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P
Y

TREASUEI DEPARTMENT
WASHINGTON 25
March 5* 1945

IT:NDC
MEMO BANDUM FOR
Mr. Blough
Reference is made to your inquiry as to the administrative problens
likely to be encountered under a capital gains penalty tax of the type
•which you ciiscussed with me.
It is understood that this type of tax has for its objective the
discouragement of speculative trading without hindrance of investment in
new ventures» The form of tax proposed is a 90 percent (less 10 points
for each additional year assets are held) tax on gains realized from the
sale of capital assets acquired after January 1, 1945* with the exception
of those purchased since January 1, 1945* which represent investments in
new ventures. Thus, gains on farms and urban properties and securities
sold after January 1, 1945* which were acquired before January 1, 1945*
would not be subject to the tax. Those acquired after January 1, 1945*
would be subject to the tax unless it could be demonstrated that they
representod.,investment in now ventures.
This proposal presents a number of major problems among which are:
I. Definition of tax base-~
(a)
(b)
(c)
(d)
(e)
(f)
II.




Distinction between old and new ventures»
Treatment of loss off-sets.
Treatment of dealers.
Treatment of organization under section 101.
Treatment of estates in liquidation.
Treatment of depreciable assets used in trade or
business.

Classification of assets—
(a) Identification of assets purchased before ana after
January 1* 1945* and separated as to new and old
vent l r s (and by time held after the first year
ie
of the penalty tax).
(b) Identification of assets by time held (as at present)
irrespective of the January 1, 1945* date and irrespective of whether the venture was old or new*

- 2 III. Expansion and complication of tax blank—
(a) additional schedules must be provided for identification of assets purchased after January 1,
1Q45, representing old ventures*
(b) Additional tax computation schedule must be provided for computation of the penalty tax a i
rd
the allowance of appropriate offsetting credits,
(c) Extension of tax blanks to persons who will be
required to pay a penalty tax but who are not
now required to file a return«
(d) Multiple adjustment schedules for use in computing
carrybacks of net operating losses, excess profits credits and accelerated amortization which
would revise, eliminate, or institute the penalty
tax retroactively by reason of the interdependent
nature of these items»
IV» Enforcement of the tax—>
(a) Taxpayers1 records are not likely to accurately reflect distinction as between old and new ventures
making voluntary compliance very spotty»
(b) Confiscatory rate and discriminatory treatment of
old versus new ventures and date of acquisition
creates a powerful incentive for tax avoidance
and evasion.
Discussion of each of the foregoing problems
I. Definition of tax base — The statute must be so drawn as to
permit definite administrative rules for determining gains subject to
the penalty tax» In order to draft the necessary regulations and instructions for forms, the statute must be rather specific. Among the
questions which the statute must provide as answer are the foliowings
(a) Are securities of all corporation organized after January 1,
1945, new ventures?
(b) Are all new securities issued after January 1, 1945, by old
corporations new ventures? And, if pot, how is a purchaser
to distinguish between issues, the proceeds of which are
used solely for a new venture, partly for a new venture or
for refinancing an old venture?




~ 3 (o) If securities issued by an old corporation are partly for a
new venture* how is the corporation to allocate a single
share of stock or a single bond between the old and the
new?
(d) Does the issuance of stock or bonds for the acquisition by a
corporation for new and improved labor-saving machinery to
manufacture the same product in additional volume constitute
a new venture?
(e) Does the liquidation of a corporation and immediate reincorporation to engage in the same type of business constitute a new venture? If not, how much change in the
character of the business is necessary in order that the
secur ity issued be exempt from the penalty as a new venture?
(f) Does the purchase of a farm formerly used in the production
of cotton for use in the production of soy beans constitute
a new venture? If not, does the purchase of idle lands for
use as a dairy farm constitute a new venture?
(g) Does the fact that a purchaser of a farm, operate it himself,
or lease it for operation by another, have any bearing on
the definition of new venture?
(h) If a returning serviceman purchases a filling station that is
in operation and after a few months disposes of it at a
gain, is the gain the result of a new venture? Does the
fact that he has changed the character of the business by
expanding its services have any effect on the definition
of new ventures? .and, if so, how will the law define the
extent and type of expansion?
A number of further technical points which must be taken into consideration from the standpoint of administrative feasibility of the
classification of old and new ventures are set forth in the appendix of
this memorandum.
A basic problem of definition is how to define net gains after loss
off-sets. VJhile it would be consistent with the prohibitory purposes of
the tax not to recognize losses, such treatment might be unduly severe
and, therefore, will probably be allowed to some extent. If the penalty
tax were applied only to net gains after loss off-sets problems would
arise in connection with the method of allowing losses * alternative
methods would be to: (a) allow all losses on assets acquired within the
effective period to be off-set indiscriminately against gains; (b) allow
losses to be off-set only against gains on assets held for the same
period; (c) allow losses to be allowed against gains with the same or
longer holding period; and (d) provide that losses be off-set first against
the longest term gains»




