This contention hardly merits formal analysis, but it represents a fairly widespread misconception.

It may be observed, first, that the Revenue Act of 1936 accorded preferential treatment to small corporations in two ways. First, it provided for lower normal taxes; and, second, it limited to 7 percent the surtax applicable to the first $5,000 of undistributed net income of those corporations that report adjusted net incomes up to $50,000. In consequence, a corporation with net income or $20,000, for example, could retain $5,000 of its earnings undistributed and still be liable to total normal and surtaxes some $160 less than the normal tax liability alone on the same income for the taxable year 1935.

The Treasury has estimated that 83 percent in number of all corporations reporting net incomes for 1936, or 214,000 out of a total of 257,000, will report net incomes of $10,000 or less. A corporation with net income of $10,000 can distribute in dividends (and not necessarily in cash) only 30 percent of its net income after normal tax, and still be liable for total normal and surtaxes aggregating only 15.6 percent of its net income.

But the capital funds available for profitable corporations, whether large or small, are not limited to the amounts that they can save directly from earnings. Corporations that desire additional capital for expansion or other purposes can obtain such capital by the sale of additional shares or other securities to their own stockholders or to investors generally.

In the case of small corporations with a limited number of stockholders, it is almost as easy to pay out earnings in dividends and have all or a part or them resubscribed by the stockholders for additional shares of the corporation's stock, as to reinvest them directly. Which method shall be followed is merely a matter of convenience and tax economy. Under the previous system of income taxation, these considerations tended to favor the process of direct reinvestment, and hence a body of examples taken from the growth of corporations over the period during which the previous system operated will naturally show that numerous small corporations grew into large ones by this method. The method of resubscribing dividends, however, would be equally effective, except for that part of the dividends which is absorbed by the shareholders' individual income taxes.

We have already observed that small corporations are given preferential treatment in the Revenue Act of 1936, as respects both normal tax and surtaxes on undistributed earnings. They also enjoy two advantages in the process of growing through resubscribed earnings. In the first place, the very compactness of most small corporations permits this process to be carried on with a directness and informality which is impossible for the larger corporations. The whole operation of declaring out the year's profits as dividends and resubscribing all or a portion of such dividends for additional shares of the corporation's stock, either pro rata or in such proportions as might be mutually agreeable to the shareholders, can be completed in the course of a short stockholders' meeting.

In the case of small or medium-sized corporations with a larger number or more scattered stockholders, a large proportion or all of the current earnings can be declared in the form of dividends consisting of scrip or promissory notes; and the corporation can offer to accept these instruments in payment of subscriptions to additional stock of the corporation, attractively priced. This would avoid all liability for the corporate surtaxes and still permit the use for expansion of the liquid resources arising out of the corporation's earnings. Similarly, by first creating a small issue of preferred stock, a corporation could thereafter distribute its current earnings to common stockholders in the form of preferred stock of the same or different character. Effective use could also be made of Section 115(f)(2) of the Act, which specifically includes as a taxable dividend a dividend that is payable, at the option of the shareholder, in either cash or common stock.

These and other lawful means available to small, medium-sized, or large corporations -- but particularly easy of adoption by small or medium-sized corporations -- for avoiding the surtax on undistributed net income, are entirely consistent with the aims of the Revenue Act of 1936. This is true because the use of any of these means does not, on net balance, deprive the Government of any tax revenues contemplated by the Act. To the extent that corporations avail themselves of any of the lawful means of avoiding the corporate surtaxes, the taxable incomes of their stockholders tend to be increased; so that the Government obtains substantially equal revenues irrespective of the dividend policies of the corporations.

The other advantage which, generally speaking, small corporations have over large ones arises out of the relatively larger proportion of dividend receipts that their stockholders would have available, after payment of individual income taxes thereon, for subscription to additional securities, as compared with the important stockholders in larger corporations. It is generally true that the principal stockholders of small corporations are individuals of much smaller incomes than the principal stockholders of large prosperous and well-established corporations. To the extent that both large and small corporations look to the dividends paid to their stockholders as sources of additional capital funds for expansion, debt retirement, and the like, small corporations are in a relatively better position, by reason of our steeply graduated individual income taxes. Dividends which go to individuals reporting surtax net incomes between $10,000 and $12,000 are subject to individual income taxes aggregating only 11 percent; whereas dividends received by individuals reporting surtax net incomes between $100,000 and $150,000 are subject to income taxes aggregating 62 percent.


