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Congress has adopted two methods in the course of its attempts to prevent corporations from defeating the purpose of the income tax laws by the simple device of refraining from distributing their earnings. Until the earnings have been distributed as dividends and, consequently, have become subject to the surtax rates in the hands of the individual stockholders the demands of the tax have not been fully met. The first method of forcing distributions in cases in which they are deliberately withheld makes the entire profits "taxable to individual stockholders" and is directed at holding companies or "close” corporations which may refrain from distributing earnings because corporations are not subject to the surtax imposed upon individuals. The law attempts to tax the individual stockholder as if the earnings were actually distributed, thus collecting the surtax. This method under the 1913 and 1916 laws entirely failed in its object. As embodied in the 1918 law it may be more successful. No information is available which would indicate that any individual has been so taxed under this provision of the 1918 law, but the Treasury, in answer to inquiries, has stated that the 1918 law will be invoked whenever it appears that the surtax should be imposed upon undistributed earnings of 1918 and 1919.

The second method ievies an "additional tax on undistributed earnings.” It does not attempt to collect a surtax from stockholders, but imposes an additional flat rate tax on the corporation itself. The 1917 law which imposed this tax may be said to have been a failure.

[Former Procedure] For text of previous laws and full discussion thereof, see Income Tax Procedure, 1919, pages 617-624.

When Entire Profits May be Taxable to Individual


Profits of corporations taxable to stockholders.

Law. Section 220. That if any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its stockholders or members through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, such corporation shall not be subject to the tax imposed by section 230, but the stockholders or members thereof shall be subject to taxation under this title in the same manner as provided in subdivision (e) of section 218 in the case of stock. holders of a personal service corporation, except that' the tax imposed by Title III shall be deducted from the net income of the corporation before the computation of the proportionate share of each stockholder or member. The fact that any corporation is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax; but the fact that the gains and profits are in any case permitted to accumulate and become surplus shall not be construed as evidence of a purpose to escape the tax in such case unless the Commissioner certifies that in his opinion such accumulation is unreasonable for the purposes of the business. When requested by the Commissioner, or any collector, every corporation shall forward to him a correct statement of such gains and profits and the names and addresses of the individuals or shareholders who would be entitled to the same if divided or distributed, and of the amounts that would be payable to each.

REGULATION. Where a domestic or foreign corporation permits its gains and profits to accumulate for the purpose of preventing the imposition of the surtax upon such income if distributed to its stockholders, it shall not be subject to the income tax as a corporation, but its stockholders shall be subject to tax in the same way as the stockholders of a personal service corporation, except that the war profits and excess profits tax on the corporation shall first be deducted from its net income before computing the proportionate shares of the stockholders. .... (Art. 351.)

Accumulation of earnings to be taxable must be with purpose of evasion.

REGULATION. The application of section 220 of the statute depends upon the two elements of (a) purpose to escape the surtax and (b) unreasonable accumulation of gains and profits. Prima facie evidence of (a) exists where a corporation has practically no business

except holding stocks, securities or other property and collecting the income therefrom, or where a corporation other than a mere holding company permits its gains and profits to accumulate beyond the reasonable needs of the business. The business of a corporation is not limited to that which it has previously carried on, but in general includes any line of business which it may legitimately undertake. However, a radical change of business when a considerable surplus has been accumulated may afford evidence of a purpose to escape the surtax. When one corporation owns the stock of another corporation in the same or a related line of business and in effect operates the other corporation, the business of the latter may be considered in substance the business of the first corporation. Gains and profits of the first corporation put into the second through the purchase of stock or otherwise may therefore, if a subsidiary relationship is established, constitute employment of the income in its own business. To establish that the business of one corporation can be regarded as including the business of another it is ordinarily essential that the first corporation own substantially all of the stock of the second. Investment by a corporation of its income in stock and securities of another corporation is not without more to be regarded as employment of the income in its business. (Art. 352.)

A corporation could pay off all its debts, add to its plant and inventories, expand in similar ways and retain substantial cash working capital without being subject to tax upon its undistributed earnings.