- 4 Any one of these alternativos add to the taxpayers1 task of recordkeeping and classification. The further question may be raised as to
the desirability from an equity standpoint of off-setting losses in excess of gains from new ventures against gains from old ventures • This
would, of course, serve farther to confase the accounting record as it
is an exception to the general classification rule«
Losses in excess of gains also raise the question as to loss carryovers. Will such losses, if carried forward, be applicable in the
following year only to gain subject to the penalty tax and will they be
allowable, if allowable at all, only against gains on assets held for
the same periods?
An important problem in defiling gains subject to the penalty tax
is how to treat dealers and traders« It is assumed that the present
definition of capital assets will continue, in which case dealers will
be exempt from the tax«
In a rising market, dealers exeiApt from the penalty tax wsuld
occupy a strategic position to reap gains subject only to ordinary income tax rates and pass on inflated values to other investors« The
dealer loophole would be especially dangerous if it were easy, as it
appears it would be, for individuals, partnerships, syndicates, pools,
and corporations to meet the requirements for dealer status.
Organizations now exempt under section 101 from income tax own
substantial amounts of capital assets» Unless the statute specifically
made these organizations taxable, it is assumed that they would retain
their nontaxable character and gains from trading would be exempt« If
they retained their nontaxable character, increased pressures for
organizations of this type would have to be mot in order to avoid use
of such organizations as a means of evading the tax« If the organizations are exempt it would also encourage the use of contributions in
the form of capital assets which if sold by the donor would bo subject
to the penalty tax«
In respect to estates in liquidation, there is a policy question
as to whether gains from necessary sales should be subject to the tax«
It would appear that all sales made necessary in closing estates and
other necessary sales made by estates might be exempt* If such exempt
tions are provided there will be an administrative problem in ascertaining the sales made as a consequence of necessity as distinct Srom thoso
not so made*
If the present definition of capital assets is used as a basis for
determining the type of assets subject to the penalty tax, an inconsistency arises in the case of the gain from the assets or exchange of property used in trade or business of the kind subject to depreciation« On
one hand, assets held less than 6 months are not considered as capital




~ 5 assets and any gain from the sale of such assets is taxed as ordinary
income* On the other hand, gains from the sale of depreciable assets
used in the trade or business and held more than 6 months arc considered capital gains and would, therefore, be subject to the penalty
tax.
II#

Classification of Capital Assets—

The record-keeping on the part of the taxpayer in respect to
identification of assets may bo visualized from the following chart
shoTdng the breakdown required for proper accounting purposes.
A* Assets acquired on or after January 1, 1945»
(1) New venture^—
(a) Hold not more than 6 months
(b) Hold for more than 6 months
(2) Old ventures—
(a)
(b)
(c)
(d)
(o)

Hold for not more than 6 months
Held for 6 to 12 months
Held for 1 to 2 years
Held for 2 to 3 years
Etc*, depending upon the length of time
the tax is in effect

B* Assets acquired prior to January 1, 194%
(1) Held for not more than 6 months
(2) Held for more than 6 months
Every share of stock, every bond, or other evidence of indebtedness,
as well as every physical asset falling under the definition of capital
assets, sold by the taxpayer must be classified according to the above
chart* The classification by time held is generally readily ascertainable
since the date acquired and date sold is determinable* The classification
as to now or old venture is not readily ascertainable by the buyer either
from the one from whom the asset was immediately purchased or from the
debtor. Moreover, a single share of stock or a single bond may be classifiable in two separate categories as it may represent a venture partly
new and partly old*
An additional complication arises in case a corporation obtains new
capital for a contemplated new venture which venture actually docs not
materialize but which capital is used in connection with an old venture*
The purchasers of the stock in this case could scarcely be expected to
properly classify their assets*




