The Constitution of the United States of America: Analysis and Interpretation Part 217

[7] United States _v._ Cla.s.sic, 313 U.S. 299 (1941); Smith _v._ Allwright, 321 U.S. 649 (1944).

[8] Nixon _v._ Herndon, 273 U.S. 536 (1927).

[9] Nixon _v._ Condon, 286 U.S. 73, 89 (1932).

[10] Grovey _v._ Townsend, 295 U.S. 45, 55 (1935).

[11] 321 U.S. 649 (1944). Notwithstanding that the South Carolina Legislature, after the decision in Smith _v._ Allwright, repealed all statutory provisions regulating primary elections and political organizations conducting them, a political party thus freed of control is not to be regarded as a private club and for that reason exempt from the const.i.tutional prohibitions against racial discrimination contained in the Fifteenth Amendment. Rice _v._ Elmore, 165 F. (2d) 387 (1947); certiorari denied, 333 U.S. 875 (1948). _See also_ Brown _v._ Baskin, 78 F. Supp. 933, 940 (1948) which held violative of the Fifteenth Amendment a requirement of a South Carolina political party, which excluded Negroes from membership, that white as well as Negro qualified voters, as a prerequisite for voting in its primary, take an oath that they will support separation of the races.

[12] Williams _v._ Mississippi, 170 U.S. 213, 220 (1898).

[13] Davis _v._ Schnell, 81 F. Supp. 872, 878, 880 (1949); affirmed, 336 U.S. 933 (1949).

[14] United States _v._ Amsden, 6 F. 819 (1881).

[15] 16 Stat. 140.

[16] United States _v._. Reese, 92 U.S. 214, 218 (1876).

[17] James _v._ Bowman, 190 U.S. 127, 136 (1903) _See also_ Karem _v._ United States, 121 F. 250, 259 (1903).

AMENDMENT 16

INCOME TAX

Page History and purpose of the amendment 1191 Meaning of income as distinguished from capital 1192 Corporate dividends: when taxable as income 1193 The "stock dividends case" 1193 Other corporate earnings or receipts: when taxable as income 1196 Gains in the form of real estate: when taxable as income 1197 Gains in the form of bequests: when taxable as income 1198 Diminution of loss: not income 1198 Dates applicable in computation of taxable gains 1199 Deductions: exemptions, etc. 1200 Illegal gains as income 1201

INCOME TAX

Amendment 16

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

History and Purpose of the Amendment

The ratification of this amendment was the direct consequence of the decision in 1895[1] whereby the attempt of Congress the previous year to tax incomes uniformly throughout the United States[2] was held by a divided court to be unconst.i.tutional. A tax on incomes derived from property,[3] the Court declared, was a "direct tax" which Congress under the terms of article I, section 2, clause 3, and section 9, clause 4, could impose only by the rule of apportionment according to population; although scarcely fifteen years prior the Justices had unanimously sustained[4] the collection of a similar tax during the Civil War,[5]

the only other occasion preceding Amendment Sixteen in which Congress had ventured to utilize this method of raising revenue.[6]

During the interim between the Pollock decision in 1895, and the ratification of the Sixteenth Amendment in 1913, the Court gave evidence of a greater awareness of the dangerous consequences to national solvency which that holding threatened, and partially circ.u.mvented it, either by taking refuge in redefinitions of "direct tax" or, and more especially, by emphasizing, virtually to the exclusion of the former, the history of excise taxation. Thus, in a series of cases, notably Nicol v. Ames,[7] Knowlton _v._ Moore[8] and Patton _v._ Brady[9] the Court held the following taxes to have been levied merely upon one of the "incidents of ownership" and hence to be excises; a tax which involved affixing revenue stamps to memoranda evidencing the sale of merchandise on commodity exchanges, an inheritance tax, and a war revenue tax upon tobacco on which the hitherto imposed excise tax had already been paid and which was held by the manufacturer for resale.

