The Committee feels that the corporation should not now be required. to change a practice which has been in existence for some thirty-odd years, and that this practice results in the filing of returns which correctly reflect the net income. The mere fact that the books were not ruled down on December 31 does not preclude the corporation from filing returns on the basis of a calendar year, provided the books were closed on that date and such closing reflects the correct financial condition and net income. The penalties recommended by the revenue agent appear to be unwarranted and should not be assessed.

In view of the foregoing the Committee recommends that since the corporation has regularly closed its books on December 31, as well as on August 31, and has regularly filed returns on the calendar-year basis, such returns should be accepted and the corporation should be permitted to file its return for 1921 on the same basis.

The corporation having exercised an option which, in the judgment of the Committee, is binding, should not now be permitted or required to change the basis of filing its returns. It is further recommended that the action of the Unit in tentatively accepting the audit of the revenue agent on the basis of a fiscal year ending August 31, be reversed, and that a reaudit be made on the basis of a calendar year and the returns as filed be accepted as covering the annual accounting period of the corporation established by election and as being within the provisions of section 212(b) of the Revenue Act of 1918 and the regulations issued thereunder.

SECTION 212, ARTICLE 25: Accounting period.

23-21-1673 O. D. 941

It is not permissible for an individual whose business is that of a sole proprietor to compute his income from his business on one basis and his income from other sources on another basis. For income tax purposes the taxable year of a taxpayer is either a fiscal year or the calendar year, and all his income must be reported upon the basis of the taxable year. Unless an individual maintains personal books of account in which his income from business and all other sources is reflected on the basis of a fiscal year, he does not have a fiscal year which can be recognized as the basis upon which his returns may be made.

SECTION 212, ARTICLE 26: Change in accounting period.

14-21-1541 Mim. 2738

APPLICATIONS FOR CHANGE IN ACCOUNTING PERIOD MUST BE MADE BY TAXPAYER

OR HIS DULY AUTHORIZED ATTORNEY OR AGENT.

The Bureau is frequently in receipt of requests for permission to change an accounting period and the basis of filing returns from others than the taxpayer directly interested. After such permission has been duly granted it often happens that the Bureau is again requested from similar sources to rescind its action in the matter and to allow the taxpayer to file returns on the old basis.

A request to change an accounting period and basis of filing returns or a request to revert to the former method after a change has been

duly granted must be made by the taxpayer directly interested or by his duly authorized attorney or agent. If the request is made by an attorney or agent, the authority to act for the taxpayer must be

shown.

The permission to make the change is not a mere option which the taxpayer may exercise or ignore as he desires. Taxpayers should be advised that where a change is authorized future returns must be filed in accordance therewith.

SECTION 213 (a).-GROSS INCOME DEFINED:

INCLUSIONS.

SECTION 213 (a), ARTICLE 31: What included in gross income.

7-21-1445

O. D. 804

Where an individual takes out a policy of insurance in favor of his estate which is assigned to a corporation as security for money advanced without interest or other charge to pay a premium thereon, and upon the death of the insured the corporation deducts the amount of the indebtedness from the proceeds of the policy paid to it as assignee, and turns the balance over to the executor of the estate, the corporation should not for income tax purposes include the proceeds of the policy in its gross income. The function of the corporation was merely that of an intermediary in the collection of the proceeds of the policy.

SECTION 213 (a), ARTICLE 31: What included in gross income.

(See 15-21-1561; sec. 213(b), art. 74.)

Profit by a bank upon

county warrants purchased at a discount from persons to whom issued.

SECTION 213 (a), ARTICLE 31: What included in

gross income.

(See 19-21-1€25; sec. 223, art. 401.) Gross income in returns of community income.

SECTION 213 (a), ARTICLE 31: What included in

gross income.

(Also Section 250, Article 1005.)

23-21-1674 Mim. 2791

TAXATION OF GAINS FROM THE SALE OF CAPITAL ASSETS.

