connection with the beneficiaries, in the carrying on of any business, are not associations within the meaning of the law. The trust and the beneficiaries thereof will be subject to tax as provided in articles 341-347. Operating trusts, whether or not of the Massachusetts type, in which the trustees are not restricted to the mere collection of funds and their payments to the beneficiaries, but are associated together in much the same manner as directors in a corporation for the purpose of carrying on some business enterprise, are to be deemed associations within the meaning of the Act, regardless of the control exercised by the beneficiaries. (Art. 1504.)

The Supreme Court based its opinion largely upon the definition of "domestic" as applied to corporations under the 1918 act which "means created or organized in the United States." The court held that organization under statute law was not necessary and that bodies having quasi-corporate organizations came within the class of associations if they were doing business. This reasoning will also hold under the 1921 and 1924 acts. The question of control by the beneficiaries was not considered by the court as conclusive.

Based upon this decision the Treasury has divided trusts into two classes (1) holding trusts, which merely collect and distribute income, and (2) operating trusts, which carry on business in an organized capacity. This classification applies to all trusts whether or not of the Massachusetts type.50

LIMITED PARTNERSHIPS.-Certain types of limited partnerships are taxed as corporations. See pages 38, 39.

"Personal Service Corporations" Under the Revenue Act

In order to relieve certain types of corporations from the excess profits tax, a special class of "personal service corporations" was established by the 1918 law and defined therein as follows:

LAW. Section 200. . . . (5) The term "personal service corporation" means a corporation whose income is 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; but does not include any foreign corporation, nor any corporation 50 per centum or more of whose gross income consists either (1) of gains, profits, or income derived from trading as a principal, or (2) of gains, profits, commissions, or other income, derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive.

50 An instructive article on the subject of Massachusetts trusts, by William W. Cook, will be found in Jour. Am. Bar Assn., December, 1923, page 763.

Corporations falling within this class were treated as partnerships, the stockholders being taxed on their distributive shares and the corporations as such being relieved of all taxes.

The personal service corporation, being essentially a creature of the excess profits tax, disappeared with the repeal of the tax as of December 31, 1921.

The Treasury, interpreting the law in a manner which, in the opinion of the author, is contrary to the intention of Congress, has denied to many corporations of the personal service type their proper classification. Relief under section 210 of the 1917 law and sections 327 and 328 of the 1918 law has been extended to them, but this is a poor substitute. Until the United States Supreme Court itself interprets the law, taxpayers should protect their rights. In 1922 a decision 51 was handed down which was distinctly in favor of the ordinary personal service corporation.

During the year the Treasury has held 52 that overassessments due to stockholders of personal service corporations cannot be used to reduce the additional tax assessed against the corporation. The ruling is ambiguous in that there can be no tax assessed against a personal service corporation. It apparently refers to the situation arising out of the Treasury's erroneous interpretation of the law in denying personal service classification to corporations entitled, in the author's opinion, to such classification. In some cases assessments were made against the corporations at a time when the individual stockholders were by lapse of time debarred from filing claims for the refund of taxes on the distributive shares of net income which they had reported in their personal returns. The author has repeatedly advised individual stockholders to file claims. for refund in any case where the status of the corporation has been called in question. Those stockholders who have not yet done so

51

[Former Procedure] The United States District Court for the Southern District of New York, in a decision handed down March 10, 1922, in the case of Martin v. Edwards (293 Fed. 258; C. B. I-1, page 8; Ct. D, 25), held "that the plaintiff had more than a nominal capital and had a substantial invested capital which was employed in making advances to or on account of the mines, and also in buying merchandise on its own account for profitable sale." The plaintiff's income from profits from buying and selling and from interest were greater than its commission from selling for account of others, The court made this significant remark: "If it had limited itself to buying and selling on commission, with a small incidental trading on its own account, the plaintiff's contention would be good."

This case dealt with nominal capital under the 1917 law, but its principles are applicable to personal service corporations.

C. B. III-1, page 346; I. T. 1993.

should file claims for such years as are not yet barred by the statute of limitations.

The Board of Tax Appeals has recently handed down its first decision dealing with personal service corporations.53 It is not surprising that the Commissioner's action in the case was reversed.

