreciation allowed by law does not include shrinkage in value of stocks, bonds, etc.

For the purpose of checking up returns and ascertaining the amount of taxable income of individuals and corporations you are given the following instructions and rules for use in determining the amount of deductible loss allowable to individuals and corporations under the fourth deduction (par. B, p. 5), regulations No. 33, and second deduction, for domestic corporations (par. G, p. 14), and second deduction, for foreign corporations (par. G, p. 15), regulations No. 33.

The loss considered here has in it no element of "depreciation," or "allowance for wear and tear," or "compensation from insurance or otherwise." It is to be such loss as is absolute and complete and which has been actually sustained.

Depreciation as an allowable deduction in ascertaining annual net income for the income tax is separately provided for and is not to be confused with loss. The depreciation provided to be taken as a deduction in a return of income is the value assigned to the deterioration of physical improvements or assets, such as are susceptible of having their value lessened through wear and tear, use or obsolescence.

The depreciation referred to in the income-tax law does not relate to evidence of a right or interest in property, and hence any shrinkage in the value of bonds, stocks, and like securities due to fluctuations in their market value is not deductible in a return of income as depreciation or loss.

Losses may be sustained by individuals or corporations on personal or real property. Only those losses are deductible which are sustained during the tax year "in trade”—that is, the business which engages the time, attention, and labor of anyone for the purpose of livelihood, profit, or improvement. Loss to be deductible must be an absolute loss, not a speculative or fluctuating valuation of continuing investment, but must be an