cluding the various items of expenditures which have been made.1

Deductions may be determined by accrual method.—

LAW. Section 212. (b) The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income.

Section 200. . . . . The term "paid," for the purposes of the deductions and credits under this title, means “paid or accrued" or "paid or incurred," and the terms "paid or incurred" and "paid or accrued" shall be construed according to the method of accounting upon the basis of which the net income is computed under section 212.

If the taxpayer keeps no regular books of account, and if he does keep books, but on the basis of cash receipts and payments, he must claim his deductions on the basis of cash actually paid out. In all cases where it is possible to do so, the taxpayer should keep his books on an "accrual" basis. If this method, which is now specifically authorized by the regulations, is once adopted it must be followed in subsequent years. The application of the accrual method is thus described in the regulation:

REGULATION. Approved standard methods of accounting will ordinarily be regarded as clearly reflecting income. A method of accounting will not, however, be regarded as clearly reflecting income unless all items of gross income and all deductions are treated with reasonable consistency. . . . . All items of gross income shall be included in the gross income for the taxable year in which they are received by the taxpayer, and deductions taken accordingly, unless in order clearly to reflect income such amounts are to be properly accounted for as of a different period. . . . . (Art. 23.)

"The form of reconcilement statement which will be found in Excess Profits Tax Procedure, Chapter XV, affords a means of preventing any allowable deduction in the books to be omitted, and as to classification it calls attention to any omission of allowable items not in the books.

Each year's return must be complete within itself.

REGULATION. Each year's return, so far as practicable, both as to gross income and deductions therefrom, should be complete in itself, and taxpayers are expected to make every reasonable effort to ascertain the facts necessary to make a correct return. . . . . The expenses, liabilities or deficit of one year can not be used to reduce the income of a subsequent year. A person making returns on an accrual basis has the right to deduct all authorized allowances, whether paid in cash or set up as a liability, and it follows that if he does not within any year pay or accrue certain of his expenses, interest, taxes or other charges, and makes no deduction therefor, he can not deduct from the income of the next or any subsequent year any amounts then paid in liquidation of the previous year's liabilities. A loss from theft or embezzlement occurring in one year and discovered in another is deductible only for the year of its occurrence. Any amount paid pursuant to a judgment or otherwise on account of damages for personal injuries, patent infringement or otherwise, is deductible from gross income when the claim is put in judgment or paid, less any amount of such damages as may have been compensated for by insurance or otherwise. If subsequently to its occurrence, however, a taxpayer first ascertains the amount of a loss sustained during a prior taxable year which has not been deducted from the gross income, he may render an amended return for such preceding taxable year, including such amount of loss in the deductions from gross income, and may file a claim for refund of the excess tax paid by reason of the failure to deduct such loss in the original return. .. (Art. III.)

These regulations must be reasonably construed. All business concerns and all individuals have items of receipts and expenses which cannot be incorporated in books of account prior to closing time. In the well-managed concern the amounts are usually insignificant and when subsequently ascertained they are entered as current items in the succeeding period. If the amounts are large the treatment is different and adjustment of the accounts of the prior period and the filing of amended returns are in order, but after the accounts for a fiscal year are once closed there should be no reopening unless it is a matter of substantial importance.

This interpretation is apparently in accord with the general rule laid down in another regulation for the inclusion or

exclusion of insignificant amounts in one year or another. It does not disturb the clear reflection of income.

REGULATION. . . . . The time as of which any item of gross income or any deduction is to be accounted for must be determined in the light of the fundamental rule that the computation shall be made in such a manner as clearly reflects the taxpayer's income. If the method of accounting regularly employed by him in keeping his books clearly reflects his income, it is to be followed with respect to the time as of which items of gross income and deductions are to be accounted for. If the taxpayer does not regularly employ a method of accounting which clearly reflects his income, the computation shall be made in such manner as in the opinion of the Commissioner clearly reflects it. (Art. 22.)

The regulation quoted on page 530 (Art. 111) makes it plain that the taxpayer may file amended returns on his own initiative. The Commissioner, in turn, may on his part require such returns.

REGULATION. If in the opinion of the Commissioner such information indicates that the returns for any previous years did not reflect the true income, amended returns for such years will be required. (Art. 23, as amended by T. D. 2873, June 24, 1919.)

It is the desire of the Treasury to obtain returns which accurately reflect for a given year the actual income and the actual expenses applicable to that year. The Treasury accepts or requires amended returns, if based on meritorious grounds, whether or not the outcome is favorable to the government. The action of some inspectors would lead one to believe that amended returns are in order only when the net result is against the taxpayer, but the responsible officers of the Treasury maintain no such attitude.

Desirability of good records.-Most individuals keep poor accounts or none at all. It is desirable from almost every point of view to keep careful financial records, and the income tax levied at the present high rates makes it almost imperative that this be done. It is important from the point of view of the government in order that no taxable items may be missed. It is important from the point of view of the individual in

order that his burden may not be inequitably large as compared with his neighbor's. But since most individuals find it easier to recall all the items of their income than of their expenditure, they usually do not avail themselves of all allowable deductions. In other words, the keeping of careful records in this case will work out more to the advantage of the taxpayer than of the government, but it will result in the tax being more equitably spread, which is an advantage from every point of view.

Accounts of partnerships and corporations are, as a rule, better kept than those of individuals. They are, of course, supposed to include all items which can be claimed as allowable deductions. The items disallowed by the law and regulations are discussed in detail in the chapters which follow. If the accrual method is used all items of deductions, minus those specifically forbidden, as taken from the record of expenses or liabilities, should yield the proper result. If the accrual method is not followed, the taxpayer must depend upon his cash

account.

DEDUCTIONS FOR EXPENSES

General

The chief problems of procedure connected with deductions for expenses are occasioned by the presence of certain restrictions in the law itself. First of all, the statute forbids the deduction of personal living expenses.1 This is quite necessary and proper, but it involves the difficult task of establishing a sharp line of demarcation between business and living expenses. Gifts, in the next place, are not generally deductible, but in many cases it is not easy to determine whether a payment, nominally a gift, is not more truly an expense. The law does not permit the deduction of capital expenditures except in the form of depreciation allowances, and here once more it is necessary to set up a series of distinctions between this type of expenditures and business expenses proper. Again, care must be taken not to allow any distribution of profits under the guise of business expense. Other difficulties are caused by the prohibition of certain expenditures as contrary to public policy and by the necessity of taking a position on the question of insurance-as to how far expenses are deductible which seek to safeguard the income from risks of various

sorts.

In this chapter the first general section is devoted to the establishment of the distinction between business and personal expenses and is consequently applicable to individuals only. The remainder of the chapter deals with various specific types of expenses and, unless otherwise specified, applies alike to individuals, partnerships and corporations. In the case of

'This rule is considerably modified if section 214 (a-6) (allowing for losses arising out of casualties) is interpreted to cover ordinary accidents to personal property, the use of which has always been regarded as private or family expense.