Until the earnings of corporations have been distributed without undue delay as dividends and, consequently, have become subject to the surtax rates in the hands of the individual stockholders, the demands of the law have not been fully met.1

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1 [Former Procedure] The 1913, 1916 and 1918 laws attempted to solve this problem by providing for a tax on the individual shareholder, equal to that which would have been payable had the earnings been distributed. It is rumored that such taxes were imposed in a few cases, but the author has not been able to learn the details of a single case. The 1917 law provided for an additional flat rate on corporations found guilty of the practice. This provision also appears to have been inoperative. The 1921 law utilized both methods. For a full discussion of the earlier laws see Income Tax Procedure, 1919, pages 617624; 1920, pages 963-974; and 1922, pages 1259–1260. The 1921 law was as follows:

LAW. Section 220. That if any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its stockholders or members through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 25 per centum of the amount thereof. which shall be in addition to the tax imposed by section 230 of this title and shall be computed, collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax: Provided, That if all the stockholders or members of such corporation agree thereto, the Commissioner may, in lieu of all income, war-profits and excess-profits taxes imposed upon the corporation for the taxable year, tax the stockholders or members of such corporation upon their distributive shares in the net income of the corporation for the taxable year in the same manner as provided in subdivision (a) of section 218 in the case of members of a partnership. The fact that any corporation is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax; but the fact that the gains and profits are in any case permitted to accumulate and become surplus shall not be construed as evidence of a purpose to escape the tax in such case unless the Commissioner certifies that in his opinion such accumulation is unreasonable for the purposes of the business. When re

The 1924 law contains the section quoted below designed to prevent the use of the corporate form to evade the purpose of the law.

LAW. Section 220. (a) If any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof, which shall be in addition to the tax imposed by section 230 of this title and shall (except as provided in subdivision (d) of this section) be computed, collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax.

(b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax.

(c) When requested by the Commissioner, or any collector, every corporation shall forward to him a correct statement of such gains and profits and the names and addresses of the individuals or shareholders who would be entitled to the same if divided or distributed, and of the amounts that would be payable to each.

(d) As used in this section the term "net income" means the net income as defined in section 232, increased by the sum of the amount of the deduction allowed under paragraph (6) of subdivision (a) of section 234, and the amount of the interest on obligations of the United States issued after September 1, 1917, which would be subject to tax in whole or in part in the hands of an individual owner.

Accumulation of earnings to be taxable must be with purpose of evasion.-The futility of the enforcement of section 220 of the 1921 and all former laws is acknowledged by the Treasury. Mr. A. W. Gregg, special assistant to the Secretary of the Treasury, made the following statement in explanation of the latest (probably not the last) effort to force the declaration of dividends:

This section [220] of the Revenue Act of 1921 imposes upon a corporation formed or availed of for the purpose of preventing the imposition of the surtax upon its stockholders by failing to distribute its gains and profits, a tax of 25 per cent of its net income. This section is ineffective in the case of the holding company which fails to distribute its gains and profits, since its net income consists entirely of dividends from the corporation, the stock of which it owns, which under the law do not form a part of the net income of the holding company. Subdivision (d) of the present draft corrects this error and also provides that in computing the net income of such a corporation quested by the Commissioner, or any collector, every corporation shall forward to him a correct statement of such gains and profits and the names and addresses of the individuals or shareholders who would be entitled to the same if divided or distributed, and of the amounts that would be payable to each.

for the purpose of this section the amount of interest on Liberty Bonds must be included if the interest on such bonds would be subject to tax in the hands of an individual owner. Under the present law such interest is not included in computing the net income of the corporation, since Liberty Bonds (except the 31⁄2 per cent issue) are not taxed to a corporation, although subject to surtax in the hands of an individual

owner.

Section 220 of the existing law also provides that the fact that any corporation is a mere holding company shall be prima facie evidence of purpose to escape a surtax. The Department has been unable to apply the section to the case of pure investment companies which reinvest their entire net income. The present draft therefore makes the fact that any corporation is a mere "holding or investment company" prima facie evidence of the purpose to escape the surtax.

As enacted, the 1924 law increases the rate in the 1921 law from 25 to 50 per cent, changes "mere holding company" to "mere holding or investment company," and cuts out the election of shareholders to be taxed as members of a partnership as well as the provision necessitating certification by the Commissioner that in his opinion the accumulation is unreasonable. The 1924 law also embodies the Treasury suggestion that dividends and certain interest be added to statutory net income for the purpose of the section.

REGULATIONS. Section 220 of the statute is designed to discourage the formation or use of a corporation for the purpose of preventing the imposition of surtaxes upon its shareholders through the device of permitting its gains and profits to accumulate instead of being distributed. If a domestic or foreign corporation is so formed or availed of after January 1, 1924, it is subject to a tax at the rate of 50 per cent upon its net income in addition to the tax imposed by section 230 of the statute. (Art. 351.)

