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jects for deduction. Furthermore, the 1918 law plainly states that the term "paid" means "paid or accrued."35 Consequently, all tax reserves, except those for federal income and excess profits taxes and for special assessments, are deductible. In these years of highly fluctuating profits, proper reserves for taxes are, of course, of great importance.

35Section 200.

DEDUCTIONS FOR LOSSES

Preceding chapters discuss the deductions for expenses, interest and taxes. It remains to discuss the deductions embraced within the comprehensive term "losses." It is desirable to subdivide this subject and to devote separate chapters to the special items, namely, losses due to bad debts, depreciation, obsolescence and depletion. (Chapters XXVIII to XXXI.) Consequently the subject matter of this chapter is a residuum consisting of the losses due to general and miscellaneous causes, including fluctuation in market values, to disasters and accidents of various kinds, to dishonesty, to faulty judgment, etc., etc.

Both individuals and corporations may deduct the losses discussed in this chapter without limitation. Until the 1918 act became effective, individuals were subject to a very definite restriction in that losses incurred by them in transactions entered into for profit outside their regular trade or business were deductible only to an amount not exceeding profits arising from similar transactions. In the next place the

[Former Procedure] The provision of the 1913 law relating to the deduction of losses by individuals was as follows:

1913 LAW. Section II (b) . . . . fourth, . . . . losses actually sustained during the year, incurred in trade or arising from fires, storms or shipwreck, and not compensated for by insurance or otherwise. . . .

The 1916 law introduced the March 1, 1913, basis of valuation and the provision permitting "outside" losses, equal to profits arising from similar transactions, to be deducted.

The 1916 law was as follows:

Fourth. Losses

1916 LAW. Section 5. [Individuals]. . . . (a) actually sustained during the year, incurred in his business or trade, or arising from fires, storms, shipwreck, or other casualty, and from theft, when such losses are not compensated for by insurance or otherwise:

Fifth. In transactions entered into for profit but not connected with his business or trade, the losses actually sustained therein during the year to an amount not exceeding the profits arising therefrom;

1918 law included certain "relief" provisions, designed to prevent hardship during the period following the war from possible violent changes in inventory values. The chief ploblems here are, therefore, the determination of procedure under these special "relief" provisions and the establishment of the standard by which to measure losses due to diminution in values. This second problem is similar to that discussed in Chapter XV, "Income from Exchanges and Sales of Property."

Individuals.

LAW. Section 214.

(a) That in computing net income there

shall be allowed as deductions: . . . .

(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in trade or business;

(5) Losses sustained during the taxable year and not compencated for by insurance or otherwise, if incurred in any transaction entered into for profit, though not connected with the trade or business; but in the case of a nonresident alien individual only as to such transactions within the United States;

(6) Losses sustained during the taxable year of property not connected with the trade or business (but in the case of a nonresident alien individual only property within the United States) if arising from fire, storms, shipwreck, or other casualty, or from theft, and if not compensated for by insurance or otherwise;

Corporations.―

LAW. Section 234. (a) ..

(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise.2

"[Former Procedure] The corresponding clause in the 1913 law

read:

LAW. Section II, G (b)

"all losses actually sustained within

the year and not compensated by insurance or otherwise."

1916 LAW. "Section 12. (a) . . . . Second. All losses actually sustained and charged off within the year and not compensated by insurance or otherwise. . . . .'

It should be noted that the 1916 law reads "actually sustained and charged off." The words "and charged off” did not appear in the section relating to individuals and were inserted in the corporation section only in 1916. This added restriction was proper. No corporation should be permitted to claim deductions in an income tax return which it is unwilling to set up on its books. If the question of a reserve enters into the disposition of a loss, the item is subject to the comments on page 680.

The 1918 law omits the words "and charged off," which formerly appeared, but it is to be assumed that losses will not be allowed unless charged off by items or through reserves.

Losses to be allowed as deductions must meet the provisions of the law that they have been actually "sustained" during the taxable year. This is a reasonable requirement. Most concerns charge off or provide reserves for losses as and when losses occur and the items to be deducted can be taken directly from the books. In the case of individuals who keep nc books, more difficulty will be experienced.

In discussing the phrase "losses sustained" the regulations state that this condition "must usually be evidenced by closed and completed transactions." This, however, does not preclude the use of inventories for the purpose of ascertaining gains or losses. The privilege of using inventories, long permitted to business men generally in the case of merchandise, was not extended to dealers in securities and real estate until late in 1917, but at that time was supported by an opinion of the Attorney-General who advised that the Supreme Court in a case under the 1909 law sanctioned the practice. For a full discussion of inventories the reader is referred to Chapter XIII, page 295, et seq.*

If an individual is engaged in business on his own account or as a partner and the year's operations result in a net loss, the amount of such loss is an allowable deduction from income from other sources in a tax return.

Dividends may be offset by losses.-Because of the arrangement of form 1040 considerable confusion arose in 1918 regarding the possibility of utilizing a net loss shown by block J, page 2 (net income subject to normal tax), as an offset against the total of block K (a) and block K (b) (dividends and certain interest, subject to surtax). In many instances losses exceeded taxable income from sources other than divi

'Reg. 45. Art. 141.
'See also page 632.

dends, so that a taxpayer, having entered all income except from dividends and having entered all losses, might find the total under block J to be a net loss. To an accountant this would be a very simple problem, as he would merely enter the net loss in red ink. Then when the totals of blocks K (a) and K (b) were entered, if the latter were greater than the net loss as shown by block J, the amount shown in block L would represent the net taxable income. But some persons thought that this arrangement of the form brought about a situation in which they were subject to tax on dividends and interest irrespective of the amount of their net loss from other sources. The point was finally settled by the following letter from the Treasury.

RULING. In reply to your second inquiry you are informed that if item J, page 2 of form 1040 shows a net loss, the amount of same may be deducted from the total of items K-a and K-b as shown on line L before bringing this item forward to line 15, page 1 of the return. (Letter to Alexander John Lindsay, New York, N. Y., signed by J. H. Callan, Assistant to the Commissioner, and dated May 6, 1919.)

"Relief" Provisions of the 1918 Law

The radical changes expected in business conditions as a result of the cessation of the war made it seem imperative that losses arising from readjustments of inventories, which could not be made within a few months, should be spread over a longer period of time. Similar conditions existed in the case of losses arising from sales or depreciation of plant and equipment acquired for war purposes. To meet these difficulties the 1918 law provided certain so-called relief measures designed to assist in the re-establishment of normal conditions. Referring to these provisions Senator Simmons said:"

In addition to the relief amendments placed in the income tax title, but affecting profits taxes as well as income taxes, amendments relating to amortization and obsolescence, shrinkage in inventories, and so forth, the Senate added a general relief clause investing more

'February 11, 1919, Congressional Record, page 3776.

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