Such an election would eliminate the possibility of "bunching" of income on the final return. For example, assume a trust files on a January 31 fiscal year. If the beneficiary dies on December 31, under the advisory group's proposal his final return would include his share of trust income for the year ended January 31, plus his share for the period from February 1 to December 31-a total of 23 months' income on one return.

There are, however, situations where "bunching" is not a factor and closing the trust's taxable year as to the deceased beneficiary would be desirable. For example, deductions on the beneficiary's final return may be lost for lack of income. In reporting income, the estate could not take advantage of income splitting as could be done on the final return of the beneficiary. For these reasons, the election to the successor is desirable.

ALLOCATION OF DEPRECIATION AND DEPLETION

We agree with the suggestion of the advisory group to treat payments to charitable beneficiaries as a distribution. This, in turn, raises a new problem in the allocation of deductions for depreciation and depletion. Under sections 167 (g) and 611 (b) (3), in the absence of provisions in the instrument, the deductions are apportioned between the trustee and the beneficiaries on the basis of the trust income.

Assume that under the trust instrument A, an individual, receives 50 percent of the income, and C, a charity, receives 50 percent of the trust income. B, an individual, receives a corpus distribution. There are no provisions for apportioning deductions for depreciation or depletion. Under the proposed four-tier system, B will receive some of the distributable net income. However, since he receives no "trust income," he is not entitled to any deduction for depreciation or depletion.

A simple solution would be to apportion the deduction between the remaindermen and the beneficiaries in accordance with the terms of the instrument, or the amount of trust income allocable to beneficiaries and remaindermen. The deduction for the beneficiaries should be divided among them, including charitable beneficiaries, in accordance with their respective shares of distributable net income.

SECTION 677-INCOME FOR THE BENEFIT OF THE GRANTOR

The advisory group's proposal relating to trusts used to pay insurance premiums is too strict. Unless the trustee actually pays premiums, the income should not be taxed to the grantor and then only to the extent premiums are paid. This would be consistent with the present rule (also retained by the advisory group) for a trust where the income may be used to meet a support obligation.

Mr. JENSEN. Unquestionably, these reports recommend many significant changes in present income-tax law. We respectfully suggest that legislation as far reaching should not be adopted until sufficient time has been allowed for adequate study.

The changes in law recommended by the advisory groups will undoubtedly affect much legitimate planning based on the present tax law. The meaning and possible effects of these proposals for legislation should be thoroughly analyzed before enactment.

Some of our 251 recommendations deal with broad problems; others are limited in scope. I should like to discuss at this time a few broad problems, some of which are of special interest to us as certified public accountants.

EXPENSE RESERVES AND PREPAID INCOME-RECOMMENDATION

NO. 150

In accordance with the direction in the Senate Finance Committee report on Public Law 74 (84th Cong.) (repeal of secs. 452 and 462), specified expense reserves should be allowed as deductions and specified items of prepaid income should be permitted to be deferred, with due regard to the transitional problems.

When sections 452 and 462 were included in the Internal Revenue Code of 1954, it was generally recognized that the purpose was to eliminate many of the existing differences between tax accounting and generally accepted accounting principles. When it appeared that the revenue loss from these sections had been greatly underestimated, legislation was passed to repeal these two sections, thereby reinstating the many differences between tax accounting and generally accepted accounting principles.

For example, Revenue Ruling 54-608, reversing earlier rulings, provides that vacation pay may not be accrued until the fact of liability has been clearly established and the amount of the liability to each individual employee is capable of computation with reasonable accu

racy.

The effective date of this ruling has been regularly extended and the latest and announced final extension is to taxable years ending before January 1, 1959. Unless legislation is enacted, many taxpayers will have no deduction for vacation pay in 1959.

A similar inequity exists with respect to prepaid income in that some taxpayers are permitted to defer prepaid income while others

are not.

At the time of repeal, the Senate Finance Committee report indicated that there would be new legislation to permit the deduction of specified expense reserves and the deferral of specified items of prepaid income. We urge that such legislation be promptly enacted. Proper regard should be given to the transitional problems to limit any loss of revenue.

