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MEMORANDUM B

MEMORANDUM OF POSSIBLE CHANGES IN THE TAX LAW
WHICH WOULD ELIMINATE CERTAIN INJUSTICES TO TAXPAYERS
TO SOME EXTENT RESULTING IN DECREASE OF REVENUE

INCOME TAX

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

Consolidated Returns
Intercorporate Dividends
Mitigation of the Statute of Limitations in Certain Cases
Mortgage Transactions
Taxation of Alimony
Cancellation of Indebtedness in Corporate Reorganizations
Ascertainment of Earnings or Profits Available for Corporate Distributions
Taxation of Undistributed Profits Despite Impairment of
Capital
Personal Holding Company Tax Where Dividends Cannot Be
Distributed
Res Judicata
Credit for Dependents
Personal Medical Expenses

GIFT TAX
13•

Gifts in Trust

14*

Gift Tax on Tenancies by the Entirety

GMERAL
15*




Interest on Deficiencies and Refunds

MEMORANDUM OF POSSIBLE CHANGES IN THE TAX LAW
WHICH WOULD ELIMINATE CERTAIN INJUSTICES TO
TAXPAYERS TO SOME ggflMT RESULTING IN DECREASE
OF REV3MJE

INCOME TAX

1*

Existing Law as to Consolidated Returns»

The in-

come tax law since 1934 has abolished the privilege of filing
consolidated corporate returns, except with reference to railroad corporations
Discussion

It seems to he generally accepted good

accounting that the accounts of affiliated corporations should
be computed on a consolidated basis*

Separate corporate returns

often mean multiple taxation of the same earnings, and put an
irresistible premium upon artificial intercompany transactions
to reduce the tax burden*

Also, Internal Revenue Bureau decen-

tralization enormously complicates the problem
consolidated returns*

of auditing un-

What is really a single business unit

should properly be taxed as such*

Although the older provisions

on this point were productive of considerable litigation as to
the existence of affiliation and the precise treatment of various
intercompany items, the use of consolidated returns would be practical and feasible, especially in the light of previous




1*

See Internal Revenue Code, Sec* 141.

-2eaqperience. Little or 1 0 loss of revenue would " e involved,
1
b
since it is impossible to administer Section 45 with thoroughness.
Re commendat ion

Affiliated companies should either be

required or permitted (if not required) to file consolidated returns -under the general method applicable to years prior to 1934*
If the latter alternative is adopted, a higher rate of tax and
consent to various regulations might be required as a price for
the privilege of filing a consolidated return; such a differential was provided in the 1932 Act.
2.

Existing Law as to Intercorporate Dividends

For

nearly twenty years the income tax statutes, until 1935i exempted
intercorporate dividends.

Recipient corporations were required

for information purposes to report dividends from domestic corporations, but were allowed to deduct such dividends to their full
extent in determining taxable net income.

Section 26 (b) of the

Internal Revenue Code now has the effect of relieving intercorporate dividends from double taxation only to the extent of 85%,1
while tax is imposed upon such dividends to the extent of the remaining 15%.

This means a normal tax of 2.jfo on intercorporate

dividends under the 1940 rates (18% of 15%)•




1.

This percentage was formerly 90%•

-3Discusslon

The purpose of the legislative change of pol-

icy in 1935 resulting in partial taxation of intercorporate dividends
was partly a revenue purpose,"*" and was also derived from a desire to
discourage complicated networks of holding companies-

This purpose

has, of course, been partly achieved in the case of management and
holding companies by the Wheeler-Bayburn Law*

A Congressional pur-

pose to discourage personal holding companies has also been achieved
by a very drastic special provision applicable to personal holding
companies first inserted in the 1937 Act and now part of Title I A
and Supplement P»

However, there still remains a necessity of dis-

couraging over-complicated corporate structures, particularly structures involving the use of a triple tier of corporations*

On the

other hand, there are undoubtedly many situations in which subsidiaries are a legal necessity, as for example where a railroad is compelled to incorporate in a number of states as the price of doing
business.2

i» Apparently another purpose in 1936 was to prevent
avoidance of tax by dividing the income of a corporation among several subsidiary corporate units• But see Twentieth Century Fund,
Facing and Tax Problem, p» 179 (1937): "However, substantial
avoidance would be impractical for a large corporation since its
business would have to be divided among numerous small subsidiaries*
Furthermore,.such avoidance could be prevented by taxing subsidiaries at the highest rate of taxation applicable to the whole affiliated group
2# Various useful and necessary purposes of holding and
subsidiary corporations are set forth in Berle and Means, Modern
Corporation and Private Property (1932).