Thanks to such endeavors the Court thus found it possible, in 1911,[10]

to sustain a corporate income tax as an excise "measured by income" on the privilege of doing business in corporate form. The adoption of the Sixteenth Amendment, however, put an end to speculation as to whether the Court, unaided by const.i.tutional amendment, would persist along these lines of construction until it had reversed its holding in the Pollock Case. Indeed, in its initial appraisal[11] of the amendment it cla.s.sified income taxes as being inherently "indirect." "The command of the amendment that all income taxes shall not be subject to apportionment by a consideration of the sources from which the taxed income may be derived, forbids the application to such taxes of the rule applied in the Pollock Case by which alone such taxes were removed from the great cla.s.s of excises, duties, and imposts subject to the rule of uniformity and were placed under the other or direct cla.s.s.[12] * * *

The Sixteenth Amendment conferred no new power of taxation but simply prohibited the previous complete and plenary power of income taxation possessed by Congress from the beginning from being taken out of the category of indirect taxation to which it inherently belonged * * *"[13]

Meaning of "Income" as Distinguished From Capital

Building upon definitions formulated in cases construing the Corporation Tax Act of 1909,[14] the Court initially described income as the "gain derived from capital, from labor, or from both combined," inclusive of the "profit gained through a sale or conversion of capital a.s.sets";[15]

and in the following array of factual situations has subsequently applied this definition to achieve results that have been productive of extended controversy.

CORPORATE DIVIDENDS: WHEN TAXABLE AS INCOME

Rendered in conformity with the belief that all income "in the ordinary sense of the word" became taxable under the Sixteenth Amendment, the earliest decisions of the Court on the taxability of corporate dividends occasioned little comment. Emphasizing that in all such cases the stockholder is to be viewed as "a different ent.i.ty from the corporation," the Court in Lynch _v._ Hornby[16] held that a cash dividend equal to 24% of the par value of outstanding stock and made possible largely by the conversion into money of a.s.sets earned prior to the adoption of the amendment, was income taxable to the stockholder for the year in which he received it, notwithstanding that such an extraordinary payment might appear "to be a mere realization in possession of an inchoate and contingent interest * * * [of] the stockholder * * * in a surplus of corporate a.s.sets previously existing."

In Peabody _v._ Eisner,[17] decided on the same day and deemed to have been controlled by the preceding case, the Court ruled that a dividend paid in the stock of another corporation, although representing earnings that had accrued before ratification of the amendment, was also taxable to the shareholder as income. The dividend was likened to a distribution in specie.

THE "STOCK DIVIDENDS CASE"

Two years later the Court decided Eisner _v._ Macomber,[18] and the controversy which that decision precipitated still endures. Departing from the interpretation placed upon the Sixteenth Amendment in the earlier cases; namely, that the purpose of the amendment was to correct the "error" committed in the Pollock Case and to restore income taxation to "the category of indirect taxation to which it inherently belonged,"

Justice Pitney, who delivered the opinion in the Eisner Case, indicated that the sole purpose of the Sixteenth Amendment was merely to "remove the necessity which otherwise might exist for an apportionment among the States of taxes laid on income." He thereupon undertook to demonstrate how what was not income, but an increment of capital when received, could later be transmitted into income upon sale or conversion, and could be taxed as such without the necessity of apportionment. In short, the term "income" reacquired to some indefinite extent a restrictive significance.