CHANGE OF TAXABLE YEAR-RECOMMENDATION NO. 148

The existence of a demonstrable natural business year should be accepted as a valid basis for a change of taxable year.

As CPA's, we have urged our clients to break away from closing their books on New Year's Eve when the calendar year is not their natural business year. The natural business year can be defined as the fiscal year ending at the annual low point of business activity, or at the conclusion of a season.

Inventories may be taken when quantities are lowest and when employees are least busy. The income statement shows the result of operations for an actual cycle of business rather than a mixture of the end of one season and the beginning of another.

Accordingly, we have urged the use of a natural business year as furnishing a more realistic picture of operations. In addition, it would result in spreading the work load of preparation of tax returns and year-end statements, and the processing of returns by the Government.

In order to obtain permission for a change of accounting period, a taxpayer must establish a substantial business purpose. But, in examining the taxpayer's business purpose, the regulations place unnecessary stress on the tax consequences.

Ördinarily, permission will not be granted for a change of accounting period which results in a shift in income or deductions so as to cause a substantial reduction in tax liability. Furthermore, a change will not be approved if there is a loss for the interim period between the 2 taxable years.

Because of the narrow position adopted by the regulations and by the service in practice, taxpayers are unable to establish the natural business year as a substantial business purpose in itself. Accordingly, we suggest statutory recognition that a demonstrable natural business year is a valid basis for a change.

TAXABLE YEARS OF NEW PARTNERSHIPS-RECOMMENDATION NO. 179

A free choice of fiscal years should be permitted for new partnerships none of whose members is a partnership, a trust, or a corporation. Present law requires that the taxable year of a new partnership and its principal partners must be the same unless a substantial business purpose can be shown for using a different year. The regulations indicate that the desire to use a natural business year may be a sufficient purpose. However, in order to use the natural business year, it is necessary for a new partnership to obtain prior permission from the Commissioner.

We suggest that in view of the importance to taxpayers in business of using the natural business year, a new partnership should be permitted to adopt such a year without first obtaining permission.

We recognize that there may be some lag in the reporting of income for tax purposes where the taxable year of a partnership differs from the taxable years of the partners. Because of the conflicting considerations between the free choice of fiscal years and the possible lag in reporting income, the advisory group on subchapter K refrained from making a recommendation for change on this point.

It is generally known that small business organizations more often use the partnership form of doing business than do large organizations. Because of the harsh rule in the law, small business partnerships are frequently discouraged from requesting permission to adopt a natural business year.

Accordingly, we suggest that new partnerships be given a free choice of fiscal years. Any lag in reporting income may be kept within reasonable bounds by limiting such choice to a new partnership which does not have another partnership, a trust, or a corporation as a member.

REIMBURSED EXPENSES OF EMPLOYEES-RECOMMENDATION NO. 9

It should be made clear that gross income does not include receipts or accruals from others as reimbursement for expenses except to the extent that the reimbursement is compensation in whole or in part for services or use of capital.

Recent announcements of the Internal Revenue Service have indicated an intent to strictly enforce in 1958 requirements in the instructions for the individual income tax return that any reimbursement to an employee for expenses is to be included in the employee's gross income, with the actual expenses incurred being shown as a deduction therefrom.

When the employee is not required to account for his expenses, we agree that an expense allowance should be included in gross income. However, in most instances, the employee must furnish his employer with a detailed accounting of his expenditures.

In such instance, we suggest that inclusion of the reimbursement in gross income is not supported by the code. It seems clear that such reimbursements are at most loan transactions between the employer

and the employee and do not even have any of the economic characteristics of income.

We do not believe that section 61 of the code, which defines gross income, authorizes the inclusion in gross income of reimbursements for expenses incurred by an individual in his capacity as an employee, and for which he renders an accounting which is accepted by the employer. In order to prevent unnecessary litigation and to avoid burdening the great majority of taxpayers in an attempt to curb the excesses of a minority, we suggest that the statute should be amended to make this clear.

