XII

TAX-FREE INCOME SUMMARY

Insurance. Illustrations of exempt interest. Property acquired by gift, bequest, devise, and inheritance. Damages. Dividends and interest from building and loan associations. Other tax-free income. General summary of income.

CERTAIN items of tax-free income have already been touched upon. Others are referred to under this heading for the first time. The principal exclusions from gross income applicable to both individuals and corporations are summarized in the paragraphs that follow.

Insurance. In the discussion of involuntary conversion (page 81), it was stated that no part of the proceeds of insurance covering property losses were subject to tax if such proceeds were invested at once in replacements which cost at least a sum equal to the proceeds realized. It has also been indicated on page 143 that additional compensation accrues to an officer or employee if premiums are paid by the corporation on a policy (unless a group insurance policy) covering the life of an officer or employee and the beneficiaries of the policy are subject to the determination of the insured.

Proceeds of life insurance policies paid on the death of the insured are non-taxable to corporations as well as individuals. Under the 1918 act, without specific exemption of such income, it was first held that corporation beneficiaries were not exempt on the excess of the amount received over the premiums paid, but a court decision1 has since reversed the action of the Department, holding that Section 233 (relating to corpo1 United States v. Supplee-Biddle, 265 U. S., 189.

rate income) of the 1918 act must be read in conjunction with Section Section 213 (individual (individual income). Amounts received by the insured or by a designated beneficiary during the life of the insured, representing returns of non-deductible premiums paid under endowment contracts, are also exempt (Sec. 213(b) (2)). Should such amounts received be in excess of amounts paid, the excess has been regarded as ordinary income. Distributions on paid-up policies coming from the earnings of a taxable insurer are taxable as dividends (Art. 47).

Both instalment payments and dividends received by the beneficiaries or the estate of the deceased are tax-free (O. D. 433); this rule applies also to an income of 6% per annum paid an income beneficiary under the terms of a will (O. 995). But if the beneficiary has the option of receiving the face value of the policy or interest thereon until the beneficiary's death, the interest is taxable (O. D. 66 and 612); and this rule was extended to a case where the option of the beneficiary was dependent on the payment of interest of at least 42% (O. D. 1010). Dividends from a life policy issued by the Bureau of War Risk Insurance was regarded as a return of premiums and therefore not taxable (O. D. 1037). A deductible loss was not occasioned by the cancelation of an endowment policy and the receipt of a sum less than the premiums paid (I. T. 1944).

Salaries of State Employees. Pages 149-151 may be reviewed in this connection.

Interest. Liberty bond exemptions have already been outlined.1 Liberty bond interest is subject to surtax only, if taxable at all; consequently, after 1921, Liberty bond interest received by any corporation was exempt. Just as compensation from a state or political subdivision thereof has been regarded as non-taxable, so all interest on state, county, or municipal obligations, has been held tax-free (Sec. 213(b) (4); Art. 74). Interest and dividends on Federal Farm Loan securities authorized by the act of July 17, 1916, and 1 See pages 134-136.

March 4, 1923, are also specifically exempted by the same section (Art. 75).

Annuities paid by religious, charitable, and educational corporations are not taxable, unless paid on devised land or unless the total exceeds the original sum paid by or for the annuitant.1 Income from purchased annuities should be applied first in reduction of the consideration paid therefor; any balance unabsorbed is taxable. (Sec. 213(b) (2); Art. 47).

Interest on obligations of the Philippines (O. D. 34 and 922) and Porto Rico (O. D. 368) and its municipalities if approved by the executive council (O. D. 637) is tax-exempt, but not obligations of Santo Domingo (O. D. 420). Interest on state irrigation district bonds is exempt (O. D. 544); also interest on city deferred assessment bonds (O. D. 447), park fund and condemnation bonds (O. D. 491), including interest on deferred condemnation proceedings (O. D. 591) or on deferred payments on a contract (O. D. 999). Interest on securities issued by utilities owned by states or subdivisions of states, such as a railroad (O. D. 250) and a water, light and power company (O. D. 328) even though paid from the income of the utility (I. T. 2074) was tax-free; but dividends thereon were taxable and could not be applied as a credit for normal tax purposes since the corporation itself was tax-free (O. D. 328). Interest on bonds of a fire district, which were assumed by a private corporation upon purchase of the water system, was held exempt because the properties would revert to the district in case of default by the purchaser (S. M. 2670).