Specifically, the Justice held that a stock dividend was capital when received by a stockholder of the issuing corporation and did not become taxable without apportionment; that is, as "income," until sold or converted, and then only to the extent that a gain was realized upon the proportion of the original investment which such stock represented. "A stock dividend," Justice Pitney maintained, "far from being a realization of profits to the stockholder, * * * tends rather to postpone such realization, in that the fund represented by the new stock has been transferred from surplus to capital, and no longer is available for actual distribution. * * * not only does a stock dividend really take nothing from * * * the corporation and add nothing to that of the shareholder, but * * * the antecedent acc.u.mulation of profits evidenced thereby, while indicating that the shareholder is richer because of an increase of his capital, at the same time shows [that] he has not realized or received any income in" what is no more than a "bookkeeping transaction." But conceding that a stock dividend represented a gain, the Justice concluded that the only gain taxable as "income" under the amendment was "a gain, a profit, something of exchangeable value _proceeding from_ the property, _severed from_ the capital however invested or employed, and _coming in_, being '_derived_,' that is, _received_ or _drawn by_ the recipient [the taxpayer] for his _separate_ use, benefit, and disposal; * * *." Only the latter, in his opinion, answered the description of income "derived" from property; whereas "a gain accruing to capital, not a _growth_ or an _increment_ of value _in_ the investment" did not.[19]

Although steadfastly refusing to depart from the principle[20] which it a.s.serted in Eisner _v._ Macomber, the Court in subsequent decisions has, however, slightly narrowed the application thereof. Thus, the distribution, as a dividend, to stockholders of an existing corporation of the stock of a new corporation to which the former corporation, under a reorganization, had transferred all its a.s.sets, including a surplus of acc.u.mulated profits, was treated as taxable income. The fact that a comparison of the market value of the shares in the older corporation immediately before, with the aggregate market value of those shares plus the dividend shares immediately after, the dividend showed that the stockholders experienced no increase in aggregate wealth was declared not to be a proper test for determining whether taxable income had been received by these stockholders.[21] On the other hand, no taxable income was held to have been produced by the mere receipt by a stockholder of rights to subscribe for shares in a new issue of capital stock, the intrinsic value of which was a.s.sumed to be in excess of the issuing price. The right to subscribe was declared to be a.n.a.logous to a stock dividend, and "only so much of the proceeds obtained upon the sale of such rights as represents a realized profit over cost" to the stockholders was deemed to be taxable income.[22] Similarly, on grounds of consistency with Eisner _v._ Macomber, the Court has ruled that inasmuch as they gave the stockholder an interest different from that represented by his former holdings, a dividend in common stock to holders of preferred stock,[23] or a dividend in preferred stock accepted by a holder of common stock[24] was income taxable under the Sixteenth Amendment.

OTHER CORPORATE EARNINGS OR RECEIPTS: WHEN TAXABLE AS INCOME

On at least two occasions the Court has rejected as untenable the contention that a tax on undistributed corporate profits is essentially a penalty rather than a tax or that it is a direct tax on capital and hence is not exempt from the requirement of apportionment. Inasmuch as the exaction was permissible as a tax, its validity was held not to be impaired by its penal objective, namely, "to force corporations to distribute earnings in order to create a basis for taxation against the stockholders." As to the added contention that, because liability was a.s.sessed upon a mere purpose to evade imposition of surtaxes against stockholders, the tax was a direct tax on a state of mind, the Court replied that while "the existence of the defined purpose was a condition precedent to the imposition of the tax liability, * * * this * * * [did]

not prevent it from being a true income tax within the meaning of the Sixteenth Amendment."[25] Subsequently, in Helvering _v._ Northwest Steel Mills,[26] this appraisal of the const.i.tutionality of the undistributed profits tax was b.u.t.tressed by the following observation: "It is true that the surtax is imposed upon the annual income only if it is not distributed, but this does not serve to make it anything other than a true tax on income within the meaning of the Sixteenth Amendment.

