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The 1918 law omits the words "and charged off,” which formerly appeared, but it is to be assumed that losses will not be allowed unless charged off by items or through reserves.

Losses to be allowed as deductions must meet the provisions of the law that they have been actually “sustained" during the taxable year. This is a reasonable requirement. Most concerns charge off or provide reserves for losses as and when losses occur and the items to be deducted can be taken directly from the books. In the case of individuals who keep nc books, more difficulty will be experienced.

In discussing the phrase "losses sustained" the regulations state that this condition "must usually be evidenced by closed and completed transactions." This, however, does not preclude the use of inventories for the purpose of ascertaining gains or losses. The privilege of using inventories, long permitted to business men generally in the case of merchandise, was not extended to dealers in securities and real estate until late in 1917, but at that time was supported by an opinion of the Attorney-General who advised that the Supreme Court in a case under the 1909 law sanctioned the practice. For a full discussion of inventories the reader is referred to Chapter XIII, page 295, et seq.

If an individual is engaged in business on his own account or as a partner and the year's operations result in a net loss, the amount of such loss is an allowable deduction from income from other sources in a tax return.

Dividends may be offset by losses.—Because of the arrangement of form 1040 considerable confusion arose in 1918 regarding the possibility of utilizing a net loss shown by block J, page 2 (net income subject to normal tax), as an offset against the total of block K (a) and block K (b) (dividends and certain interest, subject to surtax). In many instances losses exceeded taxable income from sources other than dividends, so that a taxpayer, having entered all income except from dividends and having entered all losses, might find the total under block J to be a net loss. To an accountant this would be a very simple problem, as he would merely enter the net loss in red ink. Then when the totals of blocks K (a) and K (b) were entered, if the latter were greater than the net loss as shown by block J, the amount shown in block L would represent the net taxable income. But some persons thought that this arrangement of the form brought about a situation in which they were subject to tax on dividends and interest irrespective of the amount of their net loss from other sources. The point was finally settled by the following letter from the Treasury.

*Reg. 45. Art. 141. See also page 632.

RULING. In reply to your second inquiry you are informed that if item J, page 2 of form 1040 shows a net loss, the amount of same may be deducted from the total of items K-a and K-b as shown on line L before bringing this item forward to line 15, page 1 of the return. (Letter to Alexander John Lindsay, New York, N. Y., signed by J. H. Callan, Assistant to the Commissioner, and dated May 6, 1919.)

“Relief” Provisions of the 1918 Law The radical changes expected in business conditions as a result of the cessation of the war made it seem imperative that losses arising from readjustments of inventories, which could not be made within a few months, should be spread over a longer period of time. Similar conditions existed in the case of losses arising from sales or depreciation of plant and equipment acquired for war purposes. To meet these difficulties the 1918 law provided certain so-called relief measures designed to assist in the re-establishment of normal conditions. Referring to these provisions Senator Simmons said:5

In addition to the relief amendments placed in the income tax title, but affecting profits taxes as well as income taxes, amendments relating to amortization and obsolescence, shrinkage in inventories, and so forth, the Senate added a general relief clause investing more

*February 11, 1919, Congressional Record, page 3776.

or less discretion in the Commissioner of Internal Revenue and the Advisory Tax Board for relief in cases clearly establishing injustice, inequality or discrimination. The House conferees accepted these provisions of the Senate.

Net loss sustained in 1919 by certain taxpayers may be applied against year 1918 or 1920.—The 1918 law provides that when the business of a taxpayer as ascertained for a taxable year beginning November 1, 1918, December 1, 1918, or January 1, 1919, results in a net loss, such net loss may be deducted from the net income of the next preceding taxable year and the tax of such preceding year shall be redetermined and the balance due to the taxpayer as so ascertained shall be refunded. If the net loss is greater than the net income for the preceding year, the entire net income shall be used up and a refund made, and the balance of the loss not deducted may be carried over to the next succeeding taxable year.

Losses so applicable to preceding or succeeding taxable years must be one of two types. The first type consists of those incurred in the regular business of the taxpayer. This excludes "outside" losses, such as those sustained in isolated transactions of an investment or speculative nature, and property losses, such as those sustained by fire, casualty, etc. The second class of losses applicable to prior or succeeding years also applies to business losses, but relates to those arising from sale of war plants and equipment.

