Seeger, Charles F.

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Journal of Accountancy Volume 37 Issue 2 Article 3 2-1924 Nature of Income Tax Charles F. Seeger Follow this and additional works at: https://egrove.olemiss.edu/jofa  Part of the Accounting Commons, and the Taxation Commons Recommended Citation Seeger, Charles F. (1924) "Nature of Income Tax," Journal of Accountancy: Vol. 37: Iss. 2, Article 3. Available at: https://egrove.olemiss.edu/jofa/vol37/iss2/3 This Article is brought to you for free and open access by the Archival Digital Accounting Collection at eGrove. It has been accepted for inclusion in Journal of Accountancy by an authorized editor of eGrove. For more information, please contact egrove@olemiss.edu. The Nature of Income TaxBy Charles F. SeegerAt present accountants differ as to the correct answer to the question, “Are income taxes an expense or a distribution of profits ?”In some instances leading firms have treated such taxes as an expense at the time of payment and for the current year. Other cases have been dealt with by bringing into account a provision for income taxes as an expense item for the period under review. Some have even accrued income taxes in preparing monthly interim statements in spite of the fact that the incidence of this taxation upon going concerns, is entirely dependent upon the final net results of an annual period.Other accountants have held and still hold that income taxes are a distribution of profits and as such, may, and should be charged against the surplus of a corporation in the same manner as dividends.Available court decisions dealing with this question are con­flicting; the latest United States supreme court decision touching on the subject has been construed to hold that income and profits taxes are expenses of a corporation, yet the actual effect of the complete decision is such as to require the treatment of income and profits taxes as additional income to the shareholders. How can an item be expense to a corporation and income to its share­holders?It would seem that the matter is one worthy of serious atten­tion, so that if possible a uniform method of treatment may be adopted in the preparation of financial statements.The proper solution of the problem involves the application of certain relevant economic and legal principles in combination with generally accepted definitional explanation of the words “profit, income, tax,” etc., upon which accounting procedure may be predi­cated with the assurance that a sound foundation, and not one of mere opinion or expediency, exists.At this point attention may well be directed to the following lexigraphic views which assist in obtaining a clear conception of the subject matter.101The Journal of AccountancyThe Standard dictionary gives, among others, this definition of “profit”: “Value acquired over and above the value parted with in the course of acquirement.” The following is given in respect to “income”: “the amount of money coming to a person or corporation within a specified time or regularly (when unquali­fied, annually), whether as payment for services, interest, or profit from investment; revenue.” Appearing under the definition of income, is the following definition of “income tax,” “a tax levied upon the income or profits of individuals.” The meaning of levy as expressed in the same dictionary is, in a legal sense, “(1) to seize or take (property) by virtue of a judicial writ thereunto commanding. (2) To impose or assess (a tax) on property and collect it under authority of law.”If the foregoing definitions are correct and controlling, then income tax is that part of the profits seized or taken by govern­ment and is not a deductible expense in arriving at the amount of profit made. Theoretically, most taxes are in the nature of a seizure of a portion of property, as, for example, immediately the tax is assessed the title to real estate is clouded until the lien of taxation is removed.Generally accepted economic laws and theory, with regard to taxation, appear to support the definitions just given as well as the resulting hypothesis. For instance, Ely, the economist, has said, “Nowhere has there ever existed any such thing as absolute private property. The rights of private individuals have always been of a more or less limited nature, and among the rights reserved by the people in their organic capacity will be found in every civilized state the right to take, for such purposes as the law-making power may deem fit, a portion of the wealth produced by its citizens.” Another pertinent quotation from the same source is, “Government, a partner in production—taxes have been defended on still another ground. It is said that government par­ticipates in all production, and is as much a factor in the creation of wealth as is land, labor or capital. . . . The argument con­tinues by asserting, that as government is a factor in production, it is entitled to a share of the wealth produced.” This, too, is a sound position, but it must not be overlooked that peculiar prin­ciples regulate the share of government. The portions which go to land, to labor, and to capital are determined, in a great measure, 102The Nature of Income Taxby voluntary agreement, whereas government by virtue of its own sovereignty determines what share it shall take.In Principles of Economics Taussig states, “Then it is clearly proper to provide that profits above a given rate of return on the investment shall be divided with the state. The amount going to the state in such case may be entitled a ‘tax’ or a ‘share.’ ”Now if, according to broad economic principles, taxation is based upon the right of people in their organic capacity to take a portion of the wealth produced by its citizens, and the govern­ment is a partner in production and as such is entitled to a share of the wealth produced and has a right to say what share it shall take and if it is clearly proper to provide that profits shall be divided with the state and the amount going to the state may be properly entitled either as “tax” or a “share,” it would seem that our income-tax laws come squarely within the purview of these economic laws and certainly represent in the final analysis a dis­tribution or a division of profits and not an expense.It must be admitted that the question has economic phases which might appear to support the opposite view. For instance, in discussing the subject of profits the economists incidentally include, among the deductible items, taxes. This, however, does not seem consistent with their viewpoint or construction of tax­ation as a share of profit to which the government is entitled. Is it not possible that in defining profit in that manner the economists have in mind the portion of profit which remains to the venture after deducting the government’s preferred share?It would be improper to attempt to decide the question sub­mitted without presenting the recent decisions of the federal courts in the case of the Georgia Railway & Power Company vs. Rail­road Commission of Georgia.This case had to do with the fixing of rates and was carried to the federal courts by the power company. In establishing rates the State Railroad Commission had allowed the Georgia Railway & Power Company to charge its federal income taxes as a cost of operation. Federal judges Bryan, Jack and Sibley, sitting as a special tribunal, reversed the commission on this point in the following language (Fed. Rep. Vol. 278, page 242) :“But we disagree with the commission in allowing the federal income tax as an expense of business. It is laid with substantial uniformity on all persons and business, certainly on all comparable to this. It is assessed on the net profit of 103The Journal of Accountancybusiness after it is done, and payable the following year. The rate of it has often not been fixed until late in the year affected. The acts laying the tax expressly declare it not to be allowable as an expense of business for the purpose of demanded by the government in return for its manifold this tax. It is that part of the profit realized which is services and protection. Though in some businesses the tax has been added to the price and passed to the consumer, this has not always been done. In banking and other money- lending businesses, usury laws were not relaxed because of the income tax. Usurious interest is not legalized, because the excess is to be paid over as income tax. Holders of government securities above the exempted amounts at so low a rate of returns as 4¼ per cent. must pay the tax out of it. To permit law-controlled business to pass this tax to the customer, except as it may come to be reflected in generally higher returns obtained by invested capital would be to subvert the policy of the law that imposes it, and, instead of placing them on an equal footing with other investments of capital of similar security and permanency, would be to give them an advantage. It appearing that a net sum of $45,364.00 was distributed as normal federal income tax over the months dealt with above in the accounting of operating expenses and taxes, the above profits estimated for a year should be increased by that sum, making $543,383.32 as the aggregate result.”The power company carried the case to the United States supreme court, which, on June 11, 1923, affirmed the decision but stated that the lower court erred in disallowing the federal taxes as a deduction. Yet the supreme court did not positively class the tax as an expense item but as either an expense or a charge in calculating whether the rate did yield a proper return.However, the supreme court further stated:“It must be borne in mind as pointed out in the Galveston Electric Company against City of Galveston, that, since dividends from the corporation are not included in the income on which the normal federal taxes are payable by stockholders, the tax exemption is, in effect, an additional return on the investment.”The principle enunciated with regard to the deductibility of federal taxes in both the Galveston and Georgia cases seems para­doxical, when compared with the actual effect of both decisions.Considerable space has been given in the Students’ Depart­ment of The Journal of Accountancy to the question of deductibility of federal taxes in determining a bonus.104The Nature of Income TaxAnent the foregoing the following will be found in Mont­gomery’s Income-tax Procedure (page 276, 1920 edition, and page 422, 1922 edition) :“Should taxes be eliminated from profits in computing bonus?” “In calculating the amount of tax to be paid by recipients of commissions, bonuses, etc., which are based upon the profits of a business or a department thereof, the question arises as to the obligation, if any, of such recipients to assume a share of the tax paid by the business. Payments of such commis­sions, etc., are expenses of the business and should be treated as such by deducting them from gross income before stating the net profits subject to excess profits and income taxes. It follows, therefore, that since the payments referred to are reported as allowable deductions, no tax of any kind has been paid thereon by the business, but the recipients must personally pay income taxes on any amounts they may receive, subject, of course, to statutory exemptions, other income, etc. Obviously, then, in the absence of any specific agreement to the contrary, it would be unfair to the recipients to compute such commissions, etc., on the income of the business after deducting excess profits and income taxes.”In the next two paragraphs, Montgomery continues this sub­ject, and inter alia states:“In claiming the amount paid to the employe as a deduct­ible business expense, the employer may be said to assent to the position that the employe is not liable to a tax based on net income.”As early as 1918 Montgomery’s Income-tax Procedure stressed the point that income taxes are not an expense (page 302, 1918 edition).However, Montgomery has straddled the fence because on page 534 in volume 2 of Auditing Theory and Practice, published recently, the following appears:“Profit-sharing Plans,”Distribution of earnings:“When a distribution of a percentage of a net earning is made, it becomes necessary to determine exactly what earn­ings and expense items should be included in a statement prepared for the purpose, and whether the amount provided for federal income and profits taxes should be deducted in determining the net earnings. The taxes to be paid and the amount of the profit-sharing distribution are affected each by the other, since the latter is an allowable item of expense. It is evident that the amount intended to be distributed is a 105The Journal of Accountancypart