There are various degrees of sophistication, too. I do not claim to be among the most sophisticated as to 318. I forget it myself, between weekends. It just seems to us that in the smaller cases we are dealing primarily with the small corporation here, or at least the closely held corporation, and we know the nightmares this thing creates. We know the acci dents that can happen. It was rather amazing to me, and I think speaks quite eloquently against the whole system, that the advisory group said, "We are now giving you one extra specific sanctuary. If you only own 1 percent of common stock, you can redeem your preferred. But be careful how much you own, because there may be a fellow, through some corporation or other business relationship you have, who owns aught-aught-one, and if these attribution rules bring it back to him, then even though you own 1 percent, you are outside that sanctuary." There is a perfectly understandable tendency on the part of those enforcing the law and administering it to gradually move over to where it was intended as a haven or sanctuary, so that it becomes a prison, and if you are caught outside that prison, you are a fugitive from justice, and you do not get the same impartiality of approach under the old essential equivalents test, at least we do not feel you do, that you would have had if these havens had not been there. Even though we say that here now, merely because it does not fall in a haven, a statutory haven does not necessarily mean you are all washed up. It does go on to say, "But you had better consider everything that is in 318." And that leaves you in a fairly cloudy state of mind as to just how hard and how seriously we consider all the terms in 318. The CHAIRMAN. Have you completed your statement, Mr. Lentz? Mr. LENTZ. I have one more, if I may, sir. The CHAIRMAN. Go right ahead. Mr. LENTZ. I heard here earlier, section 10 of the advisory group's proposed bill discussed. We will not go into the areas that have been discussed, but there was one that we felt, while on the surface was perfectly sensible, on analysis may cause trouble to people who are again not among the most sophisticated and not among the most wealthy. Referring patricularly to the language that says that the debt will be treated as debt under this sanctuary provided in the new section 317, it says: The circumstances of its issuance must not negative any reasonable expectation of payment. Must not negative any reasonable expectation of payment. And yet, the first additional requirement is that the obligation is not by its terms subsordinated to the claims of trade creditors generally. Our proposal is to remove that one requirement, to permit the obligation by its terms to be subordinated to trade creditors' claims. We are still forced to comply with the requirement that there be nothing to negative a reasonable expectation of payment. But in beginning a small business, we often have the case of a man who is willing to invest with one of his fellow men, only one of them has money; he is willing to put up money, he wants to be a creditor, he is willing at the early stages to subordinate those claims to trade creditors generally. If the other tests are met, if the stake of 5 to 1 is to be 20675-58-pt. 3—53 regarded as a sufficient stake in terms of percentages and the stake is in there, the equity stake, and if the circumstances do not negative any reasonable expectation of payment, to bring in another objective test that sometimes may be fair in its application but other times may not, seemed to us to put a real damper on financing some of these small businesses, where the man is putting up the money, is willing to come below the trade creditors, but wants to be and will insist on being a creditor. The cases brought to our attention are cases where quite soon after the company has been doing business awhile, the subordination becomes immaterial, anyway, because the credit is built up and established, and the creditors no longer insist on it. But in the very beginning, when you are really straining, if the stockholders had put in the necessary nestegg down to the equity, percentagewise-and they said here, 5 to 1-we are fearful that even though there is a reasonable expectation of payment, that requirement will either scare a lot of people away from putting money in or will in the end lead to a construction of the law that unless your claims are superior to those of trade creditors, you do not have debt. The CHAIRMAN. As I understand the advisory group report on that point, what they are trying to do is to establish a rule for the clear cases along the line of what the courts have decided, and not exclude other cases from equitable treatment. Mr. LENTZ. I think that is true. The CHAIRMAN. Is there anything wrong with it? Mr. LENTZ. I think there is, in the sense that when we list here 4 cardinal virtues, so to speak, and really there are 5, because you must have the reasonable expectation of payment, I greatly fear and our committee feared almost unanimously that in the administration of the law, when the revenue agent comes along and is looking over a small business that has one of these situations, he will feel that he had better disallow it if the obligation is subordinated to claims of trade creditors, even though there is a reasonable expectation of payment. The CHAIRMAN. That is a material factor, of course, in the decision, that they might be in trouble. But what impressed me in the report is on page 20, where they discuss the proposal, this language: * and is intended to be without prejudice to the determination of the status of other alleged obligations not coming within its strict requirements. Mr. LENTZ. I appreciate that. But I think we all, at least I only present the experience of the committee which I represent, that a test of this type is likely to lead to drawing the conclusion that if you do not have it, you are through. For the small man being audited by a revenue agent who, as I say, cannot possibly in all cases be trained in the law, it may mean he has to go all the way in the litigation where, it seems to us, if there is a reasonable expectation of payment, you have met a test that this thing is attempting to establish. Again, it is a double application of how good is the debt. We just did not see the functional