Nor is it true, * * *, that because there might be an impairment of the capital stock, the tax on the current annual profit would be the equivalent of a tax upon capital. Whether there was an impairment of the capital stock or not, the tax * * * was imposed on profits earned during * * *--a tax year--and therefore on profits const.i.tuting income within the meaning of the Sixteenth Amendment."[27] Likening a cooperative to a corporation, federal courts have also declared to be taxable income the net earnings of a farmers' cooperative, a portion of which was used to pay dividends on capital stock without reference to patronage. The argument that such earnings were in reality acc.u.mulated savings of its patrons which the cooperative held as their bailee was rejected as unsound for the reason that "while those who might be ent.i.tled to patronage dividends have, * * *, an interest in such earnings, such interest never ripens into an individual ownership * * * until and if a patronage dividend be declared." Had such net earnings been apportioned to all of the patrons during the year, "there might be * * * a more serious question as to whether such earnings const.i.tuted 'income' [of the cooperative] within the Amendment."[28] Similarly, the power of Congress to tax the income of an unincorporated joint stock a.s.sociation has been held to be unaffected by the fact that under State law the a.s.sociation is not a legal ent.i.ty and cannot hold t.i.tle to property, or by the fact that the shareholders are liable for its debts as partners.[29]

Whether subsidies paid to corporations in money or in the form of grants of land or other physical property const.i.tute taxable income has also concerned the Court. In Edwards _v._ Cuba Railroad Co.[30] it ruled that subsidies of lands, equipment, and money paid by Cuba for the construction of a railroad were not taxable income but were to be viewed as having been received by the railroad as a reimburs.e.m.e.nt for capital expenditures in completing such project. On the other hand, sums paid out by the Federal Government to fulfil its guarantee of minimum operating revenue to railroads during the six months following relinquishment of their control by that government were found to be taxable income. Such payments were distinguished from those excluded from computation of income in the preceding case in that the former were neither bonuses, nor gifts, nor subsidies; "that is, contributions to capital."[31]

GAINS IN THE FORM OF REAL ESTATE; WHEN TAXABLE AS INCOME

When through forfeiture of a lease in 1933, a landlord became possessed of a new building erected on his land by the outgoing tenant, the resulting gain to the former was taxable to him in that year. Although "economic gain is not always taxable as income, it is settled that the realization of gain need not be in cash derived from the sale of an a.s.set. * * * The fact that the gain is a portion of the value of the property received by the * * * [landlord] does not negative its realization. * * * [Nor is it necessary] to recognition of taxable gain that * * * [the landlord] should be able to sever the improvement begetting the gain from his original capital." Hence, the taxpayer was incorrect in contending that the amendment "does not permit the taxation of such [a] gain without apportionment amongst the states."[32]

Consistently with this holding the Court has also ruled that when an apartment house was acquired by bequest subject to an una.s.sumed mortgage, and several years thereafter was sold for a price slightly in excess of the mortgage, the basis for determining the gain from that sale was the difference between the selling price, undiminished by the amount of the mortgage, and the value of the property at the time of the acquisition, less deductions for depreciation during the years the building was held by the taxpayer. The latter's contention that the Revenue Act, as thus applied, taxed something which was not revenue was declared to be unfounded.[33]

GAINS IN THE FORM OF BEQUESTS; WHEN TAXABLE AS INCOME

As against the argument of a donee that a gift of stock became a capital a.s.set when received and that therefore, when disposed of, no part of that value could be treated as taxable income to said donee, the Court has declared that it was within the power of Congress to require a donee of stock, who sells it at a profit, to pay income tax on the difference between the selling price and the value when the donor acquired it.[34]

Moreover, "the receipt in cash or property * * * not [being] the only characteristic of realization of income to a taxpayer on the cash receipts basis," it follows that one who is normally taxable only on the receipt of interest payments cannot escape taxation thereon by giving away his right to such income in advance of payment. When "the taxpayer does not receive payment of income in money or property, realization may occur when the last step is taken by which he obtains the fruition of the economic gain which has already accrued to him." Hence an owner of bonds, reporting on the cash receipts basis, who clipped interest coupons therefrom before their due date and gave them to his son, was held to have realized taxable income in the amount of said coupons, notwithstanding that his son had collected them upon maturity later in the year.[35]

DIMINUTION OF LOSS, NOT INCOME

Mere diminution of loss is neither gain, profit, nor income.