4It would be a happy solution if we could devise some
method of taxing intercorporate dividends which, in accomplishing
desirable objects, did not penalize cases where a minor degree of
corporate complication is unavoidable*

It might also be advisable

to eliminate from this double taxation intercorporate dividends
where the receiving corporation has merely reasonably invested a
surplus in the stock of other corporations and has a small interest
which has no real controlling power in the corporation whose stock
is owned*
Recommendations

Recommendations have to be vagae on this

point but certainly certain aspects of the problem may be canvassed
as follows:
(a)

The possibility of the elimination of this type of

double taxation where a subsidiary corporation is a matter of necessity or requirement,
(b)

as in the railroad cases mentioned*

The possibility of the elimination of this type of

double taxation in cases in which a corporation has merely more or
less temporarily invested surplus as above*
(c)

The possibility of stiffening the tax in cases of in-

excusably complicated corporate structures which have no reasonable
business purpose or foundation*
3.

Existing Law as to Mitigation of the Statute of Limi-

tations in Certain Cases




Section 820 was added to the income tax

-5statutes by the Revenue Act of 1938 to prevent the possibility of
double deductions or double taxes based upon the same items. Under
this Section if there is a determination under the income tax laws
subsequent to August 27, 1938, resulting in an inconsistent treatment of a prior item - either as to the identification of the taxpayer or when an item is taxable - then the item can be corrected
by taxing the amount correctly and allowing a deficiency assessment
or refund, except that no adjustment can be made for years previous
to 1932^
Discussion

Some of the worst types of inconsistency are

not covered by this Section.

The statute treats of the double allow-

ance of a deduction, but does not affect the double disallowance of
a deduction.

The chief examples of this category are deductions for

worthless securities or bad debts*

Neither taxpayers nor government

officials are entirely innocent of inconsistent footballing regarding
such items. The government often claims, and frequently with success,
that the stock or bad debt claimed as a deduction by the taxpayer actually became worthless in a year prior to the taxable year and also
prior to the period within which refund claims are possible.

1. See generally Maguire, Surrey and Traynor, Section 820
of the Revenue Act of 1938, 48 Yale, L. J. 509, 719 (1939)•




-6The new statute thus is inconsistent in its condemnation
of inconsistencies*

Stock losses may not be claimed by the tax-

payer because of reasonable doubt as to the facts, rather than any
culpable negligence on the taxpayer1s part; and if the debt or stock
is finally held to hare become worthless in an outlawed year, then
the error is irretrievably perpetuated*

The explanations offered

informally for this incompleteness of Section 820 are not wholly
satisfactory.

It is stated that if an adjustment were here per-

mitted, the statute of limitations would be virtually abolished*1
But at least some permissive machinery might be set up to permit
the Commissioner to do justice in these excluded cases*
Recommendation

Section 820 should be extended so as to

give discretion to the Commissioner to allow adjustments back to
some appropriate date for amounts which would otherwise be completely
lost as deductions•

Also, the requirement in Section 23 (k) that a

debt ascertained to be worthless mast be "charged off within the particular year11 should be removed from the statute, and this elimination should be made retroactive to the extent outlined above*
4*

Existing Law as to Mortgage Transactions

A great num-

ber of opportunistic decisions made by a bewildering variety of administrative and judicial officials has completely confused the whole
field of transactions involving mortgaged property*




This confusion

-7«
involves questions both as to the recognizable date of the loss suffered by 4he mortgagor or mortgagee and the nature of such losses
(whether capital or ordinary).1
Discussion

Where the mortgagee bids in mortgaged prop-

erty at a price which happens to include interest accrued on the
mortgage, the Supreme Court has decided that the "interest" is constructively received and constitutes taxable income to the mortgages,
even though the fair market value of the property at the time of the
sale may have been far less than the bid price and the mortgagee
therefore had an actual loss£

On the other hand, if the property

is "voluntarily" conveyed by the mortgagor to the mortgagee in satisfaction of the debt without the formality of a foreclosure, the mortgagee is not treated as having received taxable interest unless the
fair market value of the property transferred is equal to the prin3
cipal debt plus interest.
The Board of Tax Appeals has held that the mortgagorfs loss
on foreclosure is realized only when the redemption period expires

1. See generally Paul, Federal Income Tax Problems of
Mortgagors and Mortgagees, 48 Yale L. J. 1315 (1939)*
2* Helvering v. Midland Mutual Life Insurance Co., 300
U.S. 216 (1937)•




3. Manhattan Mutual Life Insurance Co., 37 BTA 1041.

-8under local law#^

In view of the comparative infrequency of redemp-

tions, such a rule is decidedly arbitrary*

Moreoverf it causes com-

plicated questions where the period of redemption is different with
respect to different parties in interest*

It would be far more con-

venient, and certainly more realistic, to provide that the loss is
realized at least as soon as the foreclosure sale occurs*
The nature of any loss suffered by the parties (as to whether
an ordinary or capital loss for income tax purposes) has also been a
o
fertile field of disagreement.

