When Congress ratified the Sixteenth Amendment in 1913, lawmakers opened the door for what would become the federal government's largest source of revenue: income taxes. The amendment overturned a Supreme Court decision that had previously made it impossible for the government to collect a nationwide income tax. Since then, the federal government's power to tax income has remained quite broad.
"The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."
United States Library of Congress, The Constitution of the United States of America: Analysis and Interpretation
The ratification of the Sixteenth Amendment was the direct consequence of the Court's 1895 decision in Pollock v. Farmers' Loan & Trust Co.1 holding unconstitutional Congress's attempt of the previous year to tax incomes uniformly throughout the United States.2 A tax on incomes derived from property,3 the Court declared, was a direct tax, which Congress, under the terms of Article I, § 2, and § 9, could impose only by the rule of apportionment according to population. Scarcely fifteen years earlier the Justices had unanimously sustained4 the collection of a similar tax during the Civil War,5 the only other occasion preceding the Sixteenth Amendment in which Congress had used this method of raising revenue.6
During the years between the Pollock decision in 1895 and the ratification of the Sixteenth Amendment in 1913, the Court gave evidence of a greater awareness of the dangerous consequences to national solvency that Pollock threatened, and partially circumvented the threat, either by taking refuge in redefinitions of direct tax or by emphasizing the history of excise taxation. Thus, in a series of cases, notably Nicol v. Ames,7 Knowlton v. Moore,8 and Patton v. Brady,9 the Court held the following taxes to have been levied merely upon one of the incidents of ownership and hence to be excised:
Under this approach, the Court found it possible to sustain a corporate income tax as an excise measured by income on the privilege of doing business in corporate form.10 The adoption of the Sixteenth Amendment, however, put an end to speculation whether the Court, unaided by constitutional amendment, would persist along these lines of construction until it had reversed its holding in Pollock. Indeed, in its initial appraisal11 of the Amendment, it classified income taxes as being inherently indirect:
"[T]he command of the Amendment that all income taxes shall not be subject to apportionment by a consideration of the sources from which the taxed income may be derived, forbids the application to such taxes of the rule applied in the Pollock Case by which alone such taxes were removed from the great class of excises, duties and imports subject to the rule of uniformity and were placed under the other or direct class."12
"[T]he Sixteenth Amendment conferred no new power of taxation but simply prohibited the previous complete and plenary power of income taxation possessed by Congress from the beginning from being taken out of the category of indirect taxation to which it inherently belonged."13
Building upon definitions formulated in cases construing the Corporation Tax Act of 1909,14 the Court initially described income as the gain derived from capital, from labor, or from both combined, inclusive of the profit gained through a sale or conversion of capital assets;15 in the following array of factual situations it subsequently applied this definition to achieve results that have been productive of extended controversy.
Rendered in conformity with the belief that all income in the ordinary sense of the word became taxable under the Sixteenth Amendment, the earliest decisions of the Court on the taxability of corporate dividends occasioned little comment. Emphasizing that in all such cases the stockholder is to be viewed as a different entity from the corporation, the Court in Lynch v. Hornby,16 held that a cash dividend equal to 24 percent of the par value of the outstanding stock and made possible largely by the conversion of assets earned prior to the adoption of the Amendment, was income taxable to the stockholder for the year in which he received it, notwithstanding that such an extraordinary payment might appear "to be a mere realization in possession of an inchoate and contingent interest . . . [of] the stockholder . . . in a surplus of corporate assets previously existing."
In Peabody v. Eisner,17 decided on the same day and deemed to have been controlled by the preceding case, the Court ruled that a dividend paid in the stock of another corporation, although representing earnings that had accrued before the ratification of the Amendment, was also taxable to the shareholder as income. The dividend was likened to a "distribution in species."
Two years later, the Court decided Eisner v. Macomber,18 and the controversy that that decision precipitated still endures. Departing from the interpretation placed upon the Sixteenth Amendment in the earlier cases, i.e., that the purpose of the Amendment was to correct the error committed in Pollock and to restore income taxation to the category of indirect taxation to which it inherently belonged,19 Justice Pitney, speaking for the Court in Eisner, indicated that the Sixteenth Amendment did not extend the taxing power to new subjects, but merely removed the necessity which otherwise might exist for an apportionment among the States of taxes laid on income.20 The decision gave the term income a restrictive meaning.
Specifically, the Court held that a stock dividend was capital when received by a stockholder of the issuing corporation and did not become taxable as income until sold or converted, and then only to the extent that a gain was realized upon the proportion of the original investment that such stock represented.