An accumulation of gains and profits is unreasonable if it is not required for the purposes of the business, considering all the circumstances of the case. It is not intended, however, to penalize reasonable accumulations of surplus for the needs of the business. No attempt can be made to enumerate all the ways in which gains and profits of a corporation may be accumulated for the reasonable needs of the business. Distributions made by a corporation shortly after the close of its taxable year shall be taken into consideration in determining the reasonableness of the amount of earnings and profits of the corporation retained by it for the year in question. Undistributed income is properly accumulated if invested in increased inventories or additions to plant reasonably needed by the business. It is properly accumulated if retained for working capital required by the business or in accordance with contract obligations placed to the credit of a sinking fund for the purpose of retiring bonds issued by the corporation. In the case of a banking institution the business of which is to receive and loan money, using

2 [Former Procedure] If surplus funds were invested entirely in stocks or in securities which were free from the normal tax (which includes all Liberty bonds), there was no "net income" for the years 1922 and 1923 on which the 25 per cent tax would be imposed.

capital, surplus, and deposits for that purpose, undistributed income actually represented by loans or reasonably retained for future loans is not accumulated beyond the reasonable needs of the business. The nature of the investment of gains and profits is immaterial if they are not in fact needed in the business. It is an unreasonable accumulation of gains and profits by corporations, after the effective date of this Act, with the purpose of enabling their shareholders to escape surtaxes on such gains and profits, which subjects such corporations to the additional tax imposed by section 220. The financial condition of the corporation at the close of the taxable year in question, the manner in which its funds are invested at that date, determines the reasonableness of the accumulations.

For the purpose of section 220 the term "net income" means the net income of the corporation as defined in section 232 increased by the sum of (1) the amounts received as dividends and allowed as a deduction by section 234 (a) (6), plus (2) the amount of interest on obligations of the United States issued after September 1. 1917, which would be subject to tax in whole or in part in the hands of an individual owner. The Commissioner or any collector may require any corporation to furnish a statement of its gains and profits, the names and addresses of and number of shares held by each of its shareholders, and the amounts that would be payable to each, if the income of the corporation were distributed. (Art. 353.)

Prima facie evidence of a purpose to escape the surtax exists where a corporation is a mere investment company, where a corporation has practically no business except holding stocks, securities or other property and collecting the income therefrom or investing therein, or where a corporation other than a mere holding or investment company permits its gains and profits to accumulate beyond the reasonable needs of the business. The statutory presumption that a mere holding or investment company is subject to the additional tax imposed by section 220 may be overcome if the corporation can show, either by reason of the fact that it distributed a large portion of its earnings for the year in question, or that its stock was held not by the members of a family or of a small group but by a large number of persons and in comparatively small blocks, or by other evidence, that it was not availed of for the purpose of preventing the imposition of the surtax upon its stockholders.

The business of a corporation is not merely that which it has previously carried on, but includes in general any line of business which it may legitimately undertake. However, a radical change of business when a considerable surplus has been accumulated may afford evidence of a purpose to escape the surtax. When one corporation owns the stock of another corporation in the same or a related line of business and in effect operates the other corporation, the business of the latter may be considered in substance the business of the first corporation. Gains and profits of the first corporation put into the second through the purchase of stock or otherwise may therefore, if a subsidiary relationship is established, constitute employment of the income in its own business. To establish that the business of one corporation can be regarded as including the business of another it is ordinarily essential that the first corporation own substantially all of the stock of the second. Investment by a corporation of its income in stock and

securities of another corporation is not without anything further to be regarded as employment of the income in its business. (Art. 352.)

The pursuit of the reluctant dividend by the Treasury is almost pathetic. One would almost hope that its latest effort be more. fruitful (in the way of increased taxes) than its more or less continuous though hopeless efforts since 1913.

The foregoing articles are mere paraphrases of the law except that it is made clear that the 1924 changes such as the 50 per cent rate are not retroactive. Prior to 1924 the burden of proof was on the Commissioner. The new law attempts to shift the burden to the taxpayers.

Article 353 provides that the additional tax accrues on the “unreasonable accumulation of gains . . . . after the effective date of this Act." As the effective date was June 2, 1924, there evidently is serious question as to what happens to prior accumulations.

The regulations make it clear that distributions of dividends need not be made when the needs of the business would make it inadvisable. Article 352 refers to corporations in which stock is held in comparatively small blocks or by a large number of persons, it being obvious in such cases the holders are not evading the imposition of heavy surtaxes.

Even when a corporation is owned by one person or a few persons there is no evident intention to curtail legitimate expansion. In the case of a trading or manufacturing corporation the right to expand seems limitless. Perhaps the Ford Motor Company affords the best illustration of the use in the business of accumulated earnings. Mention is also made in article 352 of the use of the earnings of holding companies in financing the needs of subsidiary or affiliated corporations.

A corporation could pay off all its debts, add to its plant and inventories, maintain a reserve for further plant extensions, expand

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[Former Procedure] Although Title II of the 1921 law was generally effective as of January 1, 1921, section 220 being a penalty section became, in the opinion of good authorities, effective on November 23, 1921, and did not affect surplus or earnings accumulated prior to that date. Penalty sections, unlike others, never take effect retroactively. [The Treasury held, however, that section 220 became effective January 1, 1921. (C. B. II-1, page 139; I. T. 1572.)] If prior to November 23, 1921, surplus was available and was not distributed, the penalties for failure to distribute were found in the abortive provision of the 1918 law. It can hardly be held that the 1921 law had any retroactive effect. Penalty sections cannot be enforced until after due notice has been given.