The Treasury regulations

permit the

mortgagee to deduct as an ordinary bad debt the uncollectible deficiency upon a foreclosure, to the extent that the mortgage notes have
not been applied on the bid price.

But the regulations go on to pro-

vide that where the mortgagee bids in the property, he realizes a
capital gain or loss measured by the difference between the bid price
and the fair market value of the property.

It is also ruled by the

Bureau and the Board of Tax Appeals that except as to depreciable
property a capital loss occurs (as to both mortgagor and mortgagee)
where property is conveyed in satisfaction of the debt without a foreclosure by a mortgagor personally liable for the mortgage debt.3
1* J. C. Hawkins, 34 BTA 918, aff'd 91 F(2d) 354 (CCA 5th,
1937); Derby Realty Co., 35 BTA 335, dismissed without opinion.
2*

Reg. 101, Art. 23 (k)-3.

3. See for example Betty Rogers, et al., 37 BTA 897, aff'd
103 F(2d) 790 (CCA 9th, 1939), cert. den. Oct. 9, 1939; but see
Bingham v. Comm.,
F(2d)
(CCA 2nd, July 26, 1939).




-9There should certainly be no taxable gain from the purchase
of property by the mortgagee.

Nor should the loss of the mortgagee

upon a foreclosure, or the loss of either party upon a "voluntary"
conveyance of the mortgaged property, be treated as a capital loss*
Such a conveyance is not a nsale or exchange" except in the most technical sense of the term; the parties are in the position of debtor and
creditor rather than of seller and purchaser.

It is a medieval play

with words to say that a foreclosure sale is involuntary but that a
conveyance under threat of foreclosure is voluntary.

The mortgagor1s

equity is usually wholly worthless in either case*
Calculations of gain or loss upon foreclosure raise further
problems as to the mortgagee's cost basis for gain or loss upon a resale*

The regulations now provide that the mortgagees basis is the

fair market value at the time of foreclosure (which is taken to be the
bid price in the absence of clear contrary evidence).

However, consid-

erable doubt has been cast on the validity of these regulations by the
Midland Mutual decision*

The Supreme Court*s refusal in that case to

consider fair market value on the question of interest income may mean
that the mortgagee's basis is the price which he bid at the foreclosure,
regardless of actual value*
Recommendation

There should at least be added to Section 117

(as was done in the case of redemptions of corporate bonds) a provision
that neither a foreclosure, nor a conveyance in lieu thereof, is to be
deemed a sale or exchange for income tax purposes*




-10Such a provision might be merely part of a general revision
of Section 117, in so far as it relates to transfers which are essentially involuntary, such as losses on corporate liquidations*
5*

Existing Law as to Taxation of Alimony

The Supreme

Court several years ago committed itself to the view that alimony does
not constitute taxable income to the divorced wife*1

This principle

has been further extended to exempt from income tax in the hands of the
wife trust payments provided in lieu of direct alimony payments; the
income from such trusts remains taxable to the husband on the ground
that he is receiving its economic benefit through the discharge of his
p
legal obligation of support*
Discussion

It does not seem constitutionally necessary to

continue granting divorced wives this freakish exemption from income
tax either upon direct alimony payments or upon distributions from an
alimony trust set up by the husband*

The theory of the Supreme Court

in the Gould case was that alimony was not income, but rather a transfer to her of capital to take the place of the support which the husband would have given her in future years if the parties had continued
living together*

But while it is true that the value of the feupport

given by a husband to his wife is not taxable to her while the parties




1*

Gould v. Gould, 245 U*S. 151 (1917)*

2*

Douglas v* Will cuts, 296 U.S. 1 (1933)*

-11are living together, there seems no conclusive reason why the same
exemption should be granted to the pecuniary substitute which the
law grants to the wife upon her divorce, and which she is free to
use for any purpose she desires.
The existing treatment leads to endless complications and
controversies as to who shall be taxed on the trust income tinder varying sets of facts, as where the husband dies before the ex-wife but
the alimony trust for her benefit continues, or where the wife was the
guilty parly in the divorce proceeding and was not legally entitled to
alimony, or where the very creation of the alimony trust completely
relieves the husband under local law from any further obligation to
his ex-spouse. A typical case in this field is now pending before the
Supreme Court1 but is unlikely to afford a complete solution.