A stock dividend, Justice Pitney maintained, "[f]ar from being a realization of profits of the stockholder, . . . tends rather to postpone such realization, in that the fund represented by the new stock has been transferred from surplus to capital, and no longer is available for actual distribution. . . . We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is richer because of an increase of his capital, at the same time shows [that] he has not realized or received any income in the transaction."21
But conceding that a stock dividend represented a gain, the Justice concluded that the only gain taxable as income under the Amendment was a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being 'derived,' that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal;—that is income derived from property. Nothing else answers the description, including a gain accruing to capital, not a growth or increment of value in the investment.22
Although the Court has not overturned the principle it asserted in Eisner v. Macomber,23 it has significantly narrowed its application. The Court treated as taxable income new stock issued in connection with a corporate reorganization designed to move the place of incorporation. The fact that a comparison of the market value of the shares in the older corporation immediately before, with the aggregate market value of those shares plus the dividend shares immediately after, the dividend showed that the stockholders experienced no increase in aggregate wealth was declared not to be a proper test for determining whether taxable income had been received by these stockholders.24 The Court viewed the shareholders as essentially exchanging a stock in the old corporation for stock in the new corporation. By contrast, the Court held that no taxable income resulted from the mere receipt by a stockholder of rights to subscribe for shares in a new issue of capital stock, the intrinsic value of which was assumed to be in excess of the issuing price. The right to subscribe was declared to be analogous to a stock dividend, and only so much of the proceeds obtained upon the sale of such rights as represents a realized profit over cost to the stockholders was deemed to be taxable income.25 Similarly, on grounds of consistency with Eisner v. Macomber, the Court has ruled that a dividend in common stock paid to holders of preferred stock,26 and a dividend in preferred stock paid to holders of common stock,27 because they gave the stockholders an interest different from that represented by their prior holdings, constituted income taxable under the Sixteenth Amendment.
On at least two occasions the Court has rejected as untenable the contention that a tax on undistributed corporate profits is essentially a penalty rather than a tax or that it is a direct tax on capital and hence is not exempt from the requirement of apportionment. Because the exaction was permissible as a tax, its validity was held not to be impaired by its penal objective, which was to force corporations to distribute earnings in order to create a basis for taxation against the stockholders. As to the added contention that, because liability was assessed upon a mere purpose to evade imposition of surtaxes against stockholders, the tax was a direct tax on a state of mind, the Court replied that while "the existence of the defined purpose was a condition precedent to the imposition of the tax liability, . . . [did] not prevent it from being a true income tax within the meaning of the Sixteenth Amendment."28
Subsequently, in Helvering v. Northwest Steel Mills,29 this appraisal of the constitutionality of the undistributed profits tax was buttressed by the following observation:
"It is true that the surtax is imposed upon the annual income only if it is not distributed, but this does not serve to make it anything other than a true tax on income within the meaning of the Sixteenth Amendment. Nor is it true . . . that because there might be an impairment of the capital stock, the tax on the current annual profit would be the equivalent of a tax upon capital. Whether there was an impairment of the capital stock or not, the tax . . . was imposed on profits earned during a definite period—a tax year—and therefore on profits constituting income within the meaning of the Sixteenth Amendment."30
Likening a cooperative to a corporation, federal courts have also declared to be taxable income the net earnings of a farmers' cooperative, a portion of which was used to pay dividends on capital stock without reference to patronage. The argument that such earnings were in reality accumulated savings of its patrons that the cooperative held as their bailee was rejected as unsound because, "while those who might be entitled to patronage dividends have . . . an interest in such earnings, such interest never ripens into an individual ownership . . . until and if a patronage dividend be declared." Had such net earnings been apportioned to all of the patrons during the year, "there might be . . . a more serious question as to whether such earnings constituted 'income' [of the cooperative] within the Amendment."31 Similarly, the power of Congress to tax the income of an unincorporated joint-stock association has been held to be unaffected by the fact that under state law the association is not a legal entity and cannot hold title to property, or by the fact that the shareholders are liable for its debts as partners.32
Whether subsidies paid to corporations in money or in the form of grants of land or other physical property constitute taxable income has also concerned the Court. In Edwards v. Cuba Railroad,33 it ruled that subsidies of lands, equipment, and money paid by Cuba for the construction of a railroad were not taxable income but were to be viewed as having been received by the railroad as reimbursement for capital expenditures in completing such project. On the other hand, sums paid out by the Federal Government to fulfill its guarantee of minimum operating revenue to railroads during the six months following relinquishment of their control by that government were found to be taxable income. Such payments were distinguished from those excluded from computation of income in the preceding case in that the former were neither bonuses, nor gifts, nor subsidies, that is, contributions to capital.34
Other corporate receipts deemed to be taxable as income include the following:
Although "economic gain is not always taxable as income, it is settled that the realization of gain need not be in cash derived from the sale of an asset."39 Thus, when through forfeiture of a lease, a landlord became possessed of a new building erected on his land by the outgoing tenant, the resulting gain to the former was taxable to him in that same year.