It appears that some taxpayers in preparing their income and profits tax returns for 1920 omitted from gross income all gains derived from the sale of capital assets. The majority of taxpayers so proceeding relied, perhaps, on the decision of the District Court of the United States for the District of Connecticut in the case of Brewster v. Walsh, 268 Fed., 207. This case was appealed to the Supreme Court of the United States and by that court overruled in part. The Supreme Court held that the gain derived from the sale

of capital assets was income subject to tax, but that where property was purchased prior to March 1, 1913, and sold subsequent to that date there was no gain unless the sale price exceeded the original investment.

The Bureau did not acquiesce in the decision of the lower court, but consistently held that the gain derived from the sale of capital assets constituted taxable income. Consequently, if a taxpayer, in preparing his tax return, omitted from gross income the gain derived from the sale of capital assets, and failed to make a full disclosure of the facts pertaining to the transaction, the Bureau holds he is guilty of negligence or fraud, as the case may be, for making the understatement.

The collector should, so far as possible, expedite the examination of the returns as filed, to discover those cases in which the taxpayer omitted from gross income the gain derived from the sale of capital assets and made a full disclosure. If a full disclosure was made, negligence will not be imputed to the taxpayer. These returns should be reported to the Commissioner on Form 23-A in the usual manner prior to the serving of notice and demand. After the Commissioner has assessed the tax on the basis of the collectors' lists, the collectors shall immediately serve, upon Form 17, notice and demand for the additional tax due, and after the ten-day period proceed to collect the tax, plus interest and the penalty for delinquency, as provided for in Section 250(e) of the Revenue Act of 1918, by distraint if

necessary.

This mimeograph supersedes Mim. 2739. (Bul. 14–21, p. 6.)

SECTION 213(a), ARTICLE 31: What included in gross income.

(Also Section 215, Article 293.)

25-21-1691 Sol. Op. 110

INCOME TAX: SECTION 213(a), REVENUE ACT OF 1918-DIVIDENDS.

Where a corporation legally declares and pays a dividend which is later voluntarily returned by the stockholders in order to avoid impairment of its capital, the amount of such dividend (1) is subject to surtax in the year in which received by an individual stockholder, and (2) being a contribution to capital, may not be deducted from gross income of the stockholder in the year in which repaid to the corporation.

Opinion is requested as to whether certain dividends received in February, 1918, by the stockholders of the M Company, and subsequently returned by them to the corporation are subject to surtax for the year in which received. At the time of the declaration of the dividend the corporation had earnings and profits accumulated since February 28, 1913, out of which the dividend could be paid. In December, 1919, additional income and excess profits taxes were found to be due from this corporation for the year 1917, the collection of which would seriously have impaired the capital of the corporation. It was therefore agreed at a meeting of the stockholders, held in December, 1919, that the dividends previously paid should be returned to the corporation. It is stated that the amount so returned was credited to the accounts of the respective stockholders and that such a return was "temporary," but whether or not such was the

case is immaterial inasmuch as the corporation might or might not find itself in a position to redeclare the dividend at some subsequent time.

Although similar questions to the one under consideration were before the Solicitor in Solicitor's Memoranda 222 and 627 (not in Bulletin service), the precise question involved in the instant case has not been previously considered in an opinion of this office.

The taxpayer has cited a memorandum of the Advisory Tax Board in which it was held that a rescinded dividend should not be considered income to the stockholders when a corporation has a legal right to force rescission and the repayment thereof and where such repayment has been actually made (T. B. M. 77, C. B. 1, p. 25). The same board, however, in T. B. R. 17 (C. B. 1, p. 294), considering T. D. 2791 (not in Bulletin service), which provides that the surplus and undivided profits as of the end of the preceding tax year must be reduced by the amount of and as of the date or dates when Federal income and excess profits taxes become due and payable for that year, held with respect to a true darned surplus that:

A tax levied as these taxes are for a definite period must be considered as a liability which has fully accrued at the end of that period and if not already paid, provision for its payment must be made before there can be any true surplus or undivided profits.

