Date 20 September 1934
Author Carl Shoup
Title The Federal Revenue System: Individual Proprietorship, Partnership, and Corporation (Differential Tax Treatment Under the Income Tax Laws); Imputed Income; Miscellaneous Tax Matters
Description A report to the Secretary of the Treasury
Location Box 62; Tax Reform Programs and Studies; Records of the Office of Tax Analysis/Division of Tax Research; General Records of the Department of the Treasury, Record Group 56; National Archives, College Park, MD.


Individual Proprietorship, Partnership, and Corporation
(Differential Treatment under the Income Tax Laws);
Imputed Income; Miscellaneous Income Tax Matters

Carl Shoup.



Individual Proprietorship, Partnership, and Corporation
(Differential Treatment under the Income Tax Laws);
Imputed Income; Miscellaneous Income Tax Matters

Summary of Recommendations
Individual Proprietorship, and Corporation
     Summary of General Provisions
     Differential Treatment
     General Analysis and Recommendations
     Details of Points at Issue
          (a) Corporation Rates VERSUS Normal Rate
          (b) Gains in One year and Losses in Another
          (c) Dividends and Partially Exempt Interest
          (d) Charitable, etc., Contributions
          (e) Capital Gains and Losses
Imputed Income and the Present Income Tax Law
     Hypothetical Example
     Is the Inequity Eliminated by the Property Tax?
     Civil War Tax
     "Gross VERSUS "Net" Imputed Rental
     Extent of Imputed Income
     Treatment in Other Change
     Objections to the Change
Miscellaneous Income Tax Matters
     Deductions for Interest, Bad Debts, and Casualty and Theft 
     Interest on United States Government Bonds
     Compounding of Depreciation Allowance
     Earned Income
     Information at the Source


Individual Proprietorship, Partnership, and Corporation (Differential Treatment under the Income Tax Laws); Imputed Income; Miscellaneous Income Tax Matters

Carl Shoup.


(1)(a) Marrow the present wide spread between the corporation tax rate had the normal tax rate. A combination suggested, if increased revenue is needed, is: corporation rate, 13-3/4 per cent, normal rate, 8 per cent. Further study would probably show that other suitable combinations would be, approximately: corporation rate, 12 per cent, normal rate 6 per cent; corporation rate 10 per cent, normal rate 4 per cent; (b) in conjunction with this charge, apply the surtax only to the surtax net income LESS the normal tax payable.

(2) Omit the phrase introduced by the 1934 Revenue Act, in Section 184, reading "(Not in excess of the net income of the partnership)".

(3) Restore Section 183 of the 1932 Revenue Act, and specify that a partner is entitled this proportionate share of the charitable contribution, subject to the present limitation in Section 23(o).

(4) Specify that capital losses incurred by a partnership shall be deductible by the partner to the extent of his proportionate share therein, subject only to the limitations of Section 117(d).

(5) Restore the net (business) loss provision substantially as they existed in the 1928 Revenue Act.

(6) Tax owners of homes on net imputed income; and consider seriously the taxation of non-cash income derived from an individual's own efforts, as, for instance, food given and consumed by the same individual.

(7) Disallow deductions now granted that represent expenses not connected with the receipt of taxable income (bad debts, interest, and casualty and theft losses).

(8) Consider restricting the present allowances for traveling expenses.

(9) Impose penalties on those fail, though not "wilfully", to fulfill requirements of the law with respect to filing information returns.

(10) Require Federal disbursing officers to file information returns.

(11) Eliminate the exemption of Federal bond interest from the informational requirements.

(12) Make certain verbal changes in sections 25(a)(2) and 25(a)(5)(A) of the 1934 Revenue Act.

Recommendation (1) above could either increase, decrease, or leave almost unchanged the total revenue from the tax. Recommendations (2), (3),and (4) would cause some, but not materiel, loss in revenue. Recommendation (5) would cause a fairly substantial loss in revenue, to be made up by an increase in rates, the remaining recommendations would increase revenue from the income tax, especially recommendation (6). The writer cannot, in the time at his disposal, suggest approximate amounts to be gained or lost under all of the above provisions, but he feels that even the changes that would decrease revenue are so desirable that they would be well worth the cost.