"The fact that the gain is a portion of the value of the property received by the . . . [landlord] does not negative its realization. . . . It is not necessary to recognition of taxable gain that . . . [the landlord] should be able to sever the improvement begetting the gain from his original capital. Hence, the taxpayer was incorrect in contending that the Amendment does not permit the taxation of such [a] gain without apportionment amongst the states."40
Consistent with this holding, the Court has also ruled that, when an apartment house was acquired by bequest subject to an unassumed mortgage, and several years later was sold for a price slightly in excess of the mortgage, the basis for determining the gain from that sale was the difference between the selling price, undiminished by the amount of the mortgage, and the value of the property at the time of the acquisition, less deductions for depreciation during the years the building was held by the taxpayer. The latter's contention that the Revenue Act, as thus applied, taxed something that was not revenue, was declared to be unfounded.41
As against the argument of a donee that a gift of stock became a capital asset when received and that therefore, when disposed of, no part of that value could be treated as taxable income to said donee, the Court has declared that it was within the power of Congress to require a donee of stock, who sells it at a profit, to pay income tax on the difference between the selling price and the value when the donor acquired it.42 Moreover, "receipt in cash or property . . . not [being] the only characteristic of realization of income to a taxpayer on the cash receipt basis, it follows that one who is normally taxable only on the receipt of interest payments cannot escape taxation thereon by giving away his right to such income in advance of payment. When the taxpayer does not receive payment of income in money or property[,] realization may occur when the last step is taken by which he obtains the fruition of the economic gain which has already accrued to him." Hence an owner of bonds, reporting on the cash receipts basis, who clipped interest coupons therefrom before their due date and gave them to his son, was held to have realized taxable income in the amount of said coupons, notwithstanding that his son had collected them upon maturity later in the year.43
"We see no reason . . . why the fact that a business is unlawful should exempt it from paying the taxes that if lawful it would have to pay."46
Consistent with that decision, although not without dissent, the Court ruled that Congress has the power to tax as income moneys received by an extortioner,47 and, more recently, that embezzled money is taxable income of an embezzler in the year of embezzlement. "When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, 'he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.'"48
The authorization contained in the Sixteenth Amendment to tax income from whatever source derived does not preclude Congress from granting exemptions.49 Thus, the fact that, "[u]nder the Revenue Acts of 1913, 1916, 1917 and 1918, stock fire insurance companies were taxed upon their income, including gains realized from the sale or other disposition of property accruing subsequent to March 1, 1913," but were not so taxed by the Revenue Acts of 1921, 1924, and 1926, did not prevent Congress, under the terms of the Revenue Act of 1928, from taxing all the gain attributable to increase in value after March 1, 1913, that such a company realized from a sale of property in 1928. The constitutional power of Congress to tax a gain being well-established, the Court found Congress competent to choose the moment of its realization and the amount realized; and "[i]ts failure to impose a tax upon the increase in value in the earlier years . . . cannot preclude it from taxing the gain in the year when realized."50 Congress is equally well-equipped with the power to condition, limit, or deny deductions from gross incomes in order to arrive at the net that it chooses to tax.51 Accordingly, even though the rental value of a building used by its owner does not constitute income within the meaning of the Amendment,52 Congress was competent to provide that an insurance company shall not be entitled to deductions for depreciation, maintenance, and property taxes on real estate owned and occupied by it unless it includes in its computation of gross income the rental value of the space thus used.53
Also, a taxpayer who erected a $3,000,000 office building on land, the unimproved worth of which was $660,000, and who subsequently purchased the lease on the latter for $2,100,000 is entitled to compute depreciation over the remaining useful life of the building on that portion of $1,440,000, representing the difference between the price and the unimproved value, as may be allocated to the building; but he cannot deduct the $1,440,000 as a business expense incurred in eliminating the cost of allegedly excessive rentals under the lease, nor can he treat that sum as a prepayment of rent to be amortized over the 21-year period that the lease was to run.54
Mere diminution of loss is neither gain, profit, nor income. Accordingly, one who in 1913 borrowed a sum of money to be repaid in German marks and who subsequently lost the money in a business transaction cannot be taxed on the curtailment of debt effected by using depreciated marks in 1921 to settle a liability of $798,144 for $113,688, the saving having been exceeded by a loss on the entire operation.55