1938: Income Taxation

Federal Taxation.

Legislative Changes.

Federal income tax revisions involving the undistributed profits tax on corporations, and the manner of computing taxable gain or loss from the sale of capital assets made by individuals were the outstanding features of the Revenue Act of 1938 which became law, without the President's signature, on May 28, 1938. This constituted the only time in the twenty-five years since the adoption of the Sixteenth Amendment that a President has refused to sign a revenue measure. The two major revisions, so far as Congressional intent can be discerned, were enacted to eliminate some of the alleged tax impediments to business recovery.

The undistributed profits tax has been retained in principle with operation limited to two years. For corporations with net incomes over $25,000, exclusive of personal holding companies and other special types, a tax of 19 per cent of adjusted net income is imposed if no dividends are distributed. This may be reduced to a minimum of 16 per cent if the entire net income is distributed. Thus the maximum rate of the undistributed profits tax is 2 per cent, while under the 1936 Act it was 27 per cent.

Corporations with net incomes of $25,000 or less are taxed at graduated rates as follows: 12 per cent on the first $5,000, 14 per cent on the next $15,000 and 16 per cent on the balance. Special classes of corporations, such as banks, insurance companies, and mutual investment companies, are taxed at a flat rate of 16 per cent. Foreign corporations engaged in trade or business in the United States are subject to a 19 per cent rate on their income from sources within the United States.

Determination of corporate undistributed profits tax liability is predicated upon an allowance against the 19 per cent tax of an offset equal to 2 per cent of the dividends paid credit. This credit consists of dividends paid during the year and several other items, the main ones being the amount of 'consent dividends' and amount of preceding year net operating loss carryover. 'Consent dividends,' a new concept in revenue legislation, consists of that amount of undistributed earnings which the shareholders agree to account for ratably in their tax returns on the same basis as if such amount actually were distributed.

The new law alters the definition of capital assets by excluding depreciable property used in trade or business. A distinction is made between 'short-term' capital gains and losses derived from sales of capital assets held eighteen months or less, and 'long-term' capital gains and losses derived from sales of capital assets held over eighteen months. The percentages of gain or loss taken into account in computing net income are 100 per cent if the asset was held eighteen months or less, 66 per cent if held over eighteen but not over twenty-four months, and 50 per cent if held over twenty-four months. Net short-term gains are included in full with ordinary income. Short-term losses are allowable to the extent of gains on such transactions, with the provision that the excess of loss may be carried forward to offset the short-term gains in the next succeeding taxable year, but only to the extent of the net income of such year.

Net long-term gains are included with other income or, as an alternative, are segregated and taxed at 30 per cent, whichever method results in the lesser tax. Similarly, net long-term losses are deducted from net income, or 30 per cent of such losses are credited against the tax, whichever method produces the greater tax.

Significant administrative changes involved (1) enlarging the scope of closing agreements to permit closing agreements to cover income tax liabilities relating to transactions in the current and future tax years, as well as years in which returns have been filed, and (2) mitigating the effect of the statute of limitations to permit, generally speaking, the correction of errors, and a recomputation of tax in cases involving allocation of items of gross income and deductions to their proper years, although such years have been barred by the statute of limitations.

Tax Collections.

The income tax is a more important element of the Federal tax structure than it is of the respective state tax structures. For the fiscal year 1938 Federal collections amounted to $2,586,000,000 or 45.7 per cent of total internal revenue. Of this total, approximately $1,300,000,000 was from corporations, and $1,286,000,000 from individuals.

State Taxation.

State income tax collections for 1937, the latest available, were estimated at approximately $361,000,000 or 13.1 per cent of state tax receipts.

In the field of state personal income taxation there were no additions during the year to the thirty-four states which levied income taxes in 1937. Mississippi slightly increased the range of rates; New York continued the emergency 1 per cent tax for a year and halved the applicable rates on capital gains; Massachusetts continued the additional levy equal to 10 per cent of the computed tax; and Georgia deleted the minimum tax provisions. The thirty-three states which levied general corporation taxes in 1937 continued such taxes in 1938. New York ratified the proposal of the Constitutional Convention to prohibit the taxation of undistributed profits.

Analysis of Federal Tax Returns.

For 1936 there were filed 5,413,499 Federal individual income tax returns, 530,779 corporation tax returns, and 237,367 partnership returns. While 87,5 per cent of the individual returns filed were by individuals reporting income under $5,000, this group accounted for approximately 54 per cent of the net income, but only 4.98 per cent of the tax. On the other hand, the class reporting over $50,000 constituted only .34 of 1 per cent of the individual returns filed, but reported 9.82 per cent of the net income and 58.25 per cent of the tax.

The composition of net income for 1936 reported by the net income class under $5,000 consisted of 70.2 per cent from salaries, 5 per cent from dividends, 3.6 per cent from rents and royalties, and 1.4 per cent from capital gains. In the net income classes of $100,000 and over, a maximum of 15 per cent was from salaries, 45 to 62 per cent from dividends, 9 to 13 per cent from capital gains, and approximately 1 per cent or less from rents and royalties.

Senate Investigations.

During 1938 the United States Senate authorized a Senate Finance Subcommittee to investigate profit-sharing systems and also to investigate the 'grant of compensatory tax exemptions and tax rewards when profit sharing is voluntarily established.' Another special Senate Finance Subcommittee was authorized to investigate tax exemptions now accorded Governmental securities and salaries.