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Income from Dividends. In general, all dividends received by a corporation must be included in gross income. Under the head of deductions, it will be explained that the amount of dividends received from corporations, which are themselves subject to the income tax, may be treated as a deduction by the company receiving the dividends. However, they must be reported in gross income and taken as a deduction under the proper heading. Dividends on stock of Federal Reserve Banks are held as exempt from the tax and need not be reported. Stock dividends are not subject to the income tax.

Income from Miscellaneous Sources. If a deduction has been claimed on account of a bad debt which has been written off, and this debt has been later collected. it must be reported as income in the year when collected. Assessments made by a corporation on its stockholders are not considered as income by the receiving corporation, but are considered as an additional investment on the part of the stockholders, consequently, they are not counted as income by the corporation, nor can they be treated as a deduction by the individual paying them. If the corporation buys its own bonds at a discount, it is held that the savings thus made must be treated as income. If assets are traded for capital stock of another corporation, the difference in the cost of the assets and the value of the stock received is regarded as income. However, if the stock of one corporation is exchanged for capital stock of another corporation of the same par value, it is deemed that no profit arises as a result thereon. No appreciation of assets is recognized by the Income Tax Law, therefore, if a corporation writes up its assets and credits the amount arising as a result thereon to its Surplus account, this is not regarded as taxable income. The gross income of foreign corporations should include only the income from sources within the United States. No appreciation nor depreciation of good will is recognized. However, if the good will of a corporation is sold at a greater value than it cost, the difference is taxable income.

Net Income. The net income of corporations is that portion of the gross income which remains after subtracting all the allowable deductions. In other words, the net income of corporations is the difference between the total income and the total deductions. While the net income of a corporation is determined in the same general manner as the income of individuals, the deductions allowed corporations are not precisely the same as those allowed individuals. A comparison of Section 234 of the Revenue Act, which follows, with Section 214, stated in Unit Three, will reveal wherein the deductions allowed corporations differ from the deductions allowed individuals.

In computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:

(1) All the ordinary and necessary expenses paid or incurred during the taxable.year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, and including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity;

(2) All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title;

(3) Taxes paid or accrued within the taxable year except (A) income war profits, and excess profits taxes imposed by the authority of the United States, (B) so much of the income, war-profits and excess-profits taxes imposed by the authority of any foreign country or possession of the United States as is allowed as a credit under section 238, and (C) taxes assessed against local benefits of a kind tending to increase the value of the property assessed. In the case of obligors specified in subdivision (b) of section 221 no deduction for the payment of the tax imposed by this title, or any other tax paid pursuant to the tax-free covenant clause, shall be allowed, nor shall such tax be included in the gross income of the obligee. The deduction allowed by this paragraph shall be allowed in the case of taxes imposed upon a shareholder of a corporation upon his interest as shareholder, which are paid by the corporation without reimbursement from the shareholder, but in such cases no deduction shall be allowed the shareholder for the amount of such taxes. For the purpose of this paragraph, estate, inheritance, legacy, and succession taxes accrue on the due date thereof except as otherwise provided by law of the jurisdiction imposing such taxes;

(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise. No deduction shall be allowed under this paragraph for any loss claimed to have been sustained in any sale or other disposition of shares of stock or securities where it appears that within thirty days before or after the date of such sale or other disposition the taxpayer has acquired (otherwise than by bequest or inheritance) or has entered into a contract or option to acquire substantially identical property, and the property so acquired is held by the taxpayer for any period after such sale or other disposition, unless such claim is made by a dealer in stock or securities and with respect to a transaction made in the ordinary course of its business. If such acquisition or the contract or option to acquire is to the extent of part only of substantially identical property, then only a proportionate part of the loss shall be disallowed. The basis for determining the amount of the deduction for losses sustained shall be the same as is provided in section 204 for determining the gain or loss from the sale or other disposition of property;

(5) Debts ascertained to be worthless and charged off within the taxable year (or in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part;

(6) The amount received as dividends (A) from a domestic corporation other than a corporation entitled to the benefits of section 262, and other than a corporation organized under the China Trade Act, 1922, or (B) from any foreign corporation when it is shown to the satisfaction of the Commissioner that more than 50 per centum of the gross income of such foreign corporation for the three-year period ending with the close of its taxable year preceding the declaration of such dividends (or for such part of such period as the foreign corporation has been in existence) was derived from sources within the United States as determined under section 217;

(7) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence;

(8) In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner with the approval of the Secretary. In the case of leases the deductions allowed by this paragraph shall be equitably apportioned between the lessor and lessee;

(9) In the case of insurance companies (other than life insurance companies), in addition to the above (unless otherwise allowed): (A) The net addition required by law to be made within the taxable year to reserve funds (including in the case of assessment insurance companies the actual deposit of sums with State or Territorial officers pursuant to law as additions to guarantee or reserve funds); and (B) the sums other than dividends paid within the taxable year on policy and annuity contracts. This paragraph shall apply only to mutual insurance companies other than life insurance companies;

(10) In the case of mutual marine insurance companies, there shall be allowed, in addition to the deductions allowed in paragraphs (1) to (9), inclusive, unless otherwise allowed, amounts repaid to policyholders on account of premiums previously paid by them, and interest paid upon such amounts between the ascertainment and the payment thereof;

(11) In the case of mutual insurance companies (including interinsurers and reciprocal underwriters, but not including mutual life or mutual marine insurance companies) requiring their members to make premium deposits to provide for losses and expenses, there shall be allowed, in addition to the deductions allowed in paragraphs (1) to (9), inclusive, unless otherwise allowed, the amount of premium deposits returned to their policyholders and the amount of premium deposits retained for the payment of losses, expenses, and reinsurance reserves.