In addition to the four primary objections to undistributed profits taxation reviewed in the foregoing, a number of miscellaneous objections have been made. The more important of these are treated below:


The best case for this contention would run somewhat as
follows: "You say that we can retain the equivalent of our
current earnings for expansion by offering stock rights to our
stockholders or by selling additional securities to other
investors. This means that our capitalization would be
constantly increasing in good years. But what is to happen in
bad years when we suffer losses? No corporation likes to have a
capital deficit on its balance sheet. Moreover, some of our
investments for expansion may prove unwise. If we can write
these off against our surplus account, there is no difficulty.
It is a different thing to write down our capital because of
mistaken expansion."

This contention might have merit, though by no means
decisive merit, if the prevailing practice among American
corporations were to maintain a consistent relationship between
the carrying or par value of capital stock and the stockholders'
investment. In that case the carrying or par value of capital
stock would have a definite and consistent meaning -- though not
one of primary significance -- that it does not now possess. In
actual practice, except for corporations under public
regulation, there is no necessary or uniform relationship
between the amount of the stock-holders: investment and the par
or carrying value of the capital stocks. Most corporations today
are born with a surplus which is created at the outset by giving
a smaller carrying or par value to the capital stock than the
value of the assets presumably invested by the stockholders.
Nearly every day one or more corporations is increasing its
surplus account by reducing the par or carrying value of its
common stock, or is reducing its surplus account by dividends
payable in capital stock.

Whether expansion is financed directly from earnings or is
financed by the sale of additional securities to stockholders,
the corporation is, clearly, employing new capital funds -- and
new capital funds provided by the stockholders. If the
corporation does not desire to reflect the new capital funds in
its formal capitalization, it is able in the one case, scarcely
less than in the other, to reflect the additional capital funds
by additions to its surplus account rather than by additions to
the aggregate formal par or carrying value of its capital stock.
It may reduce the latter virtually at will, with no perceptible
effect upon the market value of its securities or upon its
credit standing. A corporation which sold to its stockholders
at $50 per share 100,000 shares of additional stock of $5 par or
carrying value, would increase its surplus account by
$4,500,000, and its capital stock account by only $500,000. It
could then write off losses against this surplus account in the
same way as against a truly earned surplus.

It is no doubt true that stockholders are apt to be
somewhat more exacting with respect to the uses of the capital
funds that they formally contribute than they are of capital
funds which they contribute in no less degree, though less
formally, through the direct corporate retention of earnings.
Hence, an unwise use by corporate managements of funds
contributed through the former, as contrasted with the latter,
method may involve greater embarrasment for corporate
managements at stockholders' meetings. But it does not appear
that any sound public purpose is served by disguising instances
of unwise use of stockholders' capital. Such losses may be
reflected either by a charge to the surplus account created in
the manner previously mentioned, or by a reduction in the
carrying or par value of the capital stock, or even by an
unvarnished deficit account, without important effect upon the
credit of the corporation or upon the market values of its
securities. The United States Rubber Company, with a balance
sheet deficit of $17.3 millions, finds its 5 percent bonds
selling at 106-1/2, its non-dividend paying preferred stock
selling at 109-1/4, and its common stock selling at 66, as of
March 13, 1937.


This objection takes two forms: First, that a corpration
with impaired capital is in no position to pay dividends until
its capital is replenished; and, second, that many State laws
prohibit the payment of dividends where such payment would
impair or add to a previous impairment of a corporation's
capital, and hence a corporation is subjected to a tax penalty
if it obeys the applicable State law.

The first objection rests on merely formal grounds.
Virtually all corporations that have balance sheet deficits are
in a position to eliminate them by minor recapitalization, such
as a reduction in the nominal or par value of the capital
stock. To allow such corporations to retain earnings free from
surtax until accumulated deficits have been removed by
reinvestment of earnings would be to grant indirectly what
Congress has in the Revenue Act of 1936 refused to grant
directly -- a carryover of losses. An individual who suffers
capital and other losses in one year is not, on this account,
given tax exemption on any portion of the earnings of subsequent
years in order to allow him to replenish his original capital.
If, nevertheless, and some considerations later cited favor it,
it is deemed advisable to allow a loss carryover for
corporations, it would be better to do this directly and for all
corporations rather than to do it by indirection, and thereby to
do it in an arbitrary and inequitable manner by making it
dependent upon the accidents of bookkeeping policies.