- 6 -

III. Expansion and complication of tax blank—
Following out the breakdown described in the chart in II above,
the additional space required TOuld necessitate adding a minimum of
two full pages to the individual tax return. In other lords, the
present capital gain schedule requires one page, the proposal would
require three» This does not include the space required for additional
instructions which instructions would be most voluminous and extremely
difficult for the average taxpayer to apply.
Since there are three possible tax results, schedules must be provided to guide the taxpayer in the arrangement of the various factors
affecting the tax in such a way as to produce the tax required to be
paid.
Complicated choice problems would arise in determining whether a
joint or separate return would produce the smaller tax in cases where
husband and wife both have capital asset transactions.
Under present law a person with a capital gain of $50 of the type
subject to the penalty tax and no other income, is not required to file
a tax return. Under the proposal, such a person would be required to
file a return for purposes of the penalty tax and liable in the first
year for the payment of
in tax. This rule would undoubtedly add
materially to the number of tax returns due to be filed.
In addition to the individual income tax returns, substantial additions must be made to the return blanks of fiduciaries and partnerships in order to show the distributive interest of each beneficiary
or partner in respect to the gains or losses attributable to new as
distinct from old ventures. Gains derived through partnerships and
fiduciaries serve to further complicate the schedules on the individual
returns.
Appropriate changes must also be made on the alien series of returns. In respect to certain nonresident aliens, there is no tax at
present on capital gains. A continuation of this exemption coupled
with the high penalty may result in the development of some tax avoid*ance schemes whereby trading may be carried on in the name of nonresident aliens for the actual benefit of citizens.
In the time allotted it has not been possible to formulate, even
in outline, a schedule which would aid the taxpayer in making the multiple adjustments in connection with carry-backs of net operating losses,
excess profits credits and accelerated amortization* The adjustments
appear at first hand to be so complex that it is doubtful if any
reasonably standard schedule can be developed.




IV. Enforcement of the taxManifestly, the penalty tax cannot be determined in the absence
of adequate records. The taxpayers, themselves, will not be in a position to maintain adequate records unless the corporations and others
embarking upon new ventures advise the taxpayers in respect to the proportion of their gains which are taxable and those nontaxable. In the
case of bearer bonds and stocks bought through record owners, the
debtors will not know the names of their bondholders and shareholders.
Thus, the taxpayers will have to take the initiative in making inquiry
of the debtors. Unless the taxpayer does voluntarily take the initiative
it is unlikely that his return will be properly prepared and the Bureau
will have to contact each taxpayer and through such taxpayer contact
each debtor in order to definitely establish the true tax liability.
On the whole subject of capital gains, even under present law, the
Government is in a rather weak position from an information return standpoint. There is no practical information-^at-the-source system available
which will furnish leads to taxpayers who fail to report their gains.
With a high penalty tax on such gains, it is likely to further discourage
voluntary reporting on the part of persons disposed to avoid taxes. For
a number of years, information returns were required of brokers in the
case of each of their customers for whom sales aggregated #25,000 or
more. This was abandoned in 1942 as a result of the burden imposed upon
brokers and others and the relatively small value of the forms due to
the high minimum amount. Under the penalty tax it would be essential
that some system of this type be re-instituted with a much smaller minimum. This is certain to add tremendous burdens to all financial offices.
However, this would not cover the private transactions which are far more
difficult to trace and around which there would be an enormous amount of
tax evasion which would bring both the tax and the Department into
disrepute.




(Signed) Norman Df Cann
Deputy Commissioner
Income Tax Unit
Bureau of Internal Revenue

APPENDIX

CAPUA!"' ''" " »
! .1 •»
l *"
1
" 1 lCONTRIBUTIONS. etc.

1 1
1

~ 1 ~
The F Corporation, engaged in mining copper in Colorado,
is approaching the ead of its pre. Its engineers locate a
body of ore adjacent to the depleted mine and the corporation^
stockholders decide to build up the capital of the corporation
to enable it to acquire the new ore.
Proposition ¿1:
The stockholders voluntarily côntributô $50.00
per share on their old stock.
Proposition £2:
A valid assessment of 350.00 per share is levied,
Proposition ?/3:
Additional stock is sold to stockholders prorata
at '¿50.00 per share.
Proposition #4:
Additional stock is sold by the corporation to
public at $50«00 per share.
Assume in each case (a) all the funds are used to acquire
the new ore; (b) half the funds are used for net; ore and other
half retained for working capital; (c) half the fund for ore other half for old debts.
TJhat is extent of new venture durinr the first year when
old mine is being worked out and new mine is dormant?
Tould it be necessary to wait until new mine is started
before this would classify as a new venture?
Answers to the above questions would necessarily have to be
spelled out in dny legislation, in order to properly recognize
bona fide net; ventures.




APPENDIX

CAPITAL CQxTTRI BUTI OES
-

2

-

A syndicate purchases for cash all of the stock of a
corporation whose only asset is a factory building. The
corporation had previously been engaged in munitions manufacturing. The factory is retooled and starts to manufacture
radios,
Query:

How can this stock be identified after the syndicate
starts to sell the stock to the public?