All the stock of a corporation which operated a commercial school was held by the principal and secretary and their wives. It was admitted by the revenue agent who examined the returns that "The school is conducted wholly on a personal service basis as the principal part of the net income is due to the services, ability, reputation and standing of the principals."

The school had about 30 subordinate teachers. The Board said: "The fact that many teachers are employed to give instruction, while it shows that the income is not attributable solely to the activities of stockholders, does not prove that the stockholders are not the primary source of income."

The corporation had about $75,000 of capital, exclusive of its liabilities. The Board said: "But it is not the existence of capital which is determinative. If it were so, the statute would be fruitless. For all business corporations have capital. It is only when capital is important in the production of income that the definition does not apply."

Referring to the principal stockholders, the Board said: "It is apparent that these men were absolutely essential to the success of the enterprise-so much so that their refusal to agree to continue to manage the school on salaries killed an offer for its purchase."

In view of the above decision, the Treasury should recall S. R. 55 54, which arrives at an opposite conclusion on a somewhat similar state of facts.

Those who are interested in the procedure which governed personal service corporations during the time the law was in force are referred to Income Tax Procedure, 1922, pages 813-841.

Section 1332 of the 1921 law which provided an alternative method of taxing personal service corporations in the event that the method provided in the 1918 and 1921 laws be held invalid was not repealed by the 1924 law and is therefore still in effect.

63

Appeal of Byrant and Stratton Commercial School, Inc., 1 B. T. A., 32. Another decision allowing personal service classification was rendered in Appeal of Dalton Gymnasium and Swimming School, 1 B. T. A., No. 31. Classification was denied in Appeal of Scheffler Hair Colorine Co., 1 B. T. A., No. 38, and in Appeal of Office of Winthrop Ames Inc., 1 B. T. A., No. 39.

54III-41-1818; S. R. 55.

Exemptions under the income tax are granted for constitutional reasons, in order to avoid double taxation, for reasons of public welfare, to assist certain kinds of enterprises, or to encourage certain forms of investment.

Exempt Income In General

Exempt income may be conveniently divided into four classes: 1. Income which is exempt from all taxes imposed by the 1924 revenue act because it is received by certain types of corporations or by states or by the political subdivisions thereof. This class of exemptions is dealt with in this chapter.

2. Income which is exempt because, geographically, it lies beyond the scope and application of the law. (See Chapter XVII.)

3. Income such as is not included in either of the above classes, which is exempt from both normal tax and surtaxes. Such items are not included in gross income. (See Chapter XVII.)

4. Income such as is not included in any of the above classes, which is exempt from normal tax but is subject to surtax. (See Chapter XVII.)

The first class may be called an "exemption of the person," while the other three are "exemptions of the income."

No individual1 is entirely exempt from the tax merely because of his status or character as an individual unless one construes the personal exemption as an exception to this statement. That exemption, of course, operates to relieve entirely from taxation the person whose income is smaller than the specified amounts.

If one should receive all his income from interest upon the obligations of a state or of a political subdivision thereof, or upon certain of the obligations of the United States or its possessions or from securities issued under the provisions of the Federal Farm Loan Act of July 17, 1916, he would be subject to no income tax and would not be required to make any return, however large that income might be. He might receive and enjoy his income as if the tax did not exist. This is true even though, in addition, he receives taxable income of any amount less than $1,000 (single person) during the year. If he receives more than $1,000 of such additional taxable income, he proceeds in the same manner as any other taxpayer.

Taxpayers who receive dividends on the stock of most domestic and certain foreign corporations, or who receive interest on certain. government securities, are exempt from the normal taxes on such income but are nevertheless required to report such items annually if their total net income is large enough to justify them in making any return at all, or if their gross income exceeds $5,000.

Exempt Corporations

Certain corporations are expressly exempt from the provisions of the law.2

Types of corporations exempt.-The law groups the corporations which are expressly exempt under thirteen heads:

LAW. Section 231. That the following organizations shall be exempt from taxation under this title

1 This statement includes minors. See Chapter V.

2

In Commercial Health & Accident Co. v. Pickering, Collector (281 Fed. 539, January 3, 1922), the court held that the principle of construing taxing acts in favor of the taxpayer and against the government, does not apply to a claim for exemption from taxation. In such a case the exempting section must be strictly construed.