The lia-

bilities of the present system, in the form of uncertainty and of the
heavy burden of litigation which it throws upon the courts, more than
outweigh its assets, since taxing the wife rather than the husband would
cause little if any decline of revenue.
Recommendation

The income tax statute should be amended to

tax the wife upon alimony payments or trust payments in lieu of alimony, and the husband should be allowed to deduct such amounts from his
own taxable income.

The revenues could be completely protected by im-

posing a gift tax upon the creation of alimony trusts; this could be

1. Fitch v. Comm., 103 F(2d) 702 (CCA 8th, 1939) cert*
granted October 9, 1939•




-12accomplished by inserting into the gift tax sections a provision that
release of marital rights to alimony should not be considered an adequate consideration in money or money's worth for a transfer of property*
The alimony situation is, of course, only a segment of the
whole field of trusts set up by a husband for members of his family*
Where such a trust is set up for a child or wife living harmoniously
with the husband, the existing cases are so confused that one never
knows when the grantor will be taxable upon the income and when the
beneficiary who received the income*

The model of the English income

tax law certainly deserves careful consideration here; the grantor
might be taxed by express statutory provision on the income from any
trust set up for a wife living with him, or for a minor child, unless
a full life estate in the income is given in trust for the child rather
than a mere terra of years*

If deemed desirable, this new statutory

scheme could be made applicable only for the future, and the old scheme
could remain for cases in which alimony arrangements have been based
upon existing law*
6*

Existing law as to Cancellation of Indebtedness in Cor-

porate Reorganizations

The Chandler Act,1 recently passed to clarify

and amend certain portions of the National Bankruptcy Act, Contains a
provision that no income tax shall be levied upon any release of indebtedness occurring when a company is reorganized and returned to




1*

Pub* No* 696, 75th Cong*, 3rd Sess*, c. 575 (1938)*

-13business under Section 77 B*

A large reduction of fixed indebtedness

usually occurs, since that is the very purpose of a corporate reorganization*

The Act, however, goes on to provide in Section 270 that the

cost basis of the assets in the hands of the reorganized company shall
be reduced by the full amount of the indebtedness cancelled or reduced*
This sweeping income tax provision crept in almost in the still of the
night, through the Judiciary Committee rather than the Ways and Means
Committee*
Discussion

The above treatment, although seemingly fair on

its face, leaves the situation worse than it was before the attempted
remedy*

Independently of this statute, the corporation would be taxed

as having received income only in the amount by which it is left with
an affirmative surplus*^ The Chandler Act, however, appears to have the
effect of imposing a deferred income tax (through a basis reduction)
on the whole amount of indebtedness cancelled, even though only a part
of the cancellation would have been taxable to the corporation under
general income tax principles*
Thus, a corporation with a debt of $1,000,000 and assets of
#800,000 which secured a #500,000 reduction of its debt, would, under
general income tax principles, not be taxable upon the first $200,000

1» Lakeland Grocery Co*, 36 BTA 289* Even this rule has
its qualifications* Several forms of release from indebtedness do
not constitute taxable income regardless of solvency* Thus the cancellation of a debt owed by a corporation to one of its stockholders
is ordinarily treated not as income, but as a contribution to the
capital of the corporation* Reg* 101, Art* £2(a)-14#




-14of tli© cancellation, since that would merely leave the assets and debts
exactly equal*

Only th© remaining #300,000 would be taxable*

Under

the Chandler Act, however, the whole #500,000 goes to reduce the cost
basis of the company's assets for depreciation purposes and for computing gain or loss upon subsequent disposition*
Recommendation

The provisions of the Chandler Act relating

to income tax seem out of place, and might be transferred to the Revenue Code, with a clear provision that cost basis should be reduced
only to the extent that the corporation would have received taxable
income except for the statutory exemption*

Section 113(b)(3) of th©

Code affords a precedent here, although even that Section is somewhat
ambiguous in its phraseology*
There seems no reason why a similar treatment should not be
extended to individuals•

Extension or re-adjustment agreements with

creditors, of the type here involved, are really adjustments

of capi-

tal rather than the creation of income in the ordinary sense of the
term*
7.