Assume a munitions manufacturer shifts from guns to soup in
1945 - is this a ne\T venture or old venture?
Assume a new corporation is formed and acquires for its own
securities, in either a taxable or nontaxable exchange, stock or
securities of "old venture" corporations. Is this corporation to
be considered a net7 venture or old venture? The formation of the
new corporation may be for a business purpose or for avoiding the
"penalty tax". In this connection attention is directed to
section 129 of the Code which was intended to plug the loophole
of advantages growing out of acquisition of corporations with
high excess profits tax credits by determining whether the
acquisition had as one of its principal purposes the avoidance
of Federal taxes. Would it be necessary to have a similar provision in the proposed legislation to distinguish business
purpose from tax purpose, not only in the formation of a new
corporation to hold "old venture" securities, but all other
types. Section 112(i) containing a similar provision has been
in effect since 1932 Act. All rulings under 112(i) must be made
by the Commissioner in advance of the transaction. From 1932 to
date, 247 applications were filed, of v/hich 208 received favorable
rulings, 26 unfavorable and 13 were withdrawn.




APPEKDIX

CAPITAI» CONTRIBUTIONS
- 3 STOCK RIGHTS

In the event rights to new securities are issued to
stockholders " y an old venture corporation, for a bona fide new
b
venture, it is necessary, as in the case of any stock rights, to
allocate a portion of the old cost of stock to the rights so
issued. Therefore, upon exercise of the rights, the stock purchased has two elements of cost, the subscription price plus an
allocated portion of the old cost. These separate elements would
necessarily have to be recorded and traced into successive stock
rights.
The difficulties of recording and reporting such elements
where the new securities are sold, is aptly illustrated in the
memorandum of March 24, 19^1 signed by J. P. Wenchel:
"Reference is made to your memorandum of
February 17, 19^1» in which you request that reconsideration be given to G.C.M. 22532» published in
Internal Revenue Bulletin (19^1) Not 5> P? 7, dated
February 3, 1941.
Upon further consideration of the issue presented,
G.C.M. 22532, supra, is withdrawn and the following
memorandum is substituted therefor as of the above date:




An opinion is requested whether in view
of certain court decisions referred to herein
G.C.M. IOO63 (C.B. X-2, 159 (1931), G.C.M.
129^2 (C,B. xmWL' f 73 (1934), and I.T. 2609
(C.B. X-2, 339 (1931)) should be revoked, and
G.C.M. 11645 (C.B. XJI-1, 117 (1933)) and
I.T. 1786 (C.B. I1-2, 45 (1923)) should be
reinstated.
The Question involved is whether stock
sold, which had been acquired by the exercise
of stock rights, was a capital asset within the
meaning of the statute; or, to state it otherwise, where stock is acquired through the
exercise of stock rights, is the date of
acquisition the date on which the original
stock (in respect of which the rights were
issued) was acquired or the date on which the
rights were exercised?

APPENDIX




CAPITAL CQxTTRI BUT I OES
- lfSTOCK RIGHTS (Cont'd)
In G.CJ4. 129^+2, supra, it was held that
where stock is acquired through the exercise of
rights, the holding period begins from the date
of acquisition of such stock and not from the
date of acquisition of the stock with respect to
which the rights were issued. That ruling revoked,
in so far as inconsistent, G.C.M. II6U5, supra,
and reinstated G.C.M. lOOöj* supra, which was in
accord with G.C.M, 129^2, supra. In G.C.M. 116^5,
supra, it was stated in effect that stock acquired
through the exercise of rights and held for less
than two years, where the stock in respect of which
the rights were issued had been held for more than
two years, was in part a capital asset (the portion
attributable to the right) and in part a noncapital
asset (the portion attributable to the subscription
price). Under the ruling made in G.C.M, 129**2t supra,
which was based upon decisions of the Board of Tax
Appeals in Rodman 35,firis com vf Commissioner
(22 B,T,A,, 979) and Sllen Ayer v/ood v. Commissioner
(29 B.T.A., IO5O), nojxacquiescence, CfB. XIII-2, 38
(193^)) t bo part of such stock was considered to be
a capital asset.
The decision of the Board in the Griscom case,
supra, earlier had resulted in the revocation of
I.T. 1786, supra, which ruling had indicated that
stock acquired through the exercise of rights, where
the stock in respect of which the rights were issued
was held for more than two years, constituted a
capital asset. I,T, 1786 was revoked by I,T. 2609,
supra, in conformity with G.C.M. IOO63 and G,C.M.
129^2, supra.
This question has now been considered by the
courts (Wood v. Commissioner, 75 ^ed, (2d) 36^;
Macy v. Belvering,
Fed, (2d), 183; I&sull v.
Commissioner, 87 Fed. (2d) 6^8), and the conclusions
reached have been in substantial accord with G.C.M.
116^5» supra.
The Board of Tax Appeals later recognized and
followed the general rule established by the courts
in the Wood case, the Macy case, and the Insull case,
and stated that its prior decisions, in so far as in
conflict, would not be followed in the future.
(Walter gitch, Jr., v, Commissioner, 35 B,T,A., 537.)

