of the taxable income of an individual who was a citizen or resident of the United States. These rates stood only until January 1, 1919, when the normal rate applying to taxable income of individuals. became 8 per cent (4 per cent on the first $4,000) and the corporation tax rate dropped from 12 to 10 per cent. Thus there reappeared a discrimination of 2 per cent in the rate against corporate incomes similar to that which obtained in the year 1917.

Surtaxes on individual incomes ranged from 1 to 65 per cent, the highest rate applying to portions of income exceeding $1,000,000. The maximum total rate in 1918 was, consequently, 77 per cent, ten points higher than that which obtained in 1917, and the higher normal rate 31 and the steeper progression made the tax much heavier upon moderate incomes than the previous one.32 The maximum total rate applied to 1919 and 1920 incomes was 73 per cent.

The 1918 law, while sufficiently complicated, was nevertheless more simple and equitable than its predecessor. One set of rates and of personal exemptions replaced the double set in force in 1917, and many of the limitations and restrictions which, since the beginning, had hedged about the various deductions and caused endless confusion and complication, were removed. Under the 1918 law the provision permitting an individual to deduct losses not incurred in trade was liberalized. For the first time the individual was required to report upon the basis of his annual accounting period, even though that period did not coincide with the calendar year. Affiliated corporations were required to file consolidated returns.33 Depreciation allowances were made more liberal. Depletion in the cases of mines and gas and oil wells was placed upon a very generous basis, with a special and rather artificial method provided for establishing "discovery value" in the case of properties owned by prospectors and "wild-catters." Special provision was made for charging off reasonable amortization on equipment which contributed to the prosecution of the war. Corporations for the first time were relieved of the arbitrary limitation on deductible interest, which had been in force in some form since 1909, and of the discriminatory tax on dividends received from other corporations. Income and excess profits taxes paid to other jurisdictions upon income.

In the case of earned incomes, the normal rate of 12 per cent was actually no higher for individuals than in 1917, because of the application in that year of the 8 per cent excess profits tax to professions and occupations in addition to the normal income tax of 4 per cent.

For a detailed table of rates, see Chapter IX. 33 Section 240.

arising therein were, under certain conditions, allowed as credits against the tax. A specific credit of $2,000 was granted corporations. The rule allocating dividends to the year earned, established in the 1917 law, was abandoned.34

The 1918 law introduced an innovation by putting in the same category with partnerships certain corporations whose income was "to be ascribed primarily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or borrowed) is not a material income-producing factor" (section 200). At the end of the taxable year the undistributed net income of each of these "personal-service corporations" was assigned for taxation to the stockholders in proportion to their holdings. They were relieved of the special profits taxes, which otherwise would have attached because of the corporate form of the enterprise. This class of personal service corporations was abolished by the 1921 law, effective January 1, 1922.

THE 1921 LAW.-Due to the insistence of business men that the taxes levied by the 1918 law were unduly burdensome and were not well fitted to post-war conditions, both political parties during the presidential campaign of 1920 committed themselves to a revision of federal taxation. The Revenue Act of 1921, approved November 23 of that year, was the result of the pledge of the Republican Party. In spite of numerous and fundamental changes, it is fair to describe the 1921 law as essentially a rewritten draft of the Revenue Act of 1918.

The effective date of the 1921 law was, for most purposes, January 1, 1921. It remained in force three years, until December 31, 1923, although a retroactive section of the 1924 law reduced the rates on 1923 income 25 per cent. Many of the most radical changes, however, did not come into force until January 1, 1922. These include the abolition of the excess profits tax and the personal service corporation, the increase of the corporation tax rate, and the establishment of the new class of "capital gains and losses."

In spite of what many considered to be a definite pledge, and due largely to the influence of the "agricultural bloc," Congress declined to repeal the profits tax for 1921 but did abolish it thereafter. With it disappeared the personal service corporation, which was, of course, a mere incident of profits taxation, devised to ex

clude corporations of a particular type from the application of such taxes. Coincident with the elimination of the excess profits tax, the income tax rate on corporations was raised from 10 to 121⁄2 per cent. The change in the rate caused corporations which made only moderate profits, to pay higher taxes, but the total tax burden on corporate income was considerably lessened thereby.

At the same time that these changes in the corporation income taxes were made, the surtax rates on individual incomes were reduced. It will be noted that the change affected small taxpayers as well as large ones. The maximum rate was reduced to 50 per cent, as compared with the maximum rate of 65 per cent under the 1918 law. Surtaxes were made to begin at $6,000 instead of $5,000 and to mount by less rapid steps.