(b) In the case of a foreign corporation or of a corporation entitled to the benefits of section 262 the deductions allowed in subdivision (a) shall be allowed only if and to the extent that they are connected with income from sources within the United States; and the proper apportionment and allocation of the deductions with respect to sources within and without the United States shall be determined as provided in section 217 under rules and regulations prescribed by the Commissioner with the approval of the Secretary.

(Section 234—1924 Act) An analysis of the deductions allowed corporations reveals that they are entitled to the same deductions as are allowed individuals excepting that corporations are permitted to deduct dividends but are not permitted to deduct charitable or other contributions.

Dividends. In discussing the Law as it applied to individuals, it was explained that individuals may treat dividends received from corporations which are themselves subject to the income tax, as a credit in the computation of the normal tax. Individuals are not permitted to treat dividends as a deduction but as a credit for normal taxes only. This means that individuals must pay a surtax on dividends received. On the other hand, corporations may treat dividends received from other corporations, either domestic or foreign, which are themselves subject to the income tax, as a deduction in the computation of the net income.

Contributions. While individuals are permitted to treat certain contributions or gifts as deductions in the computation of the net income, no such privilege is granted corporations. However, donations made by a corporation in connection with the operation of its business, when limited to charitable institutions, hospitals, or educational institutions conducted for the benefit of its employees or their dependents, are an allowable deduction. Such expenditures are classified as ordinary and necessary business expenses rather than as contributions. Likewise, donations which legitimately represent a consideration for a benefit flowing directly to the corporation as an incident of its business are allowable deductions.

For example, a street railway corporation may donate a sum of money to an organization intending to hold a convention in the city in which it operates, with the reasonable expectation that the holding of such convention will augment its income through a greater number of people using the cars. Donations to a hospital in consideration of an agreement by the hospital that a ward will be provided for the use of the employees of the company has been held as an allowable deduction. Sums of money expended for lobbying purposes, the promotion or defeat of legislation, the exploitation of propaganda, including advertising other than trade advertising, and contributions for political campaign expenses, are not deductible from gross income.

Business Expenses. The individual's income is usually derived from services rendered and, therefore, there are few expenses which he may deduct from his income. On the other hand, the income of corporations is derived chiefly from the operation of a business and, therefore, there are numerous expenses which may be deducted.

In general, all ordinary and necessary business expenses incurred during the taxable period may be deducted. Prepaid expenses should be deferred and treated as a deduction in the year to which they apply. This will include insurance, taxes, interest, advance payments on contracts, etc. Expenses paid in property or stock are deductible the same as if paid in cash. If capital stock is given in payment for services rendered, the fair market value of the stock at the time of delivery can be deducted as an expense. All salaries and wages payable by the corporation are deductible, whether paid in cash, property or stock. Salary and wages in order to be deducted, however, must be entered as an expense on the books of the corporation. In the case of salaries of officers and employees, who are stockholders in the company, the regulations prescribe that they will be given careful scrutiny, and if considered too large, they will be regarded as a distribution of profits instead of an expense.

Pensions paid to retired employees are regarded as a deductible expense.

Gifts to employees are not deductible. Bonuses paid to employees may be deducted when they are made in good faith as additional compensation for services rendered. If made as a gratuity or gift, they cannot be treated as an expense. Souvenirs given to customers are deductible as an advertising expense.

Money spent by salesmen in entertaining customers of the company is held an allowable expense. The distinction between a gratuity and an expense is sometimes hard to make. The general theory is that if an expenditure is made from which no benefit accrues to the corporation, either directly or indirectly, it cannot be treated as a deduction, but if the corporation expects to realize a benefit from an expenditure, it can be treated as a deductible expense. In the case of expenses incurred in making ordinary and incidental repairs to property, a deduction may be made, but if the expenditure results in prolonging the life of the asset or appreciably increasing its value, it is treated as an additional investment and cannot be deducted.

Organization Expenses. The Treasury Department has ruled that organization expenses are a capital expense. They are neither deductible nor subject to depreciation. This, however, is contrary to their treatment by accountants, who regard them as an expense which should be written off against income as soon as possible. All ordinary rental and royalty payments are deductible, as are also expenses incurred in making any improvements demanded by the lease. The cost of the latter, of course, should be prorated over the years during which they are used. If interest or dividends are paid to stockholders in lieu of rent, they may be deducted the same as if rent was paid.

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Taxes. All taxes paid or accrued within the taxable year are deductible except:

Special assessments which are deemed to increase the value of the property to which they pertain.

Federal inheritance taxes. 3. Federal income taxes.

Taxes imposed by states and political subdivisions thereof and by the United States Government, except as mentioned above, are deductible. This includes excise and franchise duties, custom duties, etc.

Bad Debts. A reasonable addition to a Reserve for Bad Debts, at the discretion of the Commissioner, may be deducted in arriving at net income. Under the 1918 Act, only debts ascertained to be worthless and actually charged off within the taxable year might be deducted. This was changed in the 1921 Act which made the same provision with regard to a reserve as is provided in the present Act.

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