Accumulation of earnings to be taxable must be unreasonable in amount.

REGULATION. An accumulation of gains and profits is unreasonable if it is not required for the purposes of the business, considering all the circumstances of the case. No attempt can be made to enumerate all the ways in which gains and profits of a corporation may be accumulated for the reasonable needs of the business. Undistributed income is properly accumulated if invested in increased inventories or additions to plant reasonably needed by the business. It is properly accumulated if retained for working capital required by the business or in accordance with contract obligations placed to the credit of a sinking fund for the purpose of retiring bonds issued by the corporation. In the case of a banking institution the business of which is to receive and loan money, using capital, surplus and deposits for that purpose, undistributed income actually represented by loans or reasonably retained for future loans is not accumulated beyond the reasonable needs of the business. The nature of the investment of gains and profits is immaterial if they are not in fact needed in the business. (Art. 353.)

It is fortunate for corporations that the word "reasonable” is in the law. A corporation may refrain from distributing its profits, even if it has no debts, if there is a reasonable present need for the profits in the business or a prospective need within the reasonably near future. Conservative corporations accumulate large cash surplus whenever a profitable year enables them to do so. The courts will not hold that distributions should be made to stockholders, if the directors in good faith and after due consideration decide that the present or prospective needs of the business itself (which must be paramount) do not justify larger cash dividends than are being paid.

Stockholders of properly conducted corporations need not be any more disturbed over the new law than over the old. However, if accumulated earnings are undistributed solely to permit stockholders to escape the surtax, that purpose should be frustrated. The regulations and informal rulings indicate that an attempt will be made to enforce the present


Investment of accumulation in obligations of the United States no bar to action.

RULING. In reply to your letter of March 20, 1919, you are advised that any corporation which permits its gains and profits to accumulate for the purpose of preventing the imposition of the surtax upon its stockholders, and members will be subject to the provisions of section 220 of the Revenue Act of 1918, regardless of whether or not such gains and profits are invested by the corporation in obligations of the United States. (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated April 9, 1919.)?

Excess profits tax is imposed even though stockholders are taxed individually.—Corporations whose stockholders may individually be subject to tax under this section do not escape

?[Former Procedure] Under the 1917 law [section 10 (b)] the investment of such accumulations in "obligations of the United States issued after September 1, 1917," would have relieved the corporation from the tax on undistributed profits to the extent of such investment.

the excess profits tax. As the law stands any corporation that falls within the provision must first pay the excess profits tax. Its remaining earnings are apportioned on the books (not distributed) to the stockholders, who personally are assessed on their proportionate shares. As in the case of personal service corporations, this may be a severe penalty because there may be no dividends declared from which the stockholder can pay the tax. In any event the penalty of paying both excess profits taxes and income surtaxes at the very high rates of 1919 is so severe that it is not likely to catch many corporations unprepared. Probably the only corporation which would be liable would be one formed by private individuals who diverted all their private income into a close corporation.

Retirement of preferred stock.—The retirement or purchase of preferred stock would be a proper use of surplus earnings and would not be deemed to be a method of preventing the imposition of the surtax.:

Reduction of common stock.—The purchase of common stock for the treasury or the retirement of common stock with a consequent reduction of the aggregate stock outstanding or a reduction of the par value of each share would not be deemed to be a method of preventing the imposition of the surtax. But if the common stock were purchased pro rata from stockholders at a large premium it might be held that such purchase was in effect a distribution of surplus. If the surplus earned since March 1, 1913, had not been distributed it could hardly be claimed that the premium paid on the common stock was a distribution of capital surplus or surplus accumulated prior to March 1, 1913.

*[Former Procedure] A ruling which directly related to this point was rendered under the 1916 law:

REGULATION. “.... (a) The earnings of a corporation used to purchase preferred stock for cancellation are retained for employment in the reasonable requirements of the business, and are therefore not taxable.” (T. D. 2570, November 6, 1917.)

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