necessity of this, and if it is not necessary and could cause trouble, we would urge its being dropped. The committee does not say that has to be in there, and we could see no reason for its being in there. The CHAIRMAN. Do you have anything further, Mr. Lentz? The CHAIRMAN. Gentlemen, we thank you for coming to the committee and giving us the benefit of the views of the Philadelphia bar on the advisory reports. Mr. DOHAN. Thank you, sir. Mr. LENTZ. Thank you, sir. The CHAIRMAN. Thank you, gentlemen. That concludes the call of the calendar. The committee will adjourn until 2 o'clock this afternoon for an executive session in room B15 in the Capitol, and until 10 o'clock in the morning, when the hearings will resume. (The following statement, letters, and enclosure were filed with the committee:) STATEMENT OF PENNSYLVANIA BAR ASSOCIATION RE ESTATE TAXATION OF INSURANCE We understand that once again the House Ways and Means Committee is considering the possibility of introducing a premium-payment test for the estate taxation of life insurance proceeds. Under this test, although there may be differences in detail in various proposals, proceeds of life insurance are included in the estate of a decedent even though at the time of his death he did not own the policy if at sometime or other he paid the premiums. We oppose any such test. We believe that such a proposal is contrary to the purposes of the estate-tax law. This law is characterized as an excise tax upon the transfer of property at death from the decedent to his estate or directly to his beneficiaries. The premium payment test imposes a tax on property which has been transferred prior to death, or, in some cases, on property which the decedent did not own at any time. Thus, life insurance would be singled out for tax treatment which is inconsistent with and more burdensome than the tax on property of other types. The result is that the burden is felt by estates of moderate size, where reliance upon investments in life insurance is greatest, and in small business, where the protection of life insurance is needed to stabilize long-run financial structure. The owner of a large estate can circumvent the premium payment, simply by transferring other income-producing property to his spouse, who can take out insurance on the life of the donor and pay the premiums out of the income she receives from the donated property. Such an arrangement does not involve the transfer of the policy or does the donor pay the premiums directly or indirectly. FEBRUARY 5, 1958. Hon. WILBUR D. MILLS, Chairman, Committee on Ways and Means, House of Representatives, Washington, D. C. MY DEAR MR. CHAIRMAN: I am transmitting herewith a supplementary report of the committee on taxation of the Philadelphia Bar Association, which recommends for your consideration an amendment to section 355 of the Internal Revenue Code of 1954 to reduce the control requirement in the case of a so-called "spin-off" from 80 percent to 51 percent. Respectfully submitted, STEPHEN T. DEAN, Chairman, Committee on Taxation, Philadelphia Bar Association. TAX COMMITTEE OF PHILADELPHIA BAR ASSOCIATION-RECOMMENDATION RELATING TO SECTION 355 OF THE INTERNAL REVENUE CODE The tax committee of the Philadelphia Bar Association supplements its prior recommendations under subchapter C and recommends that section 355 of the Internal Revenue Code of 1954 be amended to reduce the 80-percent control requirement to 51 percent. Section 355 provides that a corporation which controls another corporation may distribute the stock of the other corporation if the other requirements of section 355 are met. Control means ownership of stock, possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote, and at least 80 percent of the total number of shares of all classes of stock of the corporation. The introduction of the control test in the 1954 code represents a change from the Internal Revenue Code of 1939. Under section 112 (b) (11), a corporation owning 51 percent (or possibly less) of the stock of another corporation could place the stock of that corporation in a third corporation controlled by it and then distribute all of the stock of the third corporation tax-free. The use of the third corporation was to comply with the reorganization provisions of the 1939 code which previously were eliminated in the 1954 code. That this transaction could be accomplished tax-free is shown by regulations 111, section 29.112 (b) (11)-2. There appears to be no reason why the test for this purpose should not now be the same as it was under the 1939 code, and it is, therefore, recommended that the 80-percent requirement be reduced to 51 percent. WEIL, GOTSHAL & MANGES, New York, N. Y., December 23, 1957. CHAIRMAN OF THE HOUSE WAYS AND MEANS COMMITTEE, DEAR SIR: I should like to take this opportunity to bring to your attention an inequity relating to individuals on a calendar-year basis who are members of a partnership on a fiscal-year basis. If an individual on a calendar-year basis severs his membership in a fiscalyear partnership, the consequence is that he is required to report more than 12 months of income in 1 year. To take the most extreme case, suppose such an individual severs his connection on December 31, 1957. For 1957 that individual will have to report 23 months of income for Federal income-tax purposes, as follows: (a) His distributive share of the partnership income for the 12 months ended January 31, 1957. You will realize that for tax purposes he is deemed to have received all of this income on January 31, 1957, although as a practical matter he probably received a substantial part of it by way of drawing over the previous 12 months. (b) His distributive share of the partnership income for the 11-month period, February 1, 1957, to December 31, 1957. Needless to say, with the graduated surtax rates, the burden upon the individual in such a situation is quite heavy. Nor is this a situation that is unlikely to arise. Almost any person who leaves a fiscal year partnership to take a salaried position will face this problem. Even if he leaves the partnership prior to December 31, he will still have 23 months of income, since he will have to report his salary for the period from the date he left the partnership to the end of the calendar year in addition to the items mentioned