italized an obvious repair? The Department would hardly contend that this repair should stand as part of cost. Both errors are common. Certain expenditures have been variously treated by accountants. Thus, improvements expended on a machine, the result of which is to lower operating costs of future years, are sometimes classified as capital expenditures, sometimes as as revenue, and occasionally as deferred charges.1 In the event of such expenditures the method actually followed on the books should rule, and both the Department and the taxpayer should recognize that a binding option has been exercised, effective from the date on which the original entry was made. "Properly chargeable" should, therefore, be interpreted as applicable to any clearly defined capital expenditure made on an asset without reference to the actual bookkeeping procedure followed at the time it was made. REDUCTIONS OF BASIC VALUE Depreciation, or other portion of the cost or March 1, 1913, value of an asset which has been "previously allowable," should be subtracted from the basic value if the asset be sold or scrapped. "Previously allowable" is further defined in the law as that which would have been permitted as a deduction under the revenue acts in force during the various years. It has always been the practice of the Department to reduce cost, in connection with sales as well as invested capital (see page 174), in years prior to 1924, by such accumulated depreciation or depletion as had constituted or would have constituted an allowable deduction in past years (A. R. R. 3515 and 6930 are typical cases) and this practice has been upheld by the Board of Tax Appeals. 1 If these and similar items are carried to the reserve for depreciation they have been "capitalized." Further comments appear in the chapter on depreciation. Charging doubtful capital expenditures to a depreciation reserve has the same effect, for future sale and depreciation purposes, as charging them to the asset account. If no depreciation has been claimed on depreciable business property, or if the deduction was limited by statute, as in the case of depletion under the 1913 act1 and obsolescence under the acts prior to 1918,2 or if the allowance on the books since 1913 is greater or less than the allowance in the returns-in all these cases the amount which should have been claimed on tax returns must be subtracted from the basic value (Sec. 202 (b); Art. 1561). In the last six years the Department's field agents have mercilessly butchered countless depreciation accounts. A reserve for depreciation is an Achilles' heel to almost any business enterprise. Depreciation policies are hard to justify and easy to criticize. The burden always has been and still is on the taxpayer to prove the correctness of his deduction. But if he has been denied his full claim in a prior year he may derive some benefit in a later year through the realization of a correspondingly lesser profit when the property is sold or scrapped. In the 1924 act appeared the words "previously allowed" instead of "previously allowable." For that year only, therefore, basic value was to be diminished by the depreciation deducted on past tax returns, as adjusted, if at all, by the Department (S. M. 4249). This rule should have been continued, especially if expenditures, properly capitalizable but charged off, cannot now be added to the value of the asset (Sec. 202 (b), Revenue Act of 1924). EXCHANGES Thus far the value to be put against the selling price has been the only part of the sale to be discussed. If the profit is realized in cash, the determination of the basic value is the only difficulty to be faced. But when property of the same or another kind is received in exchange the assessment of a cash tax thereon does not in all cases seem justifiable. Commencing with the 1918 act there has 1 See page 186. 2 See page 174. 8 Art. 165. arisen the theory of the "continuing transaction" or "uncompleted sale"1 under which rules, more or less complicated, have been formulated so that taxpayers have been relieved, in part at least, from the burden of having to pay cash taxes on transactions from which no cash was realized. In the uncompleted transaction, the property received in exchange is regarded as taking the place of the old. But it must not be thought that the taxpayer thereby escapes all possible tax; if he sells his new property for cash, the amount received, less the cost of the property previously given in exchange, becomes taxable income. These considerations by Congress and the Treasury Department have given rise to certain rules which will be developed in this and following chapters. INTANGIBLES Sales of intangibles (patents, copyrights, franchises, goodwill, and so forth) give rise to taxable income if the selling price exceeds the cost or March 1, 1913, value adjusted by depreciation if any has been allowable in the past. Goodwill at March 1, 1913, may be proved though not set up on the books at that date nor previously purchased. The sale of the business or that portion of the business to which the good-will pertains must, however, be complete (Art. 40 and 41). March 1, 1913, values of intangibles may be proved according to the facts of the case. Three rules were suggested in A. R. M. 34: (a) Where merchandise (e. g., liquor) was sold under a brand name and without the brand name, the difference in 1 Properly, there are three sorts of transactions falling under this classification: (1) transactions in which the property received in exchange is to be put to the same use as the property given in exchange, (2) transactions the profits from which are difficult or impossible of satisfactory computation, and (3) transactions the profits from which are received in the form of assets other than cash. In the first case there has been no real conversion, in the second, no equitable rule can be devised, and in the third, some of the assets received in the exchange might have to be sold in order to pay the tax. price, capitalized at 20%, would give a fair value for the brand. (b) Comparison of the volume of business done, profits, and the selling price of other trade-marks or brands with the volume of business and profits of the trade-mark or brand under consideration provides a basis for ascertaining an approximate selling value of the latter. (c) One means of arriving at good-will value is to allow a return of 8% to 10% on net tangible assets over not less than a five-year period prior to March 1, 1913, and to capitalize the average excess earnings on a 15% to 20% basis. In the average case a 10% allowance on tangibles and the capitalization of intangibles on a 20% basis was intended by the rule (A. R. M. 68); in a later case, 7% and 10%, respectively, were permitted to be used (A. R. R. 2954). (d) If the object is to arrive at the value at March 1, 1913, of good-will sold in a later year, the first step is to ascertain the actual value of the good-will at the time of sale by subtracting the value of the tangible assets from the selling price. A fair return on the average tangible assets for several preceding years is then subtracted from the average annual earnings during the same period and the balance compared with the selling price of the good-will. The resulting percentage may then be used to capitalize the excess average earnings for the period prior to March 1, 1913, the result being the fair value of good-will on that date (A. R. R. 252). It should be added that this method may justifiably be applied only in cases where the good-will producing factors have not varied between 1913 and the date of sale. In computing average earnings of a corporation. income taxes should be deducted (A. R. R. 2954; G. C. M. 45) but not in the case of an individual (A. R. M. 145) because there were no individual income taxes prior to 1913. In the case of a partnership, an allowance for partners' salaries should be made (O. D. 937; 3 B. T. A. 873).1 A. R. M. 34 should be applied, in determining the value of stock at the date of death, only where better evidence, such as appraised values and repurchase price of similar shares acquired 1 1 Example of good-will computation, using the principle of A. R. M. 34 and A. R. R. 252: A manufacturing business was sold as at December 31, 1926, for $800,000; the values of the tangible assets, established by appraisal, were $500,000, by the corporation, is lacking (S. M. 1609). The use of the method of A. R. M. 34 does not establish value without other supporting evidence (4 B. T. A. 893). Rates of return as high as 25% or 333% on intangibles have been allowed by the Board of Tax Appeals where profits had not been established or were on the decrease (3 B. T. A. 1026; 4 B. T. A. 341). Earnings of a patent after March 1, 1913, were held to be corroborative, though not controlling, of its value at that date (4 B. T. A. 273). In one case, to ascertain the profits attributable to intangibles, the average earnings were decreased not only by a fair return on tangibles indicating a selling price of $300,000 for good-will. Following are tables of average investment and profits prior to 1913 and prior to the sale, together with the computation of a good-will value of $278,000 at March 1, 1913: The taxable profit to the corporation from the sale will be $102,000 ($800,000 $420,000-$278,000). $ 48,000 19,600 $ 60,000 29,400 $ 28,400 $ 30,600 10.2% |