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Can proceeds of sale of capital assets be reinvested without subjecting stockholders to surtax?-Article 352 states that “a radical change of business when a considerable surplus has been accumulated may afford evidence of a purpose to escape the surtax.”

Many corporations sell all or part of their capital assets and receive in payment cash or marketable securities. The question arises whether or not a corporation may invest or reinvest the proceeds of sale without subjecting its stockholders to the surtax. If a corporation were in the automobile manufacturing business or held stocks in other corporations which were in that business and sold its manufacturing business or capital stocks for cash and soon thereafter reinvested the proceeds in other automobile stocks or resumed the manufacture of automobiles, such transactions would not constitute a radical change of business and its stockholders could not be taxed. If the corporation sold its assets and purchased general investment securities with the proceeds, it would involve a radical change in the business and it could hardly be maintained that the accumulated surplus was held for the “reasonable needs of the business.” On the contrary it would be difficult to argue that a former manufacturing corporation with a large surplus, no assets except marketable securities and no debts required any surplus whatever.

It is contrary to ordinary commercial methods for a business corporation to transform itself into an investment corporation. When stockholders invest in manufacturing or trading corporations they hazard their money and expect returns commensurate with the risks of the business. Stock in a bank or trust company usually is looked upon as less of a risk. Purchases of one or the other are made, but the author has never heard of an original purchase of one class of stock by a purchaser who expected that the corporation would transform itself into a concern of an entirely different kind. When a corporation does transform itself, a prima facie case is made out for the imposition of the surtax upon its stockholders.

If corporation sells capital assets or accumulates funds in excess of its needs, how much of surplus must be divided?— If it is obvious or if it is admitted by a corporation that cash or marketable securities in hand are in excess of the needs of the business, the question arises as to what part of the accumulated surplus must be distributed or, in lieu of distribution, taxed to the stockholders.

If the amount readily available is no more than equal to the undistributed earnings of the taxable year no problem arises. But a problem does arise if conditions are as follows: A corporation in December, 1919, sells all its capital assets for $1,000,000 cash or approved stock exchange securities. After providing for all its debts it has approximately $2,000,000 of free cash assets. Capital stock is $1,000,000. Surplus, March 1, 1913, was $100,000. Undistributed surplus for fiscal years ended June 30, 1916, and each succeeding fiscal year was $200,000. Earnings from July I to December I were $100,000.

It is held by some very good lawyers that the surtax can only be imposed on the earnings, if any, which accumulate after the capital assets are sold, on the ground that up to that time the accumulated earnings were all required in the business, and that the law does not intend to impose any penalty on non-distributions of surplus properly accumulated.

The author thinks that this line of reasoning is fallacious at least to the extent of the earnings for the current taxable year. When it becomes evident that surplus is divisible under the law it cannot be assumed that the earnings of a current fiscal period can be segregated to any part of the period. In the case cited the question of taxability would not arise until the end of the fiscal year 1920. At that time the books might show that the earnings from manufacturing up to December 1, 1919, were $100,000 and from interest on bonds up to June 30, 1920, were $60,000. Nevertheless the net income for the fiscal year would be returned as $160,000. As the records would show that no part of the $160,000 was needed in the business at the end of the taxable year, it would be necessary to distribute the entire amount or in default thereof subject the stockholders to surtax.

If it be admitted that the earnings from July 1 to November 30, 1919, must be distributed, although part was legally accumulated, is it the intention of the law that the earnings accumulated during the preceding taxable year shall be likewise distributable even though it is admitted by all that at no time during such preceding taxable year was there any accumulation beyond the actual needs of the business? And if the surplus of the preceding taxable year must be distributed, does the law intend that the entire surplus earned since March 1, 1913, must be distributed ?

The Treasury holds that the 1918 law does not apply to surplus accumulated prior to January 1, 1918; that if any surplus were improperly accumulated prior to that date the laws in force during the prior period are applicable thereto. In the case cited no prior law was violated; therefore the Treasury would rule that the cash in hand, representing surplus accumulated prior to January 1, 1918, has not been improperly accumulated.

The author disagrees with the Treasury's interpretation of the law and is of the opinion that when accumulated surplus becomes available for distribution, the 1918 law can only be applied to the taxable years during which there is, in fact, an unlawful accumulation. In the case cited on June 30, 1919, there was no unlawful accumulation. At that date every dollar of surplus was needed in the business. What was lawful on that date cannot be held to be unlawful by an ex post facto legislation. There is no indication in the language of the law that it was intended to be retroactive. On the contrary, the applicable sections of the law taken together clearly indicate that the penalty is to be restricted to the taxable year or years at the close of which there was an unlawful accumulation of profits.

In fact the only authority whereby the tax can be imposed limits the penalty to the taxable year. These sections were the subject of long discussion and many amendments and if it had been intended that all accumulations, lawful and unlawful, after January 1, 1918, were to be divided or taxed when realized, provision would have been made therefor. Instead section 220, which imposes the penalty, prescribes a definite method of procedure, viz., “if any corporation .... is availed of for the purpose of preventing the imposition of the surtax .... its stockholders or members shall be subject to taxation .... in the manner as provided in subdivision (e) of section 218. ...."

The section imposes a very high penalty and must therefore be strictly construed. No sections other than those mentioned can be invoked to increase the penalty. We turn to section 218 (e): "Personal service corporations shall not be subject to taxation under this title, but the individual stockholders thereof shall be taxed in the same manner as the members of partnerships. . ..." We next ascertain how members of partnerships are taxed : section 218 (a) “.... There shall be included in computing the net income of each partner his distributive share, whether distributed or not, of the net income of the partnership for the taxable year. ...."

It is imperative that unlawful accumulations be taxed as if the stockholders were partners. The complications of such procedure are apparent when it is realized that corporations with thousands of stockholders may be held to have failed to distribute accumulated earnings. The problem is even more difficult when any change occurs in stock holdings.

During the taxable year ending June 30, 1920, the provisions of the law are easily applied. An unlawful accumulation which may occur during such taxable year is adjusted as of the end of such taxable year. We then go back to June 30, 1919, for the next preceding taxable year. Was there, during any part of such taxable year, any unlawful accumulation? All admit that there was not. If not, how would it be possible to tax to the individual stockholders of the corporation, who were “of record” June 30, 1919, an unlawful accumulation “for the taxable year” when there was no unlawful accumulation at the end of or during such year? If partners render inaccurate returns such returns must be corrected, but no means are provided whereby transactions relating exclusively to a subsequent year of a partnership can affect returns for previous years.

Sections 220 and 218 together are logical and workable when unlawful accumulations occur during a taxable year, but when no unlawful accumulation occurs during such year there is no machinery provided for the imposition of the tax.

It is clear to the author that if any retroactive intention was in the minds of Congress it would have appeared in section 220 and the use of section 218 as the sole method of imposing the tax would have had to be changed.

The Treasury admits that section 220 of the 1918 law is difficult to administer. In Notes on the Revenue Act of 1918 the Secretary of the Treasury says :*

The corporate form of organization is now used or abused by wealthy individuals who incorporate their personal business and investments and thus escape surtaxes upon that amount of their income which is reinvested or saved. Section 220 provides a remedy for this abuse, but it can be applied only by a troublesome special procedure which will necessarily restrict its use to a comparatively small proportion of cases.

*Page 8.

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