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The taxation of dividends presents certain difficulties which do not exist in the taxation of other income. Dividends are paid from the surplus earnings of corporations and as corporations have been continuously taxed on net earnings since the incidence of the federal income tax on March 1, 1913, taxation of the same earnings when distributed to stockholders would result in double taxation if provision were not made for a proper adjustment. Again, earnings distributed since March 1, 1913, out of the surplus accumulated prior to that date are sometimes held to be capital and sometimes taxable income. As surtaxes are not imposed upon corporations Congress has attempted to devise various methods of compelling corporations to declare dividends, or to penalize the corporations which do not make adequate distributions of profits.” Other complications exist which will be discussed hereinafter. The successive federal income tax laws and the decisions of

Dividends are taxable.the Supreme Court of the United States are gradually clearing up disputed points.

Law. Section 213. That for the purposes of this title .... the term “gross income”

(a) Includes gains, profits, and income derived from .... dividends ....

Dividends are relieved from normal tax.-All federal income tax laws have provided that dividends received by in

'But are only held to be taxable when paid prior to January 1, 1916. See page 452.

?See Chapter XXXII, “Tax on Undistributed Profits.”

'In view of many unsettled cases relating to returns going back to 1913 it is deemed necessary to include in this chapter copious references to past regulations and decisions. For full details, however, the reader is referred to Income Tax Procedure, 1918 and 1919 editions,

dividuals are not subject to the normal tax.* In the case of state income taxes the foregoing provision does not necessarily apply because corporations may not pay a state income tax as such. In New York state, corporations pay a 472 per cent tax on net incomes, but it is imposed as a franchise tax. Consequently an individual taxpayer must pay state income tax on the full amount of dividends received with no allowance or credit for the 47/2 per cent already collected on the same net income.

The 1918 law relieves corporations from a tax on dividends received from other corporations which are themselves taxable under the federal income tax law.5

Law. Section 216. [Individuals] That for the purpose of the normal tax only there shall be allowed the following credits:

(a) The amount received as dividends from a corporation which is taxable under this title upon its net income, and amounts received as dividends from a personal service corporation out of earnings or profits upon which income tax has been imposed by Act of Congress;

Section 234. (a) That in computing the net income of a corporation .... there shall be allowed as deductions:

(6) Amounts received as dividends from a corporation which is taxable under this title upon its net income, and amounts received as dividends from a personal service corporation out of earnings or profits upon which income tax has been imposed by Act of Congress;

Dividends on stock of federal reserve banks exempt from both normal and surtaxes.

REGULATION. As section 7 of the Federal Reserve Act of December 23, 1913, provides that federal reserve banks, including the capital stock and surplus therein and the income derived therefrom, shall be exempt from taxation, except taxes upon real estate, such

*Dividends from corporations taxed upon their net income in Porto Rico and the Philippine Islands are not allowed as credits, free of tax, in an individual return and are not allowed as a deduction in arriving at net income in a corporation return. (1918 law, section 261.)

'[Former Procedure] Under the 1909 excise tax law corporations were not subject to tax upon dividends. Under the 1913 and 1916 laws they were taxed. Under the 1917 law they were taxed 2 per cent when out of 1916 or 1917 earnings and I per cent when out of 1913, 1914 or 1915 earnings, and exempt as to the 4 per cent war income tax.

Corporation tax rates were as follows: 1913, 1914, 1915, i per cent; 1916, 2 per cent; 1917, 2 per cent and 4 per cent war income tax.

exemption attaches to and follows the income derived from dividends on stock of federal reserve banks in the hands of the stockholders, so that the dividends received on the stock of federal reserve banks are not subject to the income tax. Dividends paid by member banks, however, are treated like dividends of ordinary corporations. (Art. 76.)

The above regulation calls attention to the fact that this exemption of dividends received by member banks does not extend to dividends paid on the stock of member banks.

Owners of record liable for tax-Exception. Many stocks are owned by others than shareholders of record. In such cases the following regulation is of importance.