The relative positions of the individual proprietorship, the partnership,and the corporation, with respect to income tax liability form subject that has caused many changes in the revenue laws in the past and is almost certain to cause more changes in the future since the present situation is not satisfactory.

At the beginning a distinction should be made between organizations being used to carry on a business, and those that are used for personal ends -- the mercantile or manufacturing corporation, for example, as opposed to the "incorporated pocketbook".

With respect to the former type of organization, the chief question from a long-tern point of view becomes; does the income tax law discriminate among the various forms to such an extent that (a) business capital is distributed among the several types of organization in proportions different from what is would be if the income tax treated all forms alike, and/or (b) the total capital used in business is reduced, or used less efficiently. The tentative answer at which the writer has arrived with respect to (a) above is: Under the present income tax law the funds of moderately well-to-do investors are used more in the partnership and individual proprietorship forms and less in the corporate form than would be were it not for the decided discrimination exercised by the present income tax law as concerns wealthy investors, however, this discrimination is slight or else does not exist. with respect to (b) above little can be said except that the burden of proof is probably on those who would maintain that the discrimination does not impair the use of capital. From a short-tern point of view the chief question is: Does the differential treatment result in serious inequity as among various investors and business managers. Over a long period the question of equity becomes less important because new investors and managers will enter business with knowledge of the existing discrimination, and guide their actions accordingly. Every time the law is changed, of course, a new short-term period of inequity may result. The writer's conclusion is that serious short- term inequities have been caused by changes in the past decade, and that it is essential that a carefully throughout policy be adopted and thereafter left unchanged for at least a decade or so.

With respect to the second type -- the non-business organization -- the chief questions are: (a) Does the law permit differential treatment among individuals who are in virtually the same circumstances except that one is able to take advantage of certain organizational forms. (b) Does the law, in an effort to remedy any injustice under (a), create other injustices by (i) penalizing the use of certain organizational forms that non-tax circumstances render virtually imperative, even for these non-business matters, or (ii) discriminating, trough the use of arbitrary criteria, among taxpayers in essentially the same situation. Time limitations have prevented study of these problems of the no-business organization by the writer, but it is suggested that these points among others be considered in any future analysis of the subject.

Summary of General Provisions. -- The general situation with respect to the various forms of organization is as follows:

Under an individual proprietorship the business income (or loss) is merged with the other income (or loss), if any, of the individual proprietor, and the business enterprise as such is not taxed.

Under a partnership, the partnership net income (or loss)is determined, and each partner merges with his income (or loss) from other sources, if, any, his share of the partnership income or loss. It is immaterial whether any of the partnership income is actually distributed to the partner. The partnership as such is not taxed. It is of importance, however, that the law provides that the income of partnership as a unit shall be determined,as there are some deductions (losses from sales of property, charitable contributions) which may be more or less restricted, depending on the size and character of other elements in the unit's income statement. Furthermore, there are certain credits for normal -- tax purposes which may be transferred from the partnership to the individual only to the extent specifically allowed by law.

Under a corporation, the corporation as such pays a corporation tax, and the dividends that it distributes to its stockholders are subject only to surtax (not to normal tax). Here the divorce between the investor and his business is virtually complete.

Differential Treatment. -- The chief points of discrimination are: (a) The difference between the corporation rate (13-3/4 per cent, or 15-3/4 per cent for consolidated railroad returns) and the normal rate (4 per cent).

(b) the ability of a corporation to offset the gain of one year with a loss of another for purposes of SURTAX on the individual investor, compared with the inability of the partnership or individual proprietorship to do so.

(c) The restriction of the extent to which a partner or a shareholder, as compared with an individual proprietor, can make use of credits against income (for normal tax purposes) of (i) dividends received by the business from domestic taxable corporations, and (ii) partially tax-exempt interest.

(d) The restriction of the extent to which a partner, as compared with an individual proprietor, can deduct amounts donated by the business to charitable and similar organizations.

(e) The apparent denial to a partner or a shareholder, as compared with an individual proprietor, of the privilege offsetting losses from the sale of capital assets by the business against gains from the sale of capital assets by the individual outside the course of business.