TAXATION OF CLOSELY HELD CORPORATIONS AS PARTNERSHIPS—

RECOMMENDATION NO. 213

Closely held corporations should be granted the option to be taxed as partnerships.

Be

Many small businesses do not adopt the corporate form of organization because of the possible burden of a corporate income tax. cause of taxes, a small business may forego the corporate advantages of limited liability and continuity of legal existence. We believe that a business should be permitted to select a form of organization without being influenced by taxes.

A similar recommendation appears in the progress report by the Cabinet Committee on Small Business, dated August 7, 1956. That report states:

It

This measure was originally proposed by the administration in 1954. would particularly benefit small firms having stockholders with very modest incomes.

When the Senate was considering the proposed 1954 Code, an amendment was adopted to grant closely held corporations the right to be taxed as partnerships. This was eliminated by the conference committee.

While there are certain problems to be worked out in establishing the practical application of such a provision, these are not insurmountable. Accordingly, we favor the granting of such an option to a closely held corporation.

AVERAGING OF INCOME-RECOMMENDATION NO. 7

Averaging of income should be permitted for individuals.

For practical reasons, it has been necessary to adopt an arbitrary period of 12 months for determining taxable income. The annual taxable year usually works well, but, in those situations where a taxpayer's income fluctuates significantly from year to year, our steeply graduated rate structure can cause severe distortions.

An individual is taxed each year on the income for that year and may take into account other years' transactions in only a limited number of situations, e. g., net operating loss, back pay, etc. Averaging of income would alleviate the harsh effects of the rate structure and, moreover, would probably eliminate many disputes as to when items are taxable or deductible.

During the 1954 hearings on Forty Topics Pertaining to the General Revision of the Internal Revenue Code, our committee placed before you a plan of averaging income for the purpose of computing

tax liability of individuals. That plan contemplated the averaging of income over a 7-year period. There are other plans which are designed to accomplish the same objective. One of these is H. R. 126, introduced in the first session of this Congress, which would permit averaging over a 6-year period in certain cases.

We urge you to give careful consideration to the need for some plan of averaging of income. Our committee is continuing its studies of this problem and will be happy to offer detailed comments and suggestions at the appropriate time.

MULTIPLE TRUSTS-RECOMMENDATION NO. 163

Provision should be made for requiring the filing of a combined return by a group of trusts created substantially by one grantor for one beneficiary.

It is possible for a grantor to create a number of trusts with little or no difference in terms but all for the same beneficiary. Each trust is a separate taxpayer and the income involved may be divided among as many taxpayers as the grantor chooses to create.

In addition to obtaining the benefit of lower surtax brackets, this permits avoidance of the throwback rule by keeping accumulation distributions under the $2,000 limit.

We favor legislation which would prevent abuses of the revenue in this area. However, we have strong reservations about the desirability of legislation is broadly drawn as the amendment to section 641 proposed by the advisory group on subchapter J.

The proposed statute would give the Internal Revenue Service carte blanche authority in dealing with multiple trust whether deliberately or innocently formed. Furthermore, there are far too many administrative problems which have been left unanswered.

For instance, no rules are provided for computing the tax "as though the separate trusts were one trust." Likewise, the terms "grantor" and "primary beneficiary" are not clearly defined.

Taxpayers are entitled to as much certainty and clarity as possible in the statute. While we approve the general purpose of preventing tax avoidance in the multiple trust area, we believe that any solution must be reasonably practical in its application.

As previously stated, we plan to submit detailed comments on the advisory group proposal at a later date.

COMMUNITY PROPERTY-RECOMMENDATION NO. 1

Attention should be given to eliminating disparities in treatment between residents of community property States and other States. While the Revenue Act of 1948 first eliminated differences for many taxpayers, there are still situations where the tax result may be substantially different depending on whether a taxpayer resides in a community property State or other State. Some, but not all, of the situations are:

Section 270 limits to $50,000 per year the deductible loss from a business where there have been losses for 5 consecutive years. It is possible that the limit may be $100,000 for residents of a community property State.

20675-58-pt. 334