REGULATION. Dividends on stock of domestic corporations or resident foreign corporations are prima facie income of the record owner of the stock, and such record owner will be liable for any additional tax based thereon, unless a disclosure of the actual ownership is made to the Commissioner on form 1087 (revised) which shall show that the record owner is not the actual owner and who the owner is and his address. In all cases where the actual owner is a nonresident alien individual and the record owner is a person in the United States, the record owner will be considered for tax purposes to have the receipt, custody, control and disposal of the dividend income and will be required to make return for the actual owner, regardless of the amount of the income, and to pay any surtax found by such return to be due. (Art. 405.)

“Dividend” Defined The statutory definition of the term “dividend” follows:

Law. Section 201. (a) That the term “dividend” when used in this title (except in paragraph (10) of subdivision (a) of section 234)? means (1) any distribution made by a corporation, other than a personal service corporation, to its shareholders or members, whether in cash or in other property or in stock of the corporation, out of its earnings or profits accumulated since February 28, 1913, or (2) any such distribution made by a personal service corporation out of its earnings or profits accumulated since February 28, 1913, and prior to January 1, 1918.

'See also page 235.
'Refers to distributions by insurance companies.

The definition given in the regulations limits the meaning of the term still further :

REGULATION. Dividends for the purpose of the statute comprise any distribution in the ordinary course of business, even though extraordinary in amount, made by a domestic or foreign corporation to its shareholders out of its earnings or profits accumulated since February 28, 1913, and in the case of a personal service corporation prior to January 1, 1918. .... (Art. 1541.)

Distribution must be “in the ordinary course of business.” -It should be noted particularly that the regulation just quoted insists that the distribution shall have been made "in the ordinary course of business.” The phrase evidently is meant to distinguish such dividends from liquidation dividends which the law holds are subject to the normal tax.S

What constitutes a distribution ?

REGULATIONS. .... The mere declaration of a dividend is not a distribution. Dividends are income and are taxed at the rates for the year in which paid, regardless of when the earnings or profits out of which they were paid were accumulated..... (Art. 1541.)

.... Dividends (other than stock dividends declared before November 1, 1918, and received before March 27, 1919) are taxed at the rates for the year in which paid. .... (Art. 31.)

... Dividends on corporate stock are subject to tax when set apart for the stockholder, although not yet collected by him. .... (Art. 54.)

The last regulation cited above illustrates what is meant by constructive receipt. Very few stockholders have available or trustworthy information as to when dividends are declared. Their records show only the receipts of dividends.

In view of the definite statements in articles 31 and 1541 taxpayers should assume that the date of the receipt of a dividend is the date as of which it should be reported.

May a dividend be rescinded by directors or returned by stockholders?—It sometimes happens that a dividend is de

See page 472.
"See page 264.

clared on the strength of book or paper profits and subsequently it becomes necessary or desirable to reverse the action and arrange to secure a return of the funds paid out or credited to the accounts of stockholders.

If a single stockholder objects to the rescinding proposition after the formal declaration of a dividend is communicated to him or after the dividend has been credited, no legal remedy is available to compel action on his part. If, however, in fact the dividend has been paid out of capital, the so-called dividend is not taxable at all to the stockholders and the directors may be required to reimburse the corporation to the extent to which the dividend was illegal.10

But if every stockholder consents to a rescission the case is entirely different. If directors pay a dividend which proves to be unwise, or excessive or illegal, and every stockholder agrees to return the amounts paid or credited, it may be expected that no court will hold that the payments represent income when received and capital payments when refunded, even though the dividends were paid or credited during one taxable year and the refunds occurred during the next year.

If the entire transaction occurred during the same taxable year it would not even appear in the returns or accounts of the taxpayer. In effect it would be a transaction marked "void.” Therefore, when one part of the transaction occurs very late in one taxable year and the other part in the next taxable year a taxpayer should not be penalized thereby. The following summary of the law governing dividend declarations may be of interest.

If a dividend has been declared by a vote of the directors payable at a future time, the vote declaring it may be rescinded at a subsequent meeting of the directors, held before the dividend becomes payable, and before the fact that it has been declared has been made public, or communicated to the stockholders or any fund set aside for its payment. [7 R. C. L. 260; Ford v. Easthampton Rubber, etc., Co., 158 Mass. 84 (January, 1893).]

10 Auditing, Theory and Practice (2nd edition), by R. H. Montgomery, pages 751-758.

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