Existing Law as to Ascertainment of Earnings or Profits

Available for Corporate Distributions

The income tax statute defines

a dividend as any distribution out of "earnings or profits*n

The term

"earnings or profits* includes many items of non-taxable income, such
as interest in government bonds and dividends of domestic corporations^
Numerous questions have arisen as to whether particular receipts which




-15would otherwise be taxable income, but which have been accorded a
statutory exemption, are "earnings or profits" so that distribution
therefrom to the shareholders would be taxable to them.
For example, property may be acquired by a corporation in
the course of a tax-free reorganization. Company A, having property
for which it paid f1,000, but which has risen in value to #1,000,000,
may transfer the property to Company B in return for the latter1s
stock. A similar gain may, of course, arise on an exchange of stock
for stock. It has been held by the Board and the courts that such a
gain, though it is not recognized as taxable to the company due to the
reorganization provisions nevertheless, increases the earnings or profits of the transferring company available for taxable distribution.-*Furthermore, at least one court has indicated that a mere
rise in value of property held by the same company may constitute
earnings or profits, although unrealized increment has never been considered taxable income.
Discussion

Cases like F. J. Young Corporation ignore the

basic theory underlying the non-recognition of gain in reorganization
transactions. Section 111(c) provides: "In the case of a sale or exchange, the extent to which the gain or loss determined -under this
section shall be recognized for the purposes of this title, shall be

1. F. J. Young Corporation, 35 BTA 860, afffd 103 F(2d)
137 (CCA 3rd, 1939); Susan T. Freslman, 33 BTA 394, dismissed without
opinion CCA 2nd, 3rd, 1936.
2. Binzel v. Comm., 75 F(2d) 989 ( G C A 2nd > 1935) cert. den.
296 U.S. 579 (1935)


-16determined under the provisions of section 112." The words "for the
purposes of this title" seem to compel the conclusion that the exemption from non-recognition for income tax purposes applies equally to
the determination of earnings or profits. A correlation between these
two concepts is essential if we are to achieve the objective of the
reorganization sections, and if we are to avoid extremely difficult
problems of administration and of bookkeeping for tax purposes. The
decisions referred to are also contrary to the TreasuryTs own current
income tax regulations.
Recommendation

The statute should be amended to make it

perfectly clear that "earnings or profits" are not increased either by
appreciation, or decreased by depreciation in value, or increased by
any receipts rendered tax-free by the reorganization provisions.
8. Existing Law as to Taxation of Undistributed Profits
Despite Impairment of Capital Though expiring at the end of the current year, the undistributed profits tax still leaves a large number
of controversies arising with respect to earlier years since 1935* Relief from this tax was accorded to insolvent companies and to companies
in receivership. However, companies which had an impaired capital
structure, but which had somehow managed to stay out of bankruptcy or

1. Reg. 101, Art. 115-3* For a more complete criticism of
these cases see Paul, Ascertainment of "Earnings or Profits" for the
Purpose of Determining Taxability of Corporate Distributions, included
in Selected Studies in Federal Taxation, Second Series, p. 149 (1938).




-17receivership, were given no similar relief, even though they were
equally unable under local law to distribute any dividends. The
charter of such a corporation was held not to be a contract executed
by the corporation,1 and the statute so interpreted has been held
constitutional.^
Discussion There is still no authoritative decision upholding the right of Congress to tax as undistributed profits earnings the
distribution of which is forbidden by state law. The right to tax in
such cases will probably be upheld, but such a conflict between national and local statutes is certainly inexpedient.

It was often

not feasible, due to limitations of time or to the unwillingness of
preferred creditors, for companies with impaired capital to write down
their capital structure in order to distribute the current earnings.
Therefore, such corporations are practically in the same position as
corporations in receivership or bankruptcy, and should be given the
same relief. Otherwise, the very corporations least able to pay dividends are forced to pay the greatest undistributed profits tax.
Recommendation

If it is deemed inadvisable retroactively

to exempt deficit corporations from the undistributed profits surtax
to the extent of their capital impairment, then they should at least

1. Reg. 94, Art. 26-2.
2. Crane-Johnson Co. v. Comm., 105 F(2d) 740 (CCA 8th,
1939).




-18be given the favored treatment of a flat tax at a rate substantially
below the average effective undistributed profits tax rate.
9* Existing Law as to Personal Holding Company Tax Where
Dividends Cannot be Distributed

