INTEREST PAID TO PARTNERS.-From an accounting point. of view interest paid to partners upon contributed capital or socalled partnership loans is an expense of the business only so far as the partners themselves are concerned. Contributions by general partners are at the risk of the business so far as creditors are concerned, and it is customary in preparing balance sheets to combine all the partners' accounts as the aggregate capital of the partnership, irrespective of how the balances appear upon the firm's books. Under income tax procedure it is of no importance to the government whether interest is allowed or paid to partners. If charged on one side of the returns as an expense, the same amounts appear on the other side as income and the tax to be paid is not affected.15 5 (a) (second); section 12 (a) (third)]. The same law permitted the use of the accrual basis by corporations [section 13 (d)]. The ruling issued to cover this point was T. D. 2433 (January 8, 1917). Prior to January 8, 1917, the government insisted that the interest allowance be reported on the paid basis. This worked against the government and in favor of the taxpayers, although the latter did not seek the advantage. On the contrary, most of them found the "paid" basis very objectionable and tried to change it and in many cases made up their returns in accordance with their books rather than in strict adherence to the law. A loss to the government occurred because the tax rates increased. After that date in the case of individuals the regulations contented themselves with a general permission to make a return on a basis other than that of actual receipts and disbursements if the basis clearly reflected the income. (Reg. 33, 1918, Art. 24.) In the case of corporations, on the other hand, the utilization of the accrual basis for interest deductions was specifically authorized in the following: REGULATION.“ . . . . If the accounts of the company are kept on a basis other than actual receipts and disbursements, the amount of interest actually accrued at the contract rate. . may be deducted, provided it is so entered on the books as to constitute a liability against the assets. (Reg. 33, 1918, Art. 180.) 15[Former Procedure] Under the excess profits tax law of 1917 which required a statement of invested capital and a determination of partnership profits as distinguished from the individual's net income, it made a decided difference whether or not interest on partners' loans or capital accounts were entered as a business expense. T. D. 2613 (December 20, 1917), published as bearing on the excess profits tax only, was as follows: Individual interest deduction too broad.-While Congress may be criticized because of its former policy of restricting corporation interest deductions too narrowly,16 it may be criticized on the other hand because the interest deduction permitted individuals is too generous. The law is supposed to proceed on the theory that the specific exemptions are sufficient to cover minimum personal living expenses-to provide the creature comforts. That was the reason given for not allowing life insurance premiums to be deducted." Living expenses above this minimum are not supposed to be deductible. But if a man borrows money to buy an automobile, or places a mortgage on his house because he is living beyond his means, he is permitted under the law to deduct all such interest paid. It is clearly a living expense and theoretically should not be deductible. It would seem equitable that the law should permit the deduction of interest payments only where the interest-bearing debt was incurred in the pur REGULATION. "In computing net income for purposes of the excess profits tax a partnership will be allowed to deduct amounts paid during the year to an individual partner as interest upon any bona fide loan, but no deduction for so-called interest upon capital will be recognized." Excess profits tax returns were based on income tax returns. As the provision for the payment of interest was not mandatory, partnerships should not have availed themselves of the privilege unless the interest paid to partners was at a rate substantially greater than the rate of exemption (7 to 9 per cent) allowed on capital invested; otherwise the net tax paid to the government would have been greater than if interest paid to partners had not been treated as an expense of the business, because the deduction of interest as an expense made the sum lent unavailable as part of invested capital. The case was not the same as that of partners' salaries. The allowance of salaries as an expense of the business did not diminish the aggregate capital invested; whereas if interest on partners' loans were treated as an expense, the principal amount of such loans must have been deducted from the total of the invested capital of the partnership and the benefit of the deduction of 7 to 9 per cent thereon was lost. It was not suggested that the books of account should be changed to conform with the excess profits tax returns. It was not expected that the latter would agree with the books. See page 584. "See Chapter XXIV, "Deductions for Expenses." chase of property or investments for income-producing purposes. Such a provision raises some practical difficulties such as that of designating the particular purposes for which the proceeds of a loan are used, but these are not as a whole insurmountable. 