Moreover, any attempt to make the exemption rest upon a
balance sheet deficit, which can be created by bookkeeping just
as easily as a balance sheet surplus, would encourage evasion. A
corporation can easily eliminate a balance sheet surplus by the
declaration of a stock dividend; and it can create a balance
sheet deficit by a downward revaluation of plants and equipment.
The legal and administrative difficulties that have arisen in
connection with the determination of taxable income should
certainly discourage the proposal of a revenue provision which
would entail equally difficult problems in the valuation of
corporate assets and liabilities. The United States Rubber
Company, previously cited as a corporation with a large balance
sheet deficit, had net profits of $6.5 millions in 1935 and more
than $10 million in 1936, and wound up the latter year with net
working capital of $57 millions.

The second form of the objection relates to the fact that
some 35 States have laws or applicable common law which provide
that dividends may not be declared nor any distribution of
assets made if capital stock or capital would be impaired. This,
also, in the vast majority of cases, presents only a formal
difficulty, because most of these deficits could presumably be
eliminated by reductions in the par or nominal values of the
capital stock. Further, the Federal Government would be
incorporating a principle of extremely dubious merit if it
permitted an important part of its tax structure, which was
adopted for reasons of equity and other considerations of public
policy, to be distorted by exemptions or special treatments in
recognition of greatly varying formal restrictions obtaining in
the different States. To do so would also involve the practical
difficulty of a serious loss of revenue and of possible
competition by the States to enact laws which would provide the
maximum relief from the Federal surtax.

Most industrial and mercantile corporations are free to
obtain their charters from the State offering the greatest tax
economy, freedom from restrictions, or other inducements. To
recognize the State law as controlling in this connection would
be to introduce another element into the prevailing competition
among a number of States for charter-granting. It would appear
to be sounder policy to allow the State laws to accommodate
themselves to the new Federal statute or to allow corporations
to make the necessary adjustments in their capital structures or
in their place of incorporation.


It is objected that the tax treatment of capital gains and
losses by corporations, whereunder all capital gains are treated
as current income (without percentage deductions according to
length of time held), whereas capital losses are deductible only
up to $2,000 in excess of capital gains, provides special
difficulty in connection with the undistributed profits tax. A
corporation's capital losses in a given year may equal or exceed
its taxable income; yet its taxable income must be distributed
in dividends if it is to avoid the corporate surtax. Somewhat
similar objections are made for other kinds of non-deductible
losses suffered by corporations.

No real difficulty is necessarily involved, under present
corporate practices, in this connection. Corporations with
losses of the type just cited may distribute their taxable
incomes in the form of securities, and may restrict the addition
to their formal capitalization by giving these additional
securities only a small par or carrying value on their books.

The real issue involved here is not primarily the
undistributed profits tax as such, but the validity of the
existing limitations upon deductions from corporate incomes. It
is to be noted, however, that a loss carryover of several years,
applicable to capital as well as operating losses, would greatly
moderate the difficulties complained of in this connection.


It is contended that the requirement that current earnings
be distributed within the taxable year in order to qualify for a
dividend-paid credit is unduly stringent for virtually all
corporations, and is especially severe upon certain types of
industries and enterprises.

For corporations generally, it is held, the amount of
corporate earnings cannot be closely estimated until some time
after the end of the taxable year. In consequence, corporations
are forced to determine dividend policies upon the basis of
incomplete information. In some cases, this leads to a greater
distribution of earnings than would have been made had the year-
end results been accurately available; and in other cases, it
may lead to a greater surtax liability than the corporation
would have chosen to incur. It has therefore been proposed that
corporations be allowed a dividend-paid credit against the
adjusted net income of any taxable year for distributions made
in the first sixty days following the end of that taxable year.

