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encouraged corporations to pay out all their surplus, the stockholders were taxed on the dividend at the rates in force from 1913 to 1917, inclusive.

In 1919 the holders of the stock (of whom there were only 3) sold their holdings at 110. The holder of 500 shares of the old stock reported as follows: Cost of 500 shares......

.$ 50,000.00 Dividend received, 2,000 shares in 1917, on which tax was paid. 200,000.00

Book value or cost of 2,500 shares...
Sold 2,500 shares for.....

. $250,000.00

275,000.00

Taxable profit in 1919..

.$ 25,000.00

If it is held that the stock dividend in 1917 was not taxable, and if the tax collected is refunded, the taxpayer may find himself in an unfortunate position, which is reflected in the following statement: Refund of tax paid in 1917-trifling. Amended return in 1919: Proceeds of sale of 2,500 shares...

$275,000.00 Cost

50,000.00

Taxable profit in 1919...

$225,000.00

The additional tax to be assessed will perhaps be..

$100,000.00

The taxpayer's real grievance is that in no circumstances would he have sold his stock in 1919 except for the fact that the Treasury issued regulations holding that the decision of the Supreme Court in the Towne case did not govern dividends paid under the 1916 law.

The illustration refers to a dividend paid in 1917 in order to bring in the allocation of part of the dividend to rates in force in prior years. If the date be changed to 1915 the problem is almost the same and applies to many cases.

CHAPTER XXII

INCOME FROM PARTNERSHIPS, LIMITED PARTNERSHIPS AND PERSONAL SERVICE

CORPORATIONS

The 1918 law made no change in the status of the partnership under the income tax law. Like the previous laws, the present one in effect ignores the partnership's existence as an independent entity and taxes the partners on the income from the business in substantially the same manner as though the income were received from an individual business enterprise.

What is a partnership under income tax law?-There are three classes of taxpayers upon which in all cases, or in specific cases, taxes are imposed upon what is known as a partnership basis. This simply means that the tax is not levied upon a group or an entity, but upon the individuals who compose the group. These groups are:

1. Common law partnerships
2. Limited partnerships of a certain type

3. Personal service corporations Under the federal income tax laws the treatment of the foregoing classes is not entirely uniform. Individual members of common law partnerships are uniformly taxed as individuals. Members of limited partnerships may or may not be taxed as individuals. Stockholders of personal service corporations are supposed to be taxed as individuals, but the federal income tax law lacks the power to change a corporation into a partnership and the attempt to do so has resulted in certain complications which are discussed hereafter.

'It relieved partnerships of the excess profits tax, however.

General ownership.--Ordinarily when two or more persons are associated together for the purpose of conducting a business for profit, they are deemed to constitute a partnership. The following article points out when certain relationships do not constitute a partnership.

REGULATION. Joint investment in and ownership of real and personal property not used in the operation of any trade or business and not covered by any partnership agreement does not constitute a partnership. Co-owners of oil lands engaged in the joint enterprise of developing the property through a common agent are not necessarily partners. In the absence of special facts affirmatively showing an association or partnership, where a vessel is owned by several individuals and operated by a managing owner or agent for the account of all, the relation does not constitute either a joint-stock association or a partnership. The participation of two United States corporations in a joint enterprise or adventure does not constitute them partners. (Art. 1507.)

Domestic partnerships.—The following regulation defines a domestic partnership:

REGULATION. A domestic .... partnership is one organized or created in the United States, including only the States, the Territories of Alaska and Hawaii, and the District of Columbia, and a foreign . . . . partnership is one organized or created outside the United States as so defined. The nationality or residence of members of a partnership does not affect its status. A partnership created by articles entered into in San Francisco between residents of the United States and residents of China is a domestic partnership.

(Art. 1509.)

Net Income of Partners—How Determined The general provision of the law governing the taxation of partnerships, which includes all partnerships, except limited partnerships of the "corporation” type, reads as follows:

Law. Section 218. (a) That individuals carrying on business in partnership shall be liable for income tax only in their individual capacity. 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, or, if his net income for such taxable year is computed upon the basis of a period different from that upon the basis of which the net income of the partnership is computed, then his distributive share of the net income of the partnership for any accounting period of the partnership ending within the fiscal or calendar year upon the basis of which the partner's net income is computed. ....

The regulations, except for the following, do not attempt to elaborate this section of the law :

REGULATION. . . . . Amounts earned and distributed to a partner by a partnership after the end of its taxable year and before the end of his corresponding taxable year should be accounted for both by the partnership and by the partner in their returns for their next succeeding taxable years. (Art. 322.)

The return of the partnership (form 1065) serves two useful purposes: (1) It is such a compilation as would have to be prepared by the partnership in any event, in order to assemble and segregate the taxable, partly taxable and nontaxable income and the allowable and non-allowable deductions. (2) After the compilation is made the distributive share of each partner is so stated as to set forth clearly the manner of rendering the partners' individual returns.

Net income of a partnership defined.—The tax is to be levied on the distributive shares “of the net income of the partnership," and this phrase is defined in the law as follows:

Law. Section 218. (d) The net income of the partnership shall be computed in the same manner and on the same basis as provided in section 212 except that the deduction provided in paragraph (11) of subdivision (a) of section 214 shall not be allowed.

Section 212 describes the method of determining the net income of individuals and section 214 (a-11) permits the deduction of gifts to religious, charitable, scientific and educational corporations2 up to 15 per cent of the taxpayer's net income. The effect of the section of the law quoted above, therefore, is to put a partnership on exactly the same basis as an individual, so far as determining net income is concerned, with the single exception that gifts of the type described may not be deducted. The distributive shares of the partnership profits,

See page 558.

however, form a part of the individual partner's "net income,” from which such gifts may be deducted up to the limit of 15 per cent. Consequently no disadvantage accrues to the partnership because of the provision forbidding the deduction.

CREDITS FOR CERTAIN DIVIDENDS AND INTEREST, NORMAL TAX ONLY.—The “distributive share” upon which the partner is taxable includes certain items which when received directly as a part of an individual's income are subject only to the surtax rates. Such items are dividends and interest on certain government securities whose terms of issue provide for exemption from the normal tax. The law definitely provides that the identity of these items shall be preserved so that each partner may claim as a credit his proportionate share of the income represented by them.

Law. Section 218. (a) .... The partner shall, for the purpose of the normal tax, be allowed as credits, in addition to the credits allowed to him under section 216, his proportionate share of such amounts specified in subdivisions (a) and (b) of section 216 as are received by the partnership.

Subdivisions (a) and (b) of section 216 describe the dividends and interest referred to. These credits consist of dividends from a corporation which is taxable under this law (with an additional provision for dividends from personal service corporations out of income upon which a tax has been imposed) and of interest "upon obligations of the United States and bonds issued by the War Finance Corporation, which is included in gross income under section 213."

REGULATION. In addition to the credits ordinarily allowed to an individual, a partner is entitled to the following credits: (a) a credit against net income for the purpose of the normal tax only of his proportionate share of such dividends from corporations subject to tax and of such interest not entirely exempt from tax upon obligations of the United States and bonds of the War Finance Corporation as are received by the partnership; and (b) a credit against income tax of the partner's proportionate share of any income, war profits and excess profits taxes of the partnership paid

See pages 37-39.

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