18 [Former Procedure] Article 6 of the regulations of January 5, 1915, provided that the deduction should be "all interest paid within the year on personal indebtedness of the taxpayer incurred in the conduct of business." Note the last six words, which are not found in the law. As the law reads it is perfectly clear. Manifestly it was intended that if an individual should buy a house for $10,000 subject to an $8,000 6 per cent mortgage, he could claim an allowable deduction of $480 per annum. True, such a provision is not equitable as against an individual who pays rent but cannot include such payment as a deduction. The Commissioner, while completely rewriting the law by adding words which changed its meaning, may have endeavored to collect additional revenue from those who should have paid it; yet by so doing he usurped legislative powers. Later, the regulations were in effect changed by a telegram sent to a firm of lawyers. The lawyers telegraphed the Commissioner as follows: "Article 6 of the regulations of January 5, 1915, in referring to deductions from individual's income permits the deduction of interest 'paid within the year on personal indebtedness of the taxpayer, incurred in the conduct of business.' Do we understand that the Department does not allow deduction of interest unless incurred in the conduct of business? . . . . The Commissioner replied: "Your telegram February II received. All interest paid within the year by taxable persons on indebtedness may be deducted in computing net income.' It would be interesting to know how much revenue the government collected through this mistaken regulation, and whether or not any effort was made to advise individuals who followed the regulations that they were in error. DEDUCTIONS FOR TAXES The federal income tax law is generous in allowable deductions for taxes. All taxes paid in this country, except the federal income tax itself and certain types of special assessments,1 whether imposed in the course of earning one's income or in spending it, are eliminated in determining net taxable income. Moreover, in the case of foreign income and profits taxes the 1918 law in general adopts the very liberal policy of accepting foreign tax receipts in payment of domestic tax obligations. Individuals. Taxes Deductible LAW. Section 214. (a) That in computing net income there shall be allowed as deductions: .... (3) Taxes paid or accrued within the taxable year imposed (a) by the authority of the United States, except income, war-profits and excess-profits taxes; or (b) by the authority of any of its possessions, except the amount of income, war-profits and excess-profits taxes allowed as a credit under section 222; or (c) by the authority of any State or Territory, or any county, school district, municipality, or other taxing subdivision of any State or Territory, not including those assessed against local benefits of a kind tending to increase the value of the property assessed; or (d) in the case of a citizen or resident of the United States, by the authority of any foreign country, except the amount of income, warprofits and excess-profits taxes allowed as a credit under section 222; or (e) in the case of a nonresident alien individual, by the authority of any foreign country (except income, war-profits and excess-profits taxes, and taxes assessed against local benefits of a kind tending to increase the value of the property assessed), upon property or business; Corporations.-Deductions (a), (b) and (c) are the same as for individuals. As to (d) corporations receive 'For the status of inheritance taxes, see page 620. credit for foreign taxes under section 238, and there are the following deductions which relate solely to corporations: LAW. Section 234. (a) (3) . . . (d) in the case of a domestic corporation, by the authority of any foreign country, except the amount of income, war-profits and excess-profits taxes allowed as a credit under section 238; or (e) in the case of a foreign corporation, by the authority of any foreign country (except income, war-profits and excess-profits taxes, and taxes assessed against local benefits of a kind tending to increase the value of the property assessed), upon the property or business: Provided, That in the case of obligors specified in subdivision (b) of section 221 no deduction for the payment of the tax imposed by this title or any other tax paid pursuant to the contract or provision referred to in that subdivision, shall be allowed.3 [Former Procedure] The provisions of the 1913 law relating to individuals read simply “all national, state, county, school and municipal taxes paid within the year, not including those assessed against local benefits." (Section II, B, third.) The corporation section of the 1913 law is as follows: "All sums paid by it (viz., the corporation) within the year for taxes imposed under the authority of the United States or of any State or Territory thereof, or imposed by the govern ment of any foreign country." [Section II, G (b), fourth.] Under the law of 1913 taxes paid to a foreign country by citizens or alien residents of the United States were not allowable deductions. The provisions of the law for the deduction of taxes applied only to taxes paid to the United States, or to some state or political subdivision thereof in the United States. It was evidently an oversight on the part of the framers of the law. In his report of December 6, 1915, the Commissioner of Internal Revenue recommended that foreign taxes be made allowable deductions, and the permission was granted in the 1916 law. In considering returns prior to 1916, this change in the law must be kept in mind. 1916 LAW (as amended in 1917). Section 5. "That in computing net income in the case of a citizen or resident of the United States (a) For the purpose of the tax there shall be allowed as deductions Third. Taxes paid within the year imposed by the authority of the United States (except income and excess profits taxes) or of its Territories, or possessions, or any foreign country, or by the authority of any State, county, school district, or municipality, or other taxing subdivision of any State, not including those assessed against local benefits." The phrase "except income and excess profits taxes" was inserted in the 1917 law. The provisions of the 1917 law relating to deductions for taxes paid were exactly the same for individuals and for corporations. 1917 LAW (excess profits tax credit). Section 29. "That in assessing income tax the net income embraced in the return shall also be credited |