Since 1934 Congress has imposed upon

"personal holding companies" a tax now amounting to 65% on the first
$2,000 of undistributed income, and a tax of 75$ on the remaining undistributed income. Section 405(a) allows such companies the deduction of
dividends paid. The current act, however, denies to such companies the
benefit of the capital loss provisions which will be available to other
corporations beginning next year, and also purports to deny them the
benefit of the carry-over of net losses.
Discussion

As a result of the above provisions, many per-

sonal holding companies are being spanked much more seriously than Congress probably intended. This is especially true in the case of
corporations which have current taxable income but which have no earnings or profits available for dividend distribution, either from the
current year or from past years. This situation is possible where the
corporation has non-deductible capital losses, or other non-allowable
expenses or losses, which eliminate "earnings or profits" within/the
technical meaning of that phrase but leave current taxable income,***

1, See Foley Securities Co. v. Comm., F(2d) (CCA 8th,
1939), Here the personal holding company had a 1934 profit of $49,000.
However, it had a deficit of about #23,000 at the beginning of the
same year. It distributed approximately §42,000 to escape the personal




(continued on following page)

-19Under the existing law such a corporation may be taxable at
approximately 75$ of its net income. It cannot escape this tax, since
even if it distributes an amount equal to the total current taxable income, that amount will not be a taxable dividend because not out of
"earnings or profits11,1 and therefore would not entitle the corporation
to a dividends-paid credit. Nor can the tax be escaped through the

2
mechanism of a consent dividends credit;

the intention of Congress,

as revealed in the legislative reports and in the current regulations,
was that such a credit could be obtained only to the extent that a dividends paid credit would have been possible if the actual cash had been
distributed, which means that the amount of the credit is limited by
the amount of earnings or profits

available.^

Even complete liquida-

tion would possibly not serve to remove the strait jacket; even^here
(continued from previous page)
holding company surtax. Due to the prior deficit, it was held that
the first #23,000 had to be used to make up that amount, and the distribution to this extent was a return of capital, not taxable to the
shareholders and not available for use as a dividends credit.
This problem does not exist under the acts since 1936, since
Section 115(a) now defines "dividend" to mean a distribution out of
either earnings or profits accumulated since 1913 or current earnings
or profits of the taxable year without regard to the existence of accumulated earnings. That is since 1936 a dividend from current profits would be taxable when distributed, even though there is a deficit,
and such a dividend would be deductible by the corporation. The problem typified by the Foley case still may arise, however, where the
company has current taxable income but no earnings or profits either
from the current year or prior years since 1913*
1. See Internal Revenue Code, Sec. 115(a) defining a dividend.
2. See Internal Revenue Code, Sec. 28.
3. Ways and Means Committee Report No. i860, 75th Cong., 3rd
Sess., pp. 24-25 (193S); Reg. 101, Art. 23(c)-l.




-20the dividends paid credit might be limited.1
Recommendation

If it is deemed inadvisable to exempt from

the personal holding company surtax corporations with no current or
past earnings or profits, then an alternative mechanism would be to
extend the consent dividends credit to such personal holding companies for amounts ^hich the shareholders include in their individual
returns, even though such amounts would not have been taxable as dividends if actually distributed.
10. Existing Law as to Res Judicata The general judicial
doctrine of res judicata, namely the principle that issues of fact or
of legal rights determined in one suit cannot thereafter be re2
litigated, is applied by the courts in tax controversies.

The doc-

trine involves special questions with relation to the income tax for
the reason that the income tax involves items such as trust income, depreciation and many others which recur annually year after year, causing each year*s tax liability to constitute a different cause of action.
1. See Gaston & Co., 39 BTA 640, involving Section 351 of
the 1934 Act and holding that a liquidation distribution, not being
taxable to the shareholders except to the extent that it exceeded their
basis, could not be deducted by the corporation in computing the personal holding company tax. Under present law, however, it is possible
to obtain a dividends paid credit for some liquidation distributions;
Reg. 101, Art. 27(g)-l.
2. Tait v. Western Maryland Ry. Co., 289 U.S. 620 (1933),
discussed in Paul, Selected Studies in Federal Taxation, Second Series,
pp. 104, 106 (1938); Griswold, Res Judicata in Federal Tax Cases, 46
Yale L. J. 1320 (1937).