The amount of these taxes for any year can not therefore after the conclusion of such year be considered as a part of the surplus but is rather in the nature of a liability

It might be inferred from these rulings that no dividend may be declared from surplus and undivided profits unless a reserve fund is established for the payment of any Federal taxes which might accrue for the year prior to that in which the dividend is declared. However, such a principle could not be applicable to all prior years in which additional assessments might be made. The Commissioner is empowered, under the Revenue Act of 1918, to make an additional assessment of income and excess profits taxes for any given year at any time within five years after the return was due or was made, and in the case of a false or fraudulent return with intent to evade the tax the amount of tax due may be determined and collected at any time after the return is filed (section 250 (d)). It is apparent, therefore, that if we are to take into consideration a contingent liability that arises by reason of additional assessment, no point of time will arrive at which directors may safely say that earned surplus and undivided profits are available for distribution to stockholders in the form of dividends.

It is conceded that the dividends were paid and received in good faith, and it has not been shown that the declaration thereof was illegal. The corporation is an Illinois corporation, and the Illinois statutes provide as follows:

Dividend by insolvent corporation—liability of officers. Section 19. If the directors or other officers or agents of any stock corporation shall declare and pay any dividend when such corporation is insolvent, or any dividend the payment of which would render it insolvent, or which would diminish the amount of its capital stock, all directors, officers, or agents assenting thereto shall be jointly and severally liable for all the debts of such corporation then existing and for all that shall thereafter be contracted while they shall respectively continue in office. (II. Stat. Ann. par. 2436.)

This statute does not prohibit declaration and payment of dividends from capital but makes the assenting directors personally liable

to the creditors of the corporation. A statutory liability for divi dends paid from capital stock displaces common-law liability, and if the statute does not prohibit such dividends they may be declared and paid subject to the statutory liability. (Cook on Corporations, 7th edition, section 546.) Even if the dividend were illegal, however, it is doubtful whether the directors, or a receiver, of the corporation could have compelled its repayment. In McDonald, Receiver, v. Williams, 174 U. S. 397, under a statute which expressly prohibited the declaration of a dividend out of capital, it was held that the receiver could not recover such a dividend when received by a stockholder in good faith believing it to have been declared out of profits.

It appears, therefore, that the declaration of the dividend in the present case was a legal declaration and that the directors had no legal right to rescind it and compel its repayment. Hence the action of the stockholders in unanimously agreeing to repay the dividend was a new and independent transaction and entirely voluntary on their part.

The effect of a voluntary repayment by stockholders of a legally declared dividend was considered in T. B. R. 42 (C. B. 1, p. 65), where it was held that:

The rights of the stockholders with respect to the dividend became fixed at some time not later than the date of payment thereof. Such rights were not subject to any liability to repay amounts received. The dividend, therefore, became during the calendar year 1918 a part of the gross income of the stockholders. After it had acquired the character of gross income the stockholders could not by voluntary action on their part take away such character. The repayment of the dividend was a new and independent transaction.

This ruling is applicable to the present case. It is true that the individual stockholders might have considered that in agreeing to repay the dividend they were in effect nullifying it, but the difficulty with that view is that the income tax had already accrued on the dividends of the stockholders and could not be affected by the subsequent agreement of the stockholders. Having become liable to payment of the tax, they could not escape liability by an agreement among themselves.

What really happened in the present case was that the stockholders voluntarily assessed themselves the amount of the dividend in order to restore capital impaired by additional Federal taxes assessed against the corporation nearly two years after payment of the dividend. The amounts so paid by the stockholders constituted capital expenditures on their part and are therefore not deductible from gross income.

It is accordingly held that where a corporation legally declares and pays a dividend which is later voluntarily returned by the stockholders in order to avoid impairment of its capital the amount of such dividend (1) is subject to surtax in the year in which received by an individual stockholder and (2) being a contribution to capital may not be deducted from gross income of the stockholder in the year in which repaid to the corporation.

CARL A. MAPES, Solicitor of Internal Revenue.