You are requested by the partners (1) to prepare a balancesheet showing the actual status of each partner's investment in the business at December 31, 1920, giving effect to the appraised value of securities at that date (as indicated by the total column in the above table) and (2) to submit a scheme of capital-stock distribution between A and B, for use if the partnership should be converted into a corporation, each partner turning in his individual security holdings to such corporation.

Interest has been credited on capital accounts at 6 per cent. during the year (to A $12,600.00, to B $4,250.00) and such interest has been included among the expenses.

4. On January 1, 1920, the A. B. C. Company purchased 100 shares ($100.00 par value) of the capital stock of the X. Y. Z. Company in the open market, paying $9,000.00 therefor, and entered the item on its books as "investments."

On July 1, 1920, the X. Y..Z. Company acquired all the capital stock of the A. B. C. Company, but continued the subsidiary thus acquired as a going concern.

On November 1, 1920, the A. B. C. Company declared a dividend of 100 shares of the capital stock of the X. Y. Z. Company, payable on November 20, 1920, to stockholders of record November 15, 1920.

The market value of the X. Y. Z. stock on the dates shown was as follows:

November 1, 1920, 83%; November 15, 1920, 87%; November 20, 1920, 91.

Formulate the journal entries necessary properly to record the dividend transaction on the books of both companies and comment on the value of the shares on the books of the X. Y. Z. Company.

5. Under the terms of the mortgage securing the issue of bonds. by a corporation there is a sinking-fund provision, by which 2 per cent. per annum must be turned over to the trustees, who are empowered to invest the cash in their hands in purchasing these bonds whenever they can be obtained at par or below. During the year under review they have bought $50,000 at 90 flat and received one-half year's interest thereon at 6 per cent.

Show the entries on the company's books. Indicate whether its profit and loss or its surplus is affected by the discount and the interest.

6. How would you distinguish between:

(a) Earned surplus,

(b) Paid-in surplus,

(c) Capital surplus,

(d) Appropriated surplus?

7. What should be the procedure in determining the value of stock on hand at the time of a fire, the financial books being intact and showing the amount of an inventory taken four months prior to the fire?

By F. W. THORNTON

The present federal income-tax and profits-tax law was devised with the primary object of obtaining for the government an unprecedented income. Its provisions were mainly directed to that end, with perhaps an incidental consideration for specific sections of the population or of the country. In these circumstances, it is natural that the law should contain provisions having unforeseen effects on some classes of business. At this time, when revision of the law is expected, it is worth while to consider some of these unexpected effects that have not received general recognition, although they are of large amount.

Prior to the passage of the present tax laws, preferred stock of corporations received specific percentages of dividend, the whole of the remaining earnings accruing to the common stockholder. The income-tax law assesses on the entire earnings of a corporation 10 per cent. of so-called normal tax, which is handed on to the extent of 8 per cent. as a deduction from tax of the person receiving dividends on the stock. It is clear that the preferred stockholder now receives more than the original percentage agreed to be paid on his stock, the addition being the amount of exemption handed on to him to be deducted from his income tax. Apart from stock in the hands of those with incomes below $4,000, this privilege is equivalent to an addition of 8 per cent. to the value of the stock. The benefit to the preferred stockholder is given at the expense of the common stockholder. Before the tax law, the common stockholder had all the earnings after paying the prescribed percentage on preferred stock. Now he must pay his own share of normal tax and pay also for the preferred stockholder his normal tax. If the new corporation tax law should take the form of an increased flat income tax on corporations, the question would arise as to how much of this tax would be handed on as an exemption to the individual receiving dividends. If the amount should be increased above the present 8 per cent., it would constitute a further gift to the preferred stockholder at the expense of the common stockholder. No such benefit is given to a bondholder, and this is one of the reasons, not always understood but always effective, for the relatively high price of preferred stocks as compared with bonds.

First-class 7 per cent. preferred stock now sells at a price materially higher than 7 per cent. bonds-as, for instance, U. S. Steel preferred, 109; Standard Oil of New Jersey, 108-the difference being curiously close to the percentage of gain from abatement of normal tax. Seven per cent. bonds, having 2 per cent. paid at the source, of similar high standing, sell about 101-102.

When the supreme court decided that stock dividends were not taxable income there was general satisfaction among stockholders and a feeling that taxes for them had been saved. This is not necessarily so, and the reverse may be the case-will be, if the stock is sold.

If a stockholder receive a stock dividend and immediately report it as income, the tax to be paid on it is the tax on a dividend, that is, surtax only. Then, after paying surtax, the stockholder adds the amount of the stock dividend to his cost of securities. On final disposition he pays full tax only on the excess of the realization over the original cost plus the stock dividend.

Under the present ruling, however, the stockholder will pay, on final liquidation, normal tax and surtax on the entire gain. A figured example may make this clearer:

Stockholder owns 1 share costing $100. He receives another share as a stock dividend. If he now reports it for taxation he pays surtax only-on $100. If he proceeds to sell the two shares, receiving $220, his profit, taxable in full, is $20, on which he pays normal tax and surtax; total tax in this case is normal tax on $20, surtax on $120.

But under present rulings no income accrues until final sale, when the tax would be normal tax on $120, surtax on $120, an increased tax of normal rate on $100.

One of the unfortunate effects of this is that it is an incentive to the owners to retain such stock until, at their death, the accretion of value escapes income tax, paying only inheritance tax, which it would have paid even if the stock had been sold and income tax paid on the profit before the owner's death.

It is clear that the source of the profit in the case cited above was the profit of the corporation, which had paid tax, and it should come into the hands of the stockholder free of normal tax. Indeed there seems to be some basis for a claim to this exemption when stock received as a stock dividend is sold, even under present rulings, although no such claim has been made

within my knowledge. When a stock dividend is realized in cash, does it cease to be a dividend? If the recipient sells it together with the original stock immediately on receiving it, are not the proceeds dividends to the extent of the face value of the stock dividend? And if so, does delay in selling alter the case?

If a stock dividend has been paid and the paying company at a later date liquidates, only surplus over the face value of all the stock would be allowed as dividend in computing taxes; so that at no time has the profit of the company come into the hands of the stockholder free of normal tax unless the proceeds of sale, to the extent of the face value of the stock dividend, are considered as dividends.

The only theory consistent with the ruling that stock dividends are not taxable income is that the common stockholder always owns his share of the accrued surplus but is taxable on it only when it is converted into cash. Clearly, that accrued surplus has paid income tax in the hands of the corporation and, when realized by the common stockholder, should be income subject to the dividend exemption. A common stockholder selling his stock at a profit is therefore selling accrued surplus that is entitled to the dividend exemption, and absolute justice would be done only if all profit and loss made on the sale of common stock were treated for taxation as dividends. In the end, the final holder of common stock will be taxable on the difference between the cost to him, including all the intermediate accumulated profits, and the amount received on final liquidation. All of this amount, except the original paid-in capital, is dividend, but owing to the fact that preceding holders of that stock may have sold it at successively higher prices, the final holder would receive only a diminished amount of income and could take exemption only on that amount of the final liquidation that had not already been absorbed in the profits of the previous holders of the stock.

Another irregularity arises in the short sale of stock. When a short sale is made, stock that does not really exist is brought into theoretical existence. For each share of stock sold short there is a share owned by someone, generally on margin, that is borrowed to supply the share for delivery to the purchaser in the short sale. As a rule the owner of the stock, especially if it be stock held on margin, does not know that there has been a loan of his stock. There are, then, two owners of the share-one