Each of these points is discussed in the section below, following the next section on "General Analysis and Recommendations".

General Analysis and Recommendations. -- It is the writer's opinion that attempts to distinguish between the business as a unit and the investors in the business leads to inequitable results in that investors similarly circumstance except for the mere legal form under which their business are carried on are treated differently. To "burden" "the corporation" or "the partnership" as such is impossible -- such bodies can feel no burden. It is to the persons behind the organizations that one must look.

To remove the present discriminations against the partnership, in favor of the individual proprietorship, would be simple. All that would need to be done is to restore the provisions of the 1932 law with respect to dividend and interest credits and charitable contributions, and to disregard the partnership as an entity when computing the amount of capital loss to be allowed to the individual as a deduction. The writer recommends that these steps should be taken.

With respect to the difference in treatment of corporate- derived business income as compared with non-corporate business income, the matter is not so simple. One discrimination against the partnership -- the one concerned with years of loss and gain -- could be in large part eliminated by restoring the net (business) loss provision much as it stood in the 1928 Revenue Act. This step is so obviously desirable in the interests of equity, even apart from the particular point raised here, that is should be taken as soon as possible.

There remains the contrast between the corporation rate and the normal rate. The narrowing -- but not the entire closing -- of the spread between the normal rate and the corporation rate would eliminate a large part of the inequality for investors of low and moderate income. Closing the spread entirely would give too large a bonus to the corporate form for wealthy investors, for reasons explained in a later section.

There seems to be no other way to lessen inequality of treatment in this matter short of stripping aside entirely the corporate veil and subjecting the individual shareholder to both normal tax and surtax on his share of the corporation earnings, whether distributed or not -- just an income from a partnership is now, in general, treated. This would involve elimination of the corporation tax. Dividends would not be taxed as such, Non-resident shareholders might still be taxed by collection at the source, perhaps at a flat rate. However, the writer does not advocate this plan, for reasons to be noted below.

If revenue needs forced an increase in the normal rate to about 8 per cent, a considerable part of the discrimination with respect to the investor on the $15,000 level would be eliminated. /1/ Although any such shift in the relative positing of the rates causes a marked shift against the unincorporated form in the higher income levels, this discrimination against the unincorporated form in the higher income levels could be removed by allowing the surtax to be applied only to the surtax net income as at present defined, less the normal tax payable.

One naturally inquire what results this latter change would have other than the result aimed at. The other results would be two:

(a) A decrease in the tax revenue. This decrease would probably not be greater than $25 million, accordingly to certain rough estimates that the writer has made on the basis of 1931 Statistics of Income, and might be as low as $15 million, This decrease would be recouped many times over by the increase in the normal tax rate, which has been suggested anyway in order to narrow the spread between normal and corporation rates:

/1/ Thus a single man with no dependents, with a business earning $15,000, before salary deduction, would pay, under the incorporated form (assuming a $3,000, salary), $2,254, (corporation tax, $1,650.; surtax $468; normal tax, $136,); under the incorporated form, $1,696. Under the present law the totals are, respectively, $2,186, and $1,148.

(b) Relatively heavier taxation of the person receiving partially-exempt interest from Federal bonds as compared with the person receiving his income is such forms as salary, corporation bond interest, etc., which are subject to normal tax. For example: Under the present rate structure, taxpayer A, single and with no dependents, receiving his entire income, $42,500, from Liberty 4-1/4 per cent bonds, pays a tax (all surtax -- no normal tax) of $5,429. Taxpayer B, also single and with no dependents, receiving his entire income, $42,500, as salary, pays $7,084. Under the proposed plan (assuming the present 4 per cent normal rate), A's tax would remain the same, but B, since the could deduct his normal tax in arriving at surtaxable net income, would pay a total of only $6,699.04 -- about $400 less than before and about $1,200 more than A.