APPENDIX

CAPITAL CQxTTRI BUT I OES
- 5STOCK EIGHTS (Cont'd)

In view of the fact that the ruling made
in &.0,M. 116^5, supra, is in harmony with the
principles laid down by the courts in the above
cited court cases, that G t C f M. is reinstated,
and G>C.M. IOO63, supra, and G.C.M, 129^2, supra,
are revoked in so far as inconsistent therewith.
It is recommended, that I.3\ 2609, supra,
be revoked but that l.T. 17^6, supra, not be
reinstated,u
This matter of allocation finally became so complicated it
was eliminated by legislation.




- 1 APFEKDIX
PARTESRSBIPS

A series of problems can arise in the typical American
method of conducting business, to wit, partnerships, The use
of family partnerships for the purpose of minimizing, avoiding
or evading taxes is well known, and this problem may be interlaced with some of the examples which are given below;
The purpose of admitting a new partner to a partnership is to:
(1) Raise more capital
(2) Reduce fixed charges, as on plant and machinery,
or mortgages on land, etc.
(3) Eliminate an unprofitable part of the business
(4) Pay off pressing obligations
(5) Take care of an accumulation of unpaid obligations
(6) Exploitation by old partners, as where valuable,
assets are sold just prior to the admission of the
new partners, Before the new partner has been
admitted, has there been a definite valuation as
far as possible:
(1) Fixed tangible assets
(2) Current assets
(3) Intangible assets
These evaluations are necessary before it may be determined
that the investment is additional capital.
In the several propositions outlined hereinafter, could
it be held that the members of the partnership have entered into
new enterprises!
Proposition:




A and B are equal partners in a business having
a net worth of $30,000. More capital is needed
to pay off some of the notes payable òf the firm.
C is invited to become a partner. He makes an
investment of $10,000 and acquires a one-fourth
interest in the business.

Partnerships (cont'd)

-

2

-

Question; Does this represent the entry into a new enterprise for C?
How are A and B affected by the transaction?
Proposition;

A and B are equal partners in a business having a
net worth of $30,000, More capital is needed to
acquire additional machinery, but of the same
character now being used by the partnership.
C is invited to become a partner. He makes an
investment of ¿pl0,000 and acquires a .one-fourth
interest in the business. The new machinery is
purchased.

Question:

Does this constitute the entry into a new venture
for C? Are A and B affected by this transaction?

Proposition;

A, B and C are partners in a trading partnership.
They decide to expand the business and engage in
a nontrading business, but in a business proximately
related to the trading partnership. The capital for
the new business is contributed by A, B and C.

Question;

Can this be held to be a new enterprise for the
three partners, A, 3 and C?

Proposition:

A and B are partners in a trading partnership,
They decide to expand the business and engage in
a trading business, but wholly unrelated to the
old business. They need more capital for the new
venture. C is invited to become a partner. He
makes an investment of $10,000 and acquires a
one-fourth interest in the business.

Question:

Does this represent a new venture for the new
partner C? Kow are partners A and B affected?

Proposition;

A and B, equal partners in an established business,
consolidate with C and D, equal owners of an allied
business. A and B are each to have a one-third
and C and P each a one-rsixth interest in the new
firm. Ho change is made in the nature of the kind
of business carried on by the allied businesses.




Partnerships
Question:

(cont'd)

- 3 -

Are A, B, C and D entering into a new venture?

Proposition!

A, B and C as partners form a trading partnership,
C dies, and by operation of law the partnership is
terminated; A n \ / partnership is formed and the
e«
Estate of C becomes a member of the new firm. The
new firm continues in the same line of business and
the partnership interests remain in the same proportion.

Question;

Does this represent a new venture for the estate of C?
How are A and 3 affected by the change?

Proposition:

A, B and C are partners in a non^trading partnership,
each owning a one-third interest in the partnership.
Due to the insanity of
the partnership is dissolved by decree of the court, A new partnership is
immediately formed by A and B to continue in the
same line of business, they are to be equal partners
in the new partnership'*

Question:

Does this constitute a new enterprise for A and B?