Interest on promissory notes of a political subdivision of a state or a territory is also exempt from tax (O. D. 817). If the notes were non-interest-bearing and were discounted by the holder, the discount given to the lender in lieu of interest is not tax-free as the transaction is between the lender and the seller (O. D. 870). In the same way discount on municipal securities realized by sale before maturity was not exempt even though discount was distinguished in the sale (I. T. 1187); but discount realized at maturity was tax-free to the extent of the discount sustained originally by the municipality (O. D. 647, 774 and 856). Interest on participating certificates paid from income from municipal bonds deposited with a trustee was in

1 See page 137.

terest on the obligations of a corporation and therefore taxable (I. T. 1910), but such bond interest paid to beneficiaries by a trustee who acted as a distributer does not lose its identity (I. T. 2067). The interest purchased on municipal bonds bought and sold between interest dates should be deducted from the interest sold (I. T. 2050).

Interest on bonds of joint-stock land banks organized under the Federal Farm Loan Act of 1916 was exempt from tax but dividends on their stock (I. T. 1349) and interest on their promissory notes (I. T. 1806), unless secured by a first mortgage (T. D. 3515), were taxable. By the act of March 4, 1923, Federal intermediate credit banks and their dividends have been exempted from tax (T. D. 3515).

Stock Dividends. See page 131.

Property Acquired by Gift, Bequest, Devise, and Inheritance. Profits from the sale of property thus acquired arise under the circumstances described on page 83. The fact that a value is put on such property when received or at the time of death does not affect its taxable status to the donor or to the estate of the decedent in the amount of the excess of such value over cost. The recipient derives income from the sale of the property to the extent that the selling price exceeds the original value (fair value at the time received in the case of property acquired by bequest, devise, and inheritance, or by gift prior to December 31, 1920; or cost to the donor in the case of gifts or transfers in trust acquired after December 31, 1920). (Art. 1593-5). Where a father made an absolute gift of property to his minor child, even though he continued to administer the property, the income need not be returned by the father (Sol. Op. 14). A taxpayer sold his undivided interest in property to his sisters for less than the appraised value for inheritance tax purposes and at less than the estimated forced sale value; the loss was not deductible, being in the nature of a gift to his sisters (O. D. 847). The fair market value of land conveyed to a corporation in consideration of the moving of the factory thereto is not a gift, but taxable income (A. R. R. 3513).

Damages. Insurance and damages received on ac

count of accident or sickness are not taxable (Sec. 213(b) (6); Art. 72).

Damages received which represent compensation for the loss of anticipatory benefits are taxable; these are illustrated by damages recovered in a libel suit (S. 957), for alienation of a wife's affections (S. 1384), and for a threatened or actual suit for a breach of promise to marry (O. D. 501; I. T. 2170). But damages are not taxable if they represent compensation for "a past injury suffered through an invasion of an inherent, personal right, a right which is granted by law to all persons in similar circumstances, as distinguished from one which arises out of a contract of which the benefits are due, in the last analysis, to the exercise of the mental faculties" (S. M. 2042). In S. O. 132 it was held that damages for "alienation of affections or defamation of personal character or in consideration of the surrender of the custody of a minor child” did not constitute income.

Dividends and Interest from Building and Loan Associations. These are specifically exempted (up to $300) where substantially all of the business is confined to making loans to members (Sec. 213 (b) (10); Art. 89 (2)). Under laws prior to 1924 the business of any building and loan association in this connection must have been confined exclusively to the making of loans to members.

The $300 exemption on dividends and interest received from a building and loan association as defined in 213(b) (10) and not in 231 (4) applies to amounts received in any one year (I. T. 1193), notwithstanding the fact that a single payment may include accumulations for several years (I. T. 1608). Earnings paid or credited to holders of instalment stock are dividends, not interest, and amounts in excess of the $300 exemption are subject to surtax only (I. T. 1665). Each income beneficiary in the case of income from a trust (I. T. 1641), each partner in the case of a partnership (S. M. 2395), and each spouse in the case of community income (I. T. 1675) is entitled to an individual exemption of $300 from his portion of the dividends and interest from building and loan associations.

Other Tax-free Income includes income of foreign governments and official representatives (Sec. 213 (b) (5); Art. 86), income of the United States Government,