In general, this plan of allowing the taxpayer to subtract his normal tax payable from his net income in order to arrive at the surtax base would have this effect: Among the taxpayers of low and moderate incomes it would disturb the present relative positions of various kinds of taxpayers hardly at all; among taxpayers of large incomes it would favor the recipient of salary, corporation bond interest, and proprietorship and partnership profits, as compared with the recipient of partially exempt Federal bond interest and corporation dividends. It would be recalled that this "discrimination" against wealthy dividend recipients is necessary because they would otherwise be unduly favored by the narrowing of the spread between the corporation rate and the normal rate -- a narrowing that is necessary in order to remove the present heavy discrimination against the investor of moderate means who wishes to do business under the corporate form.

Details of Points at Issue. -- The points at issue with respect to discrimination were noted briefly above in the section headed "Differential Treatment". They are here taken up in detail, the divisions being lettered (a), (b), etc., to correspond with the points noted in the above section.

(a) Corporation Rates versus Normal Rate. -- Since dividends and partnership profits are subject to the same surtax rates, the comparison to be drawn ins one between (i) the normal rate (4 per cent) applicable to partnership and individual proprietorship profits but not dividends, and (ii) the corporation rate (13-3/4 per cent) applicable to corporation profits (and hence indirectly a burden on the dividend recipient) but not to partnership or individual proprietorship profits.

Serious as this discrepancy appears to be on the surface, it provides in fact relatively little, if any, discrimination against the corporate form of doing business when one considers an individual whose net income reaches well up into the surtax brackets. Primarily this is so because the surtax on dividends necessarily can reach only this that part of the profits left after payment of the corporation tax, whereas the surtax on profits of a partnership or individual proprietorship is levied on the individual's share in these profits before deduction of normal tax payable. Thus if an individual proprietorship nets $100,000, the proprietor pays normal tax an surtax on these amounts (after deduction of the proper credits); while if a one-man corporation earns $100,000, the most that can be subject to surtax (as dividend) is $100,000 less corporation tax of $13,750, or $86,250. With high surtax rates the importance of this factor is obviously considerable.

If the individual investor in question has a relatively small income -- below $30,000 or so -- this point becomes of little consequence, and the apparent discrimination against the corporate form is indeed a real one.

Another consideration operating to lessen the apparent discrimination is that the corporate investor has the privilege of "reinvesting" his profits without, for the moment, paying surtax. If the corporation profits are not declared at once as dividends but are instead "reinvested in" or "ploughed back into" the business, there is of course no surtax. This is a somewhat doubtful advantage, however, as a continuation of this process builds up the value of the shares of stock and renders the shareholders liable, ultimately, to both normal and surtax on gain when he disposes of the shares, and, since the accumulated profits became taxable in a lump sun in one year, he may find himself hard hit by the progressive surtax rates. True, he may never sell the shares; he may pass them on to others at his death, and because of the present loophole in the income tax laws the gain accruing up to his death goes free of income tax. Furthermore, he may at a time when tax rates are lower, or when he has some capital losses that can be offset against the gain. Still further, under the present capital gains provision, as the years pass the percentage of the gain which he must enter for tax purposes diminishes. Finally, it may noted that he saves interest charges by not having to pay the tax until some years have passed (as compared with the individual proprietor). The numerous advantages and disadvantageous attendant upon this "privilege" of reinvesting without immediate surtax payment form a complex problem not possible of general evaluation, but it is perhaps fair to say that for the well-to-do investor the privilege is on the whole a real one. /1/ For the investor of moderate means the value of the privilege seems more doubtful.

The general conclusion to which the writer has come is that for investors whose total net income is in the neighborhood of $30,000 or above, on the average, the present rate structure offers no incentive -- again, on the average -- to avoid the corporate form. At least, the problem involves so many future unknowns that he cannot calculate with reasonable accuracy which way his best interests lie. Quite different is the situation with respect to the small investor, particularly one whose net income is below $15,000 or $20,000. Under almost any likely circumstances the present tax structure tends to force him away from investment in the corporate form, particularly in new enterprises in which he is to be one of the chief interested parties. As concerns readily marketable shares in large, long- established corporations, it may well be that processes of capitalization in the market have adjusted the price so as to negative this handicap.

/1/ The degree to which the privilege is exercised by the share- holder on his own initiative varies of with the degree of his control over the corporation.