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INCOME FROM THE APPRECIATION OF
It is hardly accurate to state without reservation that unrealized appreciation is not taxable under an income tax law but that realized appreciation is taxable. The law purports to tax "net income,” but, in the absence of a comprehensive definition of net income in the law, it is not easy to determine when appreciation was intended by the lawmakers to be taxed and when not. Moreover, even though their intentions were clearly enough expressed in the law, the Supreme Court might hold that unrealized appreciation may never be taxed as income. In fact it is not certain that the Supreme Court will hold that all realized appreciation, even if accrued since March 1, 1913, is taxable income.
One of the statements in the new regulations can hardly be improved upon as an expression of an equitable basis of taxation. “Both a change in substance, and not merely in form, and a change into the equivalent of cash are required to complete or close a transaction from which income may be realized.” (Art. 1563, see page 388.) This is the principle upon which the author has based his rather extended arguments in former editions of Income Tax Procedure.
In many reorganizations, recapitalizations, mergers and exchanges of property or securities for other property and securities there is no change in substance. The changes are largely "paper" changes in which the United States courts have expressed an unwillingness to find taxable income. In other cases, where there are substantial changes in interests and capitalizations, the transactions constitute changes in substance as well as in form. A full discussion of sales will be found in Chapter XV.
Is Appreciation in Value of Property Income?
Before proceeding to a discussion of the taxability of appreciation under an income tax law, it is desirable to point out some of the difficulties which surround the determination of taxable income itself. It will never be a simple matter to decide off-hand that a certain gain is taxable but that another gain is not taxable—that one item of cash receipts is taxable but that another item is not taxable. If it is difficult for individual taxpayers to decide one or two points, how almost impossible must it be for lawmakers to enact a law which will control tens of thousands of cases all unlike.
Law. Section 212. (a) That in the case of an individual the term “net income” means the gross income as defined in section 213, less the deductions allowed by section 214.
We then find that section 213 (a) states that:
(a) Includes gains, profits, and income derived from .... businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property;
It is obvious that nothing taxable is left untaxed, and it is equally obvious that the words "gains, profits and income" might be construed by a zealous tax collector to include unrealized as well as realized gains. But the Supreme Court and our lower courts have been reluctant to define anything as income unless it bears all (not part only) of the evidences of true income.
In the Maryland Casualty Co. case the court said:
Decision. . . . . the courts have not departed, unless it expressly appears otherwise, from a construction of the law in accord with an intention to reach the actual and not the potential income of the corporation. .... One cannot be said to receive an income of defined proportions until he balances receipts and deductions at the end of a stated period and ascertains not what is due but what has been actually received.
Maryland Casualty Co. v. U. S. Court of Claims, No. 33191, decided February 12, 1917.
In a notable article published recently? Professor Edwin R. A. Seligman discusses the economic theory underlying the distinction between capital and income and reaches the conclusion that to qualify as income a gain must be both realized and separated. “Realization and separation," he contends, "constitute the true criterion of income.”
It may not be possible to make a general rule which will enable us to determine when we can be charged with actual profits or income and when what we have is potential only. It is, however, fairly safe to say that when there is a real doubt as to whether a gain or profit has been actually realized such doubt will be resolved by the courts in favor of the taxpayer.
There are wide variations in theory and practice among economists, financiers and legislators as to the proper meaning of the term "income.” Particularly with reference to appreciations in the value of property are there differences of opinion. Some contend that appreciation is true income and others deny it. Concerning the realization of increases in the value of property in the form of stock-in-trade of a business enterprise there is little dispute; but, granting that such increases are income, many contend that the situation is entirely different in the case of increments of value accruing to pieces of property which are not a part of one's stock-in-trade, such, for example, as securities acquired by gift or purchase and held primarily as investments. Appreciations in the value of property of this type, many contend, are not items of income in any real sense and they cite the practice in England and Germany as precedents for excluding them from taxable income. Some even predict that the United States Supreme Court, when it comes face to face with this question, will draw a distinction between property purchased to be resold at a profit and property purchased primarily as an investment and will decline to include in the definition of income the ap
2" Are Stock Dividends Income?” American Economic Review, September, 1919.
preciation in the value of property of the latter class. The average person, however, considers the profit realized from the sale of property in excess of its cost to be income and does not object to assessment of the profit for income tax purposes. To tax it does no violence to accounting principles, provided care is taken to levy the tax only when there has been a definite realization.
There are, however, many who concede that capital profits should be taxed but do not think that the entire gain should be taxed in the year of realization. Others think that a lower rate of tax should be imposed than on other profits or income. It is urged by some that in very few cases do capital profits accrue within the taxable years in which realized.
The sale of property in 1919 at a large profit renders the seller liable to tax on the entire profit above cost or value March 1, 1913, at the high rates in force in 1919.
The Investment Bankers Association and others advocate a limited tax on capital profits. Others suggest that the profit be prorated over the years elapsed since purchase or since March 1, 1913. In the latter case there might not be much saving in tax if a property purchased in 1917 were sold in 1920, as the aggregate of the prorated tax of the three years might be as great as the 1920 tax.
In most cases, however, the prorating method would result in decreased revenue to the government. Corporation profits from 1915 to 1920 have been larger than during 1913, 1914 and 1915. In the case of the sale of corporation property or capital stocks the plan which would yield the largest revenue to the government would be to apportion the realized profit on the basis of the net income of the corporation during the years 1913 to 1920. It might fairly be assumed that the appreciation in value finally realized would closely approximate the aggregate earnings of the corporation. In the case of other property of individuals the prorating method might be equitable.
Another plan to avoid taxation in one year of appreciation which has been accruing with some regularity over a period of years would be to extend to taxpayers the privilege of reporting annually increases in values which are not realized but are so nearly realizable that a taxpayer is willing to take chances on subsequent decreases in values. Joined with the right to take credit as allowable deductions for losses, the plan might work out more equitably than the present system. In effect it would simply be the extension of the inventory system to such property as securities, real estate and similar assets owned by investors or carried as capital investments by business concerns.
If the plan were made optional with taxpayers they could not raise the objection that property rather than realized income or profits was being taxed. The practicability of this plan is open to serious question.
As explained in Chapter XIII, it is not a simple matter to draw a strictly logical line of division between profits from dealings in property and profits from business. The solution here adopted is to discuss in this chapter merely the subject of profits from appreciation in the value of property which is of the nature of fixed assets or of investments entered into as more or less isolated transactions. Appreciations in the value of property which is ordinarily considered stock-intrade, as well as all the miscellaneous items connected with income from business and dealings in property, are considered in the chapter which precedes this.
Definition of income under early United States law.—The income tax law of 18674 defined income as “gains, profits, and income .... whether derived from any kind of property rents, interest, dividends or salaries, or from any profession, trade, employment .... or from any other source whatever.” In the famous case of Gray v. Darlington, Justice Field of the Supreme Court of the United States gave the following as the court's interpretation of this law:
See page 290. '14 St. at L. 471. '15 Wall 63.