-21As applied to tax cases t i doctrine is further complicated
le
by the fact that tax suits may sometimes be brought against the Collector of Internal Revenue and sometimes against the Commissioner or against
the United States. On this point the law may be summarized by stating
that decisions in the cases involving the United States or the Commissioner as a party may be res judicata as to later actions involving the
Collector, whereas the converse of this proposition is not true.1
Discussion The application of res judicata causes some startling instances of martyrdom as tax law progresses and changes. Consider
2
the plight of the unhappy husband in Helvering v. Brooks*

The Second

Circuit Court of Appeals in this case held that a certain husband who
had created an alimony trust in behalf of his divorced/wife was taxable
on the trust income upon the ground that the income operated to discharge his legal obligation towards the ex-spouse. Several years later
(long after the time for any direct appeal in the Brooks case3had expired) the same Circuit Court of Appeals in a different case, involving
a substantially identical alimony trust held that the husband was not
taxable and expressly overruled its prior decision in the Brooks case.
1. Cf. Bankers Pocahontas Coal Co. v. Burnet, 287 U.S. 308
(1932) and Tait v. Western Maryland Ry. Co., 289 U.S. 620 (1933)•




2. 82 F(2d) 173 (CCA 2nd, 1936).
3.

Helvering v. Leonard, 105 F(2d) 900 (CCA 2nd, 1939)•

-22Nevertheless, because of the operation of res judicata, Mr. Brooks must
apparently continue to pay income taxes upon the trust income so long
as the trust endures. An error has been perpetuated v/hich neither Uie
Court, nor the taxpayer, nor the government can do anything to alleviate.
The doctrine has further complications in tax cases due to
the system of Supreme Court certiorari. The United States Supreme Court
rarely grants certiorari in tax cases unless the lower courts are in
conflict; but conflict may develop only after it is too late for the
original taxpayer to petition for certiorari. The purposes of the doctrine of res judicata, namely, to lessen litigation is, of course, a
worthy objective, but objectives of the doctrine are defeated instead
of achieved. In cases decided adversely to the particular litigant,
whether government or taxpayer, every avenue of appeal must be exhausted,
however small the amount involved, since otherwise the original decision
will result in a binding adjudication which may be conclusive as to all
future tax liabilities relating to the same item.
Recommendation The existing distinction between suits involving the United States, the Commissioner and the Collector is highly
artificial, and there is no reason why all tax suits and proceedings
should not be required to be brought against the United States, the real
party in interest.
It also need not be too loose a remedy to authorize the courts
and the Board of Tax Appeals to relax the rule of res judicata in




-23meritorious cases upon a showing of additional or different facts in
the subsequent year or upon a showing that the rules of law as announced by the courts have changed since the prior determination. This
can be accomplished procedurally by permitting motions to strike out
pleadings on the ground that res judicata applies and permitting such
motions to be defended on the ground of additional or different facts
or a new rule of law.
11. Existing Law as to Credit for Dependents. The existing
law granting a f400 credit for dependents has been stated in the accompanying memorandum. This credit for dependents now provided by the
statute ceases when the dependent reaches the age of 18 years, unless
the dependent is physically incapable of self support.
Discussion The accompanying memorandum suggests an elimination of the discrimination involved in the fact that taxpayers in the
high brackets receive more tax saving than those in the lower brackets.
On the other hand, the credit for dependents is inadequate in that it
stops, as indicated above, at the age of 18 years. This is about the
college entering age when in many families dependents become most expensive and the credit for dependents is most needed.
Recoifflnendation

Assuming the discrimination involved in the

credit is eliminated, it is worth serious consideration whether the
maximum age of 18 should not be lifted to 21 years, the standard age of
attaining majority.




-2412. Agisting Law as to Personal Medical Expenses The present statute expressly disallows all personal living expenses"1" and this
disallowance includes any amount expended for medical services.
Discussion It would be wholly logical and fair to allow taxpayers some deduction for expenses incurred in protecting their own
health - their chief income-producing capital asset. It is plainly inconsistent to permit a farmer to deduct the expense of veterinarian service to his cattle, but not to deduct medical expenses made to protect
the health of himself and his family. A deduction here would encourage
the obtaining of adequate medical attention by taxpayers in the lowermiddle income brackets. An experiment in permitting such a deduction
has worked successfully under some of the state income tax laws.
Recommendation A maximum deduction of perhaps $100 a year
should be allowed for medical or dental expenses paid by the taxpayer
on behalf of himself or any member of his family.
GIFT TAX
13. Existing Law as to Gifts in Trust Section 505(a) of the
1938 law amended Section 504 (b) of the 1932 law by providing that the
|4,000 annual exclusion allowed generally for gift tax purposes shall
not apply to gifts in trust.
Discussion

This amendment was inserted to remedy the evil

of creating a number of trusts for the same beneficiary in order to




1. Internal Revenue Code, Sec. 24(a)(1).

-25secure the benefit of more than one exclusion.

