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poration is subject to the graduated excess profits tax rates, but it can apply for relief under the appropriate sections of the 1918 law.33

“Trading" corporations cannot qualify as personal service corporations.—When 50 per cent of the gross income of a corporation consists of "gains, profits or income derived from trading as a principal” such corporation cannot qualify as a personal service corporation.34

Many close corporations carry on extensive business with little invested capital of their own. In some cases the funds necessary to carry on the business are derived from borrowed money and in other cases the trading is done as broker or agent. The reference in the law is to the activities of the principal owners. If the principal owners are not engaged in "trading” as "principals," the limitation does not apply. This probably will be interpreted to include as personal service corporations certain types of brokerage and commission houses which do not take title to the property they sell and do not have a substantial amount of invested capital. In general, trading is any kind of commercial activity wherein buying and selling of commodities are concerned. Selling the product of one's brains or skill, or selling one's services would appear not to be "trading" in the strict sense of the section. Selling anything else would seem to be trading.

Corporations with large government contracts may not qualify.—When 50 per cent or more of the gross income of a corporation is derived from “gains, profits, commissions or other income derived from a government contractor contracts made between April 6, 1917, and November II, 1918,” it cannot qualify as a personal service corporation.* This would include engineering and other corporations whose activities were devoted to government work during 1918.36

"Sections 327 and 328.
"Section 200.
*Section 200.
“For definition of government contract, see section 1.

Corporations which do not distribute earnings may be classed as personal service corporations.—The attempt to impose in the 191837 law a penalty tax on the undistributed profits of all corporations was very properly defeated.

But corporations which do not reinvest their earnings in, nor hold them for the need of, the business may in certain circumstances have to face the charge that the failure to distribute is intended to prevent the imposition of the surtax on stockholders. If and when “the Commissioner certifies that in his opinion such accumulation is unreasonable for the purposes of the business” the stockholders will be taxed in the same manner as the stockholders of a personal service corporation. 38 As this would mean, first, that the corporation would be subject to excess profits tax, and, second, that the stockholders would be subject to the normal income tax and surtax on the entire balance of the net income of the corporation, it is not likely that any corporation would voluntarily submit to the tax.39

Computation of tax when corporation is partly a personal service corporation.-Section 303 provides that if at least 30 per cent of the net income of a corporation is derived from a business, which if constituting its sole business would bring it within the class of personal service corporations, the tax upon that part of the income shall be computed separately. Such a corporation is subject to the excess profits tax. It should be noted on this point, however, that in computing the tax there must be ascribed to the personal service part of the business the same amount of capital which is normally required by corporations which have been deemed to be personal service corporations not subject to the excess profits tax.

Status of stockholders in personal service corporation.The surplus accumulated prior to December 31, 1917, by a

s* See Chapter XXXII for discussion of the 1917 law,
*Section 220.
"See Chapter XXXII.

corporation designated under the 1918 law as a personal service corporation, will have been subjected to the normal income taxes imposed between March 1, 1913, and December 31, 1917. The status of the surplus follows any transfers of shares of capital stock—that is, dividends declared before or after the transfer were free from the normal tax whether paid to a new or to an old stockholder. In 1919 the purchaser of shares of stock of a personal service corporation would certainly be free from the normal tax on dividends declared out of surplus accumulated prior to January 1, 1918, and would be free from the surtax as well on dividends declared from earnings accumulated during 1918.

Because of the fact that all earnings after January 1, 1918, are subjected not only to normal tax but also to personai surtax, regardless of whether distributed or not, whereas only normal tax has been paid on the undistributed earnings accumulated prior to that date, it is important that the corporation's books show a clear line of demarcation between the surplus or undistributed profits accumulated respectively prior to and subsequent to January 1, 1918.

A partner may demand that his account be segregated from his other partners' and usually has full power to withdraw all or part of the earnings of a previous year. Certainly he can withdraw enough to pay his taxes. The stockholder of a personal service corporation has no right (as a stockholder) to insist that a dividend be paid, and may find himself liable to a very large surtax with no power to reach the fund, a part of which is supposed to be available for taxes. Thus a minority stockholder in a very profitable personal service corporation might be assessed for a surtax on net income of $100,000 based on his proportionate share of the earnings for 1919. The corporation might pay no dividends. This would be a good method for freezing out minority stockholders.

The remedy would be to require a personal service corporation to pay the tax assessed on its stockholders. The corporation could then adjust its dividend policy accordingly.

PART III

DEDUCTIONS

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