The most revolutionary change in the 1921 law was the establishment of the new division of income known as "capital gains." Beginning January 1, 1922, profits made by individuals from sales or exchanges of property "held for profit or investment" for at least two years, were made subject to a maximum rate of 121⁄2 per cent instead of the regular normal and surtax rates.35 The reason for the adoption of some such provision as this is plain, whatever one may think of this particular method of meeting the situation. As everyone knows, many sales of property which had greatly increased in value since the date of purchase or March 1, 1913, had been postponed or entirely blocked by the unwillingness of prospective sellers to take profits which would immediately become subject to heavy surtaxes in the year of realization. The solution adopted was to wipe out almost entirely the offensive surtaxes on profits from this class of transactions.

In general, it is now clear that this provision has not only complicated the procedure and discriminated against earned income instead of in favor of it, but it has also operated to give an essentially unfair advantage to those who were able to work out plans of waiving interest and dividends and substituting therefor non-interest-bearing and other forms of securities wherein the increment in value falls within the statutory definition of capital gain.

The advantage to the investor in property conferred by the "capital gain" section was greatly accentuated by the provisions of the section prescribing the calculation of gain or loss 36 which

35

1921 law, section 206. This was hedged about by several restrictions. See Chapter XXVI.

36 Section 202.

became effective as of January 1, 1921. Not only did this section adopt the so-called Frierson rule (which, in the case of property purchased before March 1, 1913, stated that a profit or loss must be shown when comparison is made with original cost and be limited to the portion thereof which accrued after March 1, 1913), but it also liberalized the definition of the closed transaction. The law stated positively that no gain or loss on exchanges of property for property should be recognized unless the property received in the trade had "a readily realizable market value," and even though it had a readily realizable market value, the gain need not be accounted for at the time of exchange in certain specified cases. This is one such case as it stood in the 1921 law when originally passed: When any such property held for investment or for productive use in trade or business (not including stock-in-trade or other property held primarily for sale), is exchanged for property of a like kind or use. The operation of this section was so unsatisfactory that amendments were passed in 1923 effective as of January 1 of that year, eliminating securities from the property falling within the scope of the provision.37 Other exceptions, covering cases of corporate reorganizations and sales of property to corporations, made it unnecessary to report many gains which had theretofore been subject to tax at the time the transaction was made.

The 1921 law took an important forward step when it broke away from the practice of refusing to permit a business loss in one accounting period to offset income of another. Section 204 (effective January 1, 1921) permitted, within certain restrictions, a net loss from business suffered in one year to be offset against any net. income realized in the two next succeeding years. In other words, such losses could be used to offset subsequent gains, but losses were "outlawed" for this purpose after the expiration of two years. This change went far toward rendering unnecessary any averaging device such as has been often urged as a means of making the income tax more equitable. The Commissioner was also authorized to transfer a loss from the year in which sustained to a different period if, in his opinion, net income is thus more clearly reflected.38

In addition to the reduced surtax rates, effective in 1922, the personal exemptions were made more liberal, the changes affecting the 1921 returns. In the case of a married person or a head of a See Chapter XXIII.

Section 214 (a-6) and section 234 (a-4); see Chapter XXXVIII for discussion.

family whose income did not exceed $5,000, the exemption was increased from $2,000 to $2,500.39 The allowance for each dependent was raised from $200 to $400. A new provision was inserted regarding gifts, which required the recipient, when he disposed of the gift, to account for the gain in the value of the gift in the hands of the donor before he parted with it, together with any subsequent appreciation in value. Another provision aimed to prevent "wash sales" to establish losses. Also, the law at last recognized additions to reserves for bad debts as proper deductions. The Liberty bond exemptions were consolidated and simplified appreciably by another section. Affiliated corporations were given the option after January 1, 1922, of filing separate or consolidated returns. A clause was also inserted validating the requirement of consolidated returns (including even partnerships) under the 1917 law.

A Tax Simplification Board has been set up under the 1921 law to investigate the procedure of the Bureau of Internal Revenue and to make recommendations for its simplification.40

Congress, finally convinced that the Treasury should not be allowed to withhold taxes overpaid, without granting compensation for the delay, directed the Treasury to pay interest on taxes refunded. The importance of this provision may be gauged from the fact that the Treasury paid in such interest during the fiscal year 1923 no less than $3,856,124.32.

Other changes in the law included a limitation of time for the filing of amortization claims; a requirement that returns be filed in all cases where an individual's gross income exceeded $5,000; a limitation on the deduction of interest paid to carry Liberty bonds; permission to deduct business traveling expenses in full; and a change in the limitation periods for additional assessments and suits. Finally there were important changes in administrative features, such as the sections permitting binding agreements between the Treasury and the taxpayer to prevent the subsequent reopening of cases, changing the procedure with reference to appeals, and authorizing the Treasury to defer collection in cases of undue hardship.

The following three amendments were approved by the President, March 4, 1923; first an act amending section 202 (c) so as

39

For a full statement, see 1921 law, section 216 (c).

40 This board ceases to exist December 31, 1924.