LETTER OF TRANSMITTAL. THE SECRETARY OF THE TREASURY, MY DEAR MR. FORDNEY: In the course of interpreting the warrevenue act of 1918 and framing appropriate regulations a number of suggestions for the amendment of the law have occurred to the various officers of the Internal Revenue Bureau. These suggestions have been recorded and associated with similar suggestions received from outside sources for further consideration, and I am sending you herewith a set of this material (as Part I of the attached compilation) in response to your request of September 23, 1919, in which you announced that the Committee on Ways and Means will soon. undertake a study of the internal-revenue legislation. This material is not in the form of recommendations by the department, as a decision has not yet been reached with respect to all of the suggestions; and, indeed, the department entertains serious doubt as to the advisability of the adoption of some of them. When the department has had sufficient time to study, in the light of further administrative experience, all the suggestions which have been assembled and such additional suggestions as may occur to the officers of the department, I shall be pleased to cooperate with: the committee in the complete analysis of the law and the legislative requirements, as well as to detail to the committee the experts of the department who have had occasion to give personal study and attention to this matter. In further compliance with your request of September 23, 1919, F have had a digest prepared of the decisions of the United States courts (arranged in accordance with the subject matter) under the internal-revenue acts from 1909 to 1919, both inclusive, which is inclosed herewith as Part II of the attached compilation. Sincerely, yours, Hon. JOSEPH W. FORDNEY, Chairman Committee on Ways and Means, CARTER GLASS.. House of Representatives. 3. NOTES ON THE REVENUE ACT OF 1918. The only purpose of Part I of the following notes is to compile the various suggestions made to the Treasury Department with respect to amending the revenue act of 1918 in convenient form in one document for the consideration of the Ways and Means Committee of the House, the Finance Committee of the Senate, and the officials of the Treasury Department charged with the administration of the various sections. These notes must not be considered as recommendations of the Treasury Department. In the preparation of this compilation the suggestions have been arranged in accordance with the section numbers of the revenue act of 1918. Part II contains a digest of the decisions of the United States courts (arranged in accordance with the subject matter) under the internal revenue acts from 1909 to 1918, inclusive. The West Publishing Co. and the Banks Law Publishing Co. authorized such use of their syllabi in the preparation of this compilation as the Treasury Department deemed proper. The department desires in this way to acknowledge the valuable assistance rendered it by these companies. In the suggested amendments the part printed in roman shows the text of the present law; new matter that has been suggested is indicated in italics; and matter that has been suggested to be stricken out is shown in stricken-through type. 4 NOTES ON THE REVENUE ACT OF 1918. TITLE II-INCOME TAX. Section 200. Extension of the class of personal service corporations. The definition of the term "personal service corporation" contained in section 200 excludes from the class of personal service corporations all corporations in which capital (whether invested or borrowed) is a material income-producing factor. It has been suggested that this definition be amended so as to include all corporations whose principal stockholders regularly devote their chief time and attention to the active conduct of the affairs of the corporation, except (a) foreign corporations, and (b) corporations 50 per cent or more of whose gross income consists of income derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. If this change were made, it would be desirable to change the term applied to the class from "personal service" to some such term as "personal corporation," "close corporation," ," "corporation partnership," or "private company." It might also be expedient to require, if the proposed extension of this class were made, the principal stockholders to own a stipulated proportion of the stock, say 85 per cent, and to place a limit, say 10, upon the number of stockholders not regularly devoting their chief time and attention to the active conduct of the affairs of the personal corporation. Among the arguments advanced in support of this proposed change are the following: 1. Under the legislation as it now stands, the stock of a corporation may be closely held or owned-except for qualifying shares-by one person; the owner or owners may devote themselves so effectively and exclusively to the conduct of the business that it is impossible to distinguish satisfactorily between the profits of the business paid to stockholders as dividends and the personal compensation paid to the officers as salaries; and the principal competitors of the corporation in question may be partnerships or sole proprietors. Nevertheless, if capital is a material income-producing factor in the operation of the corporation, the corporation takes its place with corporations rather than partnerships, and pays the war-profits or excessprofits tax in place of income surtaxes upon undistributed profits. The resulting differences are so arbitrary and in many cases so extreme that it is suggested that the class of personal service corporations should be extended to cover all corporations whether employing a material amount of capital or not, in the active conduct of whose affairs the principal stockholders are regularly engaged. 2. The treatment of partnerships and corporations under the present legislation is radically different. The ordinary corporation of a given size or class in a particular line of business may pay 50 per cent of its net income in income and profits taxes, whereas the members of the average partnership in the same line of business may pay only 20 per cent of their net income in normal and additional income taxes. The profits left in the business are subject in the one case to income surtaxes but not to profits taxes; in the other case they are subject to profits taxes but not to income surtaxes. This vital difference turns upon the mere form of organization, yet the two forms of business may be in close competition. It is suggested that different treatment in the tax law should turn upon distinctions of fact and not of form, and that real distinction exists between the closely owned corporation whose stockholders give their principal time and attention to the business of the corporation, and those very large corporations whose stockholders are widely scattered and are in many respects investors rather than owners. It is suggested that the tax law should follow more closely this fundamental economic distinction. 3. 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. A large proportion of these cases would be automatically and easily dealt with if the law be amended as here proposed. 4. The suggested amendment would go far toward the solution of the difficult problem of determining what constitutes reasonable salary or compensation in the case of officers of a corporation who own all or nearly all of its stock. In such situations the natural elements or checks which keep salaries within reasonable limits are absent, and the department is forced to rely upon estimates which are as unsatisfactory to the Government as they are irritating to the tax payers. 5. The present definition of a personal service corporation is exceedingly difficult to apply with precision. To decide in thousands of cases what circumstances make a given amount of capital "a material income-producing factor," is an elusive and difficult administrative task which, other things being equal, it is highly desirable to avoid. It has been suggested that these changes could be accomplished by an amendment in substantially the following form: Strike out the fourth paragraph of section 200, which is as follows: The term "personal-service-corporation" means-a-corporation whose-income-is-to-be-ascribed primarily-to-the-activities-of-the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or borrowed) is not a material income producing factor; but does not include any foreign corporation, nor any corporation 50 per centum or more of whose gross income consists either (1) of gains, prefits or income derived from trading as a principal, or (2)-of-gains, profits, commissions, or other income, derived from-a-Ger ernment contract, or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive; and insert in lieu thereof the following: The term "personal corporation" means a corporation (1) whose principal stockholders (a) regularly devote their chief time and attention to the active conduct of the affairs of the corporation, and (b) own not less than 85 per centum of the capital stock of the corporation and (2) in which the number of stockholders not regularly devoting their chief time and attention to the active conduct of its affairs does not exceed ten; Section 202. Gain or loss from exchange of property. Subdivision (b) of section 202 provides for the inclusion in the computation of income of gain or loss resulting from the exchange of property by the comparison of the fair market value (if any) of the property received in exchange with the cost or, if acquired prior to March 1, 1913, the fair market price or value on that date of the property relinquished. The only exception which the law provides to this rule is when in connection with the reorganization, merger, or consolidation of a corporation a taxpayer receives in place of stock or securities owned by him new stock or securities of no greater aggregate par or face value. The present law provides in such case that no gain or loss shall be deemed to occur from the exchange and that the new stock or securities received shall be treated as taking the place of the stock, securities, or property exchanged. It has been suggested that there are other similar transactions in which it is difficult to determine the gain or loss in the absence of an actual sale and which should be treated in the same manner in connection with the reorganization, merger, or consolidation of a |