above. The only possible way to hedge against such a situation is for the individual to adopt a fiscal year himself which coincides with the fiscal year of the partnership. Leaving aside any question of the consent of the commissioner to such a change, the individual then runs afoul of the provisions of section 443 (b) (1) of the Internal Revenue Code of 1954. This section provides that, in the event of such a change, the income for the short year must be annualized-that is, the income for the short year must be multiplied by twelve, the tax computed, and the result divided by twelve. The result of this annualization requirement can be quite harsh. Assume an individual on a calendar year basis is a member of a partnership having a fiscal year ending January 31. The individual decides to change to a January 31 fiscal year. As a result, he is required to file a return for the short year, namely, January 1 to January 31, 1957, and to annualize this income. Let us further assume that the individual's sole income was his distributive share of partnership income for its fiscal year ending January 31, 1957, that this amounted to $15,000 after deductions and exemptions, and that the individual was married but had no children. His tax for the short period would be computed as follows: (a) Income__. (b) Annualized ($15,000 x 12). (c) Tax on $180,000-- (d) Tax payable (1/12 of (c))-- $15,000 180,000 117.240 9, 770 For a person to have to pay a tax of $9,770 on a net income of $15,000 is to put it mildly a heavy burden. Section 443 (b) (2) purports to provide some relief by allowing a taxpayer in such a situation to recompute his tax after a period of 12 months from the beginning of the short period and then taking a prorata amount of that tax (i. e., that proportion which the net income for the short period bears to the net income for the 12-month period). Let us assume that the individual taxpayer described above continues as a partner and has no other income than that derived from the partnership. His income will, therefore, remain at $15,000 for the 12-month period January 1, 1957 to December 31, 1957, since the next partnership distribution date will be January 31, 1958. At the end of 1958, he may then compute his tax on the basis of $15,000, which will amount to $3,620, and obtain a refund of $6,150. The difficulty with the relief provisions of section 442 (b) (2) is that one needs to have the cash to finance the change of taxable year. It seems strange indeed that the practical availability of a provision of this kind should be dependent upon the financial condition of the taxpayer. I do not believe that such a situation fits into the basic philosophy upon which our tax laws are predicated. The argument may be made that the individual in the situation described had a year free of tax when he was originally made a partner. The fact is, however, that he merely postponed his liability to tax; he was not relieved of a year's taxes. Eventually these taxes have to be paid, and, as the law stands now, at higher surtax rates. I suspect that, in enacting section 443 (b) (and its predecessor section 47 (c) of the 1939 code), Congress never considered the impact of annualization on an individual who derived his principal income from a partnership. In all probability Congress had in mind the situation of an individual who received his taxable income fairly ratably over the year and inserted section 443 (b) to cover situations where occasionally a slight variation might arise. The inequitable situation which I have described can, I believe, be taken care of by the addition of a subsection (3) to section 443 (b) reading as follows: "(3) Rule in case of partnership income.—If the gross income of the taxpayer for the short period includes the taxpayer's share of the net income of a partnership for a taxable year ending within the short period, then the following rules shall apply in computing the tax as provided in subsection (1): "(A) the taxpayer's share of the net income of such partnership shall be excluded and the tax shall be computed as provided in subsection (1); "(B) the tax shall be computed on the taxable income for the short period, including the taxpayer's share of the net income of such partnership, but without placing such income on an annual basis as provided in subsection (1); "(C) the tax shall be computed on the taxable income for the short period, excluding the taxpayer's share of the net income of such partnership, but without placing such income on an annual basis as provided in subsection (1); "(D) the final tax shall be the tax as computed under subparagraph (A) plus the tax as computed in subparagraph (B) minus the tax as computed in subparagraph (C).” If the above amendment is applied to a sample situation, its operative effect will be clearer. Assume an individual on a calendar year basis is a member of a partnership having a fiscal year ending January 31. He decides to change to a January 31 fiscal year. As a result he is required to file a return for the short period; namely, January 1 to January 31, 1957, and to annualize. Let us further assume that the individual has $1,000 of interest income and $15,000 of distributable income from the partnership for its fiscal year ending January 31, 1957, and that all deductions and exemptions are ignored except for the fact that the taxpayer as a married man is entitled to split his income. If there were no annualization, the taxable income would be $16,000, and the tax payable would be $3,920. Applying my suggested amendment, the tax would be computed as follows: (A) Income $1,000. Annualized $12,000. Tax on $12,000-$2,720. Tax payable (1/12th)—$226.67. (B) Income $16,000. Tax payable-$3,920. (C) Income $1,000. Tax payable-$200. (D) Final tax-$226.67 plus $3,920 minus $200, or $3.946.67. I respectfully urge that consideration be given to the problem I have described and that a provision along the lines above suggested be inserted in the amendments to the Internal Revenue Code to be proposed at this session of Congress. I shall, of course, be pleased at any time to furnish additional information and discuss the matter with you or the staff of your committee. Sincerely, THEODORE TANNENWALD, JR. (Thereupon, at 12:30 p. m., the committee adjourned, to reconvene at 10 a. m., Thursday, February 6, 1958.) |