The net loss which a corporation may desire to make applicable to a prior or succeeding year will have to be adjusted from that shown in its returns for income tax purposes. In the income tax statement dividends have been deducted from net income and interest received on tax-exempt securities has not been reported as gross income. In preparing a statement of net loss under the section, dividends received must not be deducted from income and interest on tax-exempt securities must be included among gross income.

Law. Section 204. (a) That as used in this section the term "net loss” refers only to net losses resulting from either (1) thç

operation of any business regularly carried on by the taxpayer, or (2) the bona fide sale by the taxpayer of plant, buildings, machinery, equipment cr other facilities, constructed, installed or acquired by the taxpayer on or after April 6, 1917, for the production of articles contributing to the prosecution of the present war; and when so resulting means the excess of the deductions allowed by law (excluding in the case of corporations amounts allowed as a deduction under paragraph (6) of subdivision (a) of section 234) over the sum of the gross income plus any interest received free from taxation both under this title and under Title III.

(b) If for any taxable year beginning after October 31, 1918, and ending prior to January 1, 1920, it appears upon the production of evidence satisfactory to the Commissioner that any taxpayer has susfained a net loss, the amount of such net loss shall under regulations prescribed by the Commiss'oner with the approval of the Secretary be deducted from the net income of the taxpayer for the preceding taxable year; and the taxes imposed by this title and by Title III (excess profits tax] for such preceding taxable year shall be redetermined accordingly. Any amount found to be due to the taxpayer upon the basis of such redetermination shall be credited or refunded to the taxpayer in accordance with the provisions of section 252. If such net loss is in excess of the net income for such preceding taxable year, the amount of such excess shall under regulations prescribed by the Comm 'ssioner with the approval of the Secretary be allowed as a deduction in computing the net income for the succeeding taxable year.

(c) The benefit of this section shall be allowed to the members of a partnership and the beneficiaries of an estate or trust under regulations prescribed by the Commissioner with the approval of the Secretary.

It would appear from the foregoing that a taxpayer with a fiscal year which began on February 1, 1918, or the first day of any succeeding month to October 1, 1918, both inclusive, sustaining a loss during a fiscal year ending in 1919 will be entitled to no credit therefor against the profits of 1918 or 1920. In the Senate draft of the 1918 bill due consideration was given to all years ending in 1919, but the restriction was made by the conference committee. The effect seems to be grossly inequitable and is probably unconstitutional. It is absurd to think that one concern which made a big loss in January, 1919, in cleaning up its war business can secure a reduction in taxes therefor as of the year 1918 because its fiscal year ends the last day of October, November or December, whereas another concern which sustained a similar loss in the same month cannot secure the same relief because its fiscal year ends on the last day of any month from January to September.

The Treasury should have ignored the law and prepared regulations which would have equalized the privilege and made it apply to all taxpayers similarly situated. The regulations also should have provided adequately for an extension of the privilege to taxpayers who were not in business for an entire year and to reorganizations. As a matter of fact the regulations made no attempt to extend the relief beyond the narrow' limits laid down in the statute, and taxpayers were refused permission to change their fiscal years to one of the dates mentioned. The Treasury's interpretation follows.

REGULATION. As used in the statute the term “net loss” means either a business operating loss or a loss realized by a bona fide sale of property constructed, installed or acquired on or after April 6, 1917, for the production of articles contributing to the prosecution of the war. The amount of net loss claimed must represent an actual net loss over and above all income, including tax-free income. Such losses will be allowable only in respect of a taxpayer having a taxable year beginning after October 31, 1918, and ending prior to January 1, 1920, and after one claim has been allowed no further claim can be considered. (Art. 1601.)

The meaning of the last statement is not clear. If a taxpayer claims a loss as provided in the law and finds later that the claim was erroneous an amended return should be made.

REGULATIONS. A taxpayer having such a net loss may file a claim on form 46 with his return of income for the taxable year 1919. Such claim should contain a concise statement setting forth the amount of the loss sustained, in accordance with the accompanying return, the nature of the loss, the amount of the taxpayer's net income for the taxable year 1918, the taxes paid by him with respect thereto, and all pertinent facts necessary to enable the Commissioner to determine the allowability of the claim. (Art. 1602.)

'[Former Procedure] The procedure was made somewhat more precise in revised Regulations 45 than in the preliminary edition.

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