The calculation of the

exclusion in this situation has been the subject of a difference of
opinion between the Board of Tax Appeals and the courts; the courts
have finally held* under the laws prior to 1938 that the beneficiaries
are the true donees rather than the trustees, and therefore the tax
avoidance which the 1938 amendment was assigned to prevent has proven
illusory*

At any rate the remedy adopted in the act amounts to burning

down the house to destroy the rats*

Trusts for minor children and other

members of the family are a useful social device, and it seems unwise
to give them a virtual death blow ty completely removing the exemption.
Recommendation

The $4,000 gift tax exclusion should be re-

stored to gifts made by way of trust, with the limitation that only one
trust should be recognized for each beneficiary in computing the tax*
The exclusion, in other words, should be in all cases determined according to the number of beneficiaries rather than the number of trusts.
If one exclusion is claimed with respect to a gift in trust for a certain beneficiary, no additional exclusion should be allowed in the same
year for a gift made directly to the same beneficiary.
14*

Existing Law as to Gift Tax on Tenancies by the Entirety.

The existing regulations under the gift tax provide that if a- husband
purchases property and causes title to be conveyed to himself and his

1. Welch v. Davidson, 102 F(2d) 100 (CCA 1st, 1939);
Rheinstrosm v. Comm., 10$ F(2d) 642 (CCA 8th, 1939)•




-26wife as tenants by the entirety, then the transaction amounts to a
taxable gift to the wife, consisting of the value of her interest in
the property.

This position has been upheld by the courts.1

However,

the estate tax law provides that upon the death of the husband in such
a situation, the whole value of the property is includible in his estate for estate tax purposes.2
Discussion

The above treatment means that the government

inconsistently treats such a conveyance as a completed transfer to
the wife for gift tax purposes, but disregards the transfer for estate
tax purposes.

The gift tax rule, moreover, involves considerable dif-

ficulties of valuing the wife f s right to the joint use of the property
for life and her contingent right to become sol© owner of the property
in case she survives the husband; and it is possible that refined distinctions may have to be drawn according to the exact legal rights
which the law of the particular locality gives to the wife as one of
the joint owners.
Since the estate tax and gift tax were clearly designed as
supplementary to one another,3 the gift tax should not be interpreted
as covering transfers which are explicitly covered by the estate tax.

1. Lilly v. Smith, 96 F(2d) 3 U (CCA 7th, 1938) cert. den.
305 U. S. 604 (193S).
2. Sec. 302 (e).
3» The precise extent to which this is true will be further
illuminated by the decision in Sanford Estate v. Comm., U.S. (1939)
afffg 103 F(2d) 81 (CCA 3rd, 1939).




-27The more significant shift of economic interests occurs at the husbands death; and here, as elsewhere, the imposition of tax should be
laid upon economic realities rather than artificial legal technicalities. The gift tax upon the type of transfer in question would, of
course, be an allowable deduction in computing the estate tax; but
due to the methods of computing such a credit, this is an inadequate
protection. Moreover, the husband may not consciously have intended
to make a gift to the ? i f in the sort of transaction here involved,
r.e
and imposing a gift tax traps the unsuspecting taxpayer.
Recommendation

Assuming, as we apparently must, that Lilly

v. Smith is a correct interpretation of the statute, the gift tax law
should be amended to provide that no transfer (except gifts ultimately
determined to have been made in contemplation of death) should be subjected to gift taxation wkere the same property would be included in
the transferor's taxable estate upon his death.
GENERAL
15. Existing Law as to Interest on Deficiencies and Refunds.
The present law allows interest of G o upon the amount of any deficienf
cies, and also allows the same rate of interest upon any refunds found
to be due the taxpayer.
Discussion These percentages are out of line with present
interest rates and should be reduced. Such a reduction would benefit
taxpayers since the amount of deficiencies collected by the government




-28imist considerably exceed the amount of refunds collected by taxpayers.
Recommendation The interest rate on both deficiencies and
refunds should be lowered to 4$.
(s'gd) Randolph E. Paul
November 13, 1939
Note; Section number references under the gift and estate taxes
are to the several acts and not to the new Internal Revenue Code with
which latter section numbers most persons are not yet familiar.