of the net profit which is available for dividends. The average concern considers federal taxes as an expense which is deducted in arriving at the net profit figure. It follows, therefore, that unless otherwise provided, these taxes should be considered before arriving at the amount on which the distribution is based.”The Students’ Department overlooked publishing a court decision, squarely in point, which sustained the view that income taxes are not deductible (unless so provided by contract) in determining an employee’s profit-sharing bonus.The decision (as taken from Montgomery) was as follows:“Decision Edgar W. S. Reeder vs. G. Winthrop Coffin and Quincy A. Gilmore, individually and as copartners, trad­ing as Coffin & Gilmore, Court of Common Pleas No. 3 (Philadelphia), June term, 1918. No. 3268. Extract from opinion:“We have considered the question of deduction of income taxes before allowing the plaintiff 5 per cent. of the net profits as salary. We do not think this deduction should be made, as it is not in any way contemplated by the contract.”A pamphlet issued recently by Prentice-Hall, Inc., entitled, Profit-sharing Contracts, as affected by Federal and State Taxes, yields the following:“The recent decision in the case of Stanley vs. Leary, et al., 199 New York supp., 617 (Supreme Court of New York) sustains the view that, in the absence of specific agree­ment, the compensation should be calculated upon the profits before any deduction for taxes.”In this case the plaintiff was employed as sales manager for a given salary plus a 5 per cent. commission computable annually upon the net profits. The defendants were copartners. The contract dated from January 1, 1914. The revenue act of 1917 imposed an excess-profits tax upon copartnerships.The decision state inter alia:“The defendants . . . made a profit of $204,459.97 during the year 1917. From this profit they paid a tax of $86,576.35. In computing the amount due plaintiff, the defendants first deducted the tax paid . . . and based the amount of plaintiff’s commission on $117,883.62, the difference between the profits earned by defendants and the sum paid as taxes. . . . The income tax provisions were enacted long after the agreement for compensation was made between the parties. They could not, therefore, have con­templated that such a tax would be imposed. This fact as 106The Nature of Income Taxwell as the provision in our law for the deductions of salary and other compensation as expenses of the business before the tax is paid may account for the contrary views expressed in Patent Castings Syndicate, Lim., vs. Etherington (1 ch. 306). That ruling was based upon the English income statute. It would seem, therefore, that inasmuch as the amount of plaintiff’s commissions was deductible as an item of expense, such computations should be based upon the profits before any deduction for payment of taxes.”Certain words have been underlined in the foregoing quota­tion for the purpose of emphasizing the court’s viewpoint, as interpreted by the writer, to the effect that profits earned by a concern are determined without first deducting income tax.In the case of Schoettolkotte vs. Buckeye Cotton Oil Company, heard by Chancellor Heiskell at Memphis, Tennessee, in January, 1923, it was decided that federal taxes were not deductible in determining bonus. This case is pending before a higher court. Other cases involving the same point are now before courts of other states.It is, therefore, apparent that in the calculation of bonuses present court decisions uphold the calculation before the deduction of the tax.While the practical side of the problem ought not to control the truth of the matter, nevertheless certain accounting difficulties which arise if income taxes are considered an expense in either rate or bonus determinations, cannot be lightly overlooked.Copartnerships, as such, are not subject to this tax and it is believed there is no legal inhibition to a copartnership owning and operating a public utility which would be subject to statutory rate regulation. Should a corporate public utility be entitled to higher rates than one owned by a copartnership? While a public utility owned by a copartnership or an individual might be profitable such profit may have been offset by losses from other properties as a consequence of which the owners would be subject to no tax.Then the question of determining the charge for this tax in fixing the rates of a public utility subsidiary to a larger holding corporation which might be subject to the consolidated return rule would seem difficult and especially so if the consolidated return showed no tax.Somewhat similar difficulties are present in bonus determina­tions. If federal or other income taxes are considered as an 107The Journal of Accountancyexpense, different results will be gotten in calculating the bonus if the employer is a corporation or a Massachusetts trust or a copartnership or an individual.The employee might be a new man in an old corporation which made money for the first time in several years and after applying previous losses the employer paid no federal tax. The question then arises, “Would the employee be entitled to have the benefit of the previous losses or should the bonus be calculated after deduct­ing the income tax which the employer would pay if there had been no previous losses ?”In the case of departmental heads employed on a bonus basis, what intricate methods might be required to apportion federal and state income taxes of a holding company to its subsidiaries and their respective departments ?In view of the foregoing economic, legal and practical aspects of the situation; the fact that dividends are exempt from normal income taxation; the consolidation rule applicable to many cor­porate groups, and the fact that two or more separate businesses are not severally subject to income tax when owned by one copartnership or individual, the logical conclusion is, that, in the final analysis, income taxes are a distribution of profits and not expense, and when assessed against a corporate body or group constitute only payment of the shareholders’ tax at the source, and, in effect, the courts have so held.108

Nature of Income Tax

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Nature of Income Tax

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