The decisive consideration that presumably dissuaded the
House Ways and means Committee and the Senate Finance Committee
from recommending such a provision was the large and permanent
loss in revenue that it would entail. It would have meant that
corporations could avoid 1936 surtax liability by distributing
earnings in the first two months of the calendar year 1937
without making their shareholders subject to individual income
taxes on the dividends incorporating these 1936 corporate
earnings until the latter half of the fiscal year 1938 and the
first half of the fiscal year 1939. Similarly, in the taxable
year 1937, corporations could withhold all or an extremely
large portion of their earnings, and yet avoid surtax liability
to the extent that these were disbursed in the first two months
of 1938. And their shareholders, though receiving dividends
representing 1937 corporate earnings, by reason of the receipt
in the first two months of 1938, would not pay individual income
taxes thereon until the latter half of the fiscal year 1939 and
the first half of the fiscal year 1940. And so on.

It is apparent, therefore, that the Treasury could lose
forever one full year's tax revenues on that proportion of the
corporate earnings which avoided corporate surtaxes by reason of
distribution in the forepart of the ensuing year and which
avoided individual income taxes until the next following
calendar year. The loss in revenues would not consist of regular
annual recurring losses, but would be of the character of a
capital loss -- the loss would consist primarily of the first
year's postponement of tax liability; but this loss would never
be retrieved until the books were balanced on Judgment Day or
the law altered. Such a provision would offer a very strong
inducement to all corporations, particularly during the first
year in which it went into effect, but also thereafter, to
concentrate a very large proportion of their dividend
disbursements in the two months following the close of their
taxable year.

A further disadvantage of such a provision would be the
inducement offered to evasion of both the corporate and
individual surtaxes by the use of a chain of holding companies.
Company A received dividend income in 1936 which it distributes
to Company B in February 1937, which Company B distributes to
Company C in February 1938, which Company C distributes to
Company D in February 1939, which Company D distributes to
Company E in February 1940. In each of these cases except the
last, each corporation has avoided surtax liability by full
distribution of its income without making any shareholder
subject to individual income tax liability. The principal
deterrent to the use of a device of this character for the
substantial postponement, at least, of income tax liability,
would be the corporate normal tax applicable to 15 percent of
dividends received by corporations. This tax amounts to
something less than 2.25 percent of dividend income. An
individual might find it more profitable to pay this tax ten
times over on the same income during a series of years than to
receive the income himself in a year when he was subject to high

Although it is doubtless true that some risk of over-or
under-estimating earnings is involved by the requirement that
distributions must be made before the end of the taxable year to
enjoy the dividend-paid credit, it must be remembered that more
than eleven months of the taxable year elapse before a corporate
management faces this problem of estimating, and that the
twelfth month's business is already well in hand. Further, to
allow for errors in estimating, and for other reasons, Congress
provided that a dividend-paid credit may be taken by a
corporation for any dividends paid in excess of earnings during
the two preceding taxable years.

A different but somewhat related objection to the required
timing of dividend disbursements is made on behalf of
corporations whose taxable incomes often consist in substantial
measure of additions to their inventories of raw materials, as
is frequently the case with leather and metal companies; or of
additions to their holdings of promissory notes or installment
payment contracts, as is frequently the case with farm equipment
companies; and that the distribution of such earnings is
therefore impossible within a limited period without serious
curtailment of their business.

As against this objection, however, it might be said that
such corporations have the clear option of paying out their
earnings in the form of additional securities -- securities that
would represent the additions to their inventories in value and
quantity, or the additions to their accounts and notes
receivable. To grant a special exemption from the surtax for
portions of corporate earnings used to increase inventories or
holdings of receivables would not only invite widespread tax
avoidance, but would also be exceedingly arbitrary and
inequitable as between different enterprises engaged in the same
or similar lines of business.

Deere and Company may show an increase of $12 millions in
its holdings of farmers' promissory notes and this increase may
represent virtually all of its earnings for a good year. Another
farm equipment manufacturer sells its farmers' paper to an
installment finance company and its earnings may therefore take
the form of an equivalent increase in cash. Shall Deere and
Company be accorded preferential tax treatment because it
chooses to engage in the banking business as an adjunct of farm
equipment manufacturing?

Kennecott Copper has a far smaller refining and fabricating
capacity in relation to its copper output than has Anaconda
Copper. In consequence, Anaconda must maintain far larger
inventories of copper metal than Kennecott. Shall Anaconda be
given preferential tax treatment because it chooses to integrate
its operations more fully than does Kennecott?

In these and similar cases, earnings taking the form of
increased inventories or increased portfolios of receivables
may be distributed to stockholders in the form of securities
without reducing the resources of the corporation available for
maintained or increased operations.