decedent's estate. Under this draft, certain distributions in kind, whether of securities or other property, would be treated as corpus distributions and not as distributions of income. We consider this as a minimum acceptable alternative to the primary proposal in the Advisory Group Report. We would not consider as satisfactory a limitation of the distribution-in-kind approach to tangible personal property, since in this form the problem discussed in the second preceding paragraph would not be met.

Another alternative to the method of taxation of decedents' estates has been proposed in various quarters. This proposal is in substance to tax an estate on all income received by it in the same manner as an individual, without deduction for any income distributions paid to the beneficiaries of the estate. This is frequently referred to as the "entity" approach. Its advocates contend that it would minimize the opportunities for "manipulation." They further contend that most estates are small in size and are administered by lawyers or executors who are not experts in income tax law, and who would find such an approach simpler to deal with than present law with or without the modifications discussed. We feel strongly that the "entity" approach would be undesirable for the following reasons:

1. Opportunities for "manipulation" and tax-avoidance would in fact be increased in smaller estates, which we are told are in the great majority. Most individuals who are beneficiaries of even small estates have some independent taxable income. Under the entity approach they would be permitted to receive distributions of current income without including the distributions in their own taxable in

come.

2. The entity approach would cause gross inequities in the case of the beneficiary of a small share of a large estate, whose income from the estate would be lumped with the income of all other beneficiaries.

3. Great differences in the impact of taxation would be caused by the accident of how the decedent's property was held prior to his death. For example, if he had his assets in a revocable trust the trust rules would apply, while if he did not, the entity rules would apply. 4. The suggested simplicity of the entity approach is illusory. Its advocates propose that the estate be considered simply as an extension of the existence of the decedent. By the time joint returns, medical deductions, dependency exemptions, retirement income credit, and numerous other special provisions of the tax law intended to apply to living individuals are taken into consideration, the opposite of simplicity would be achieved.

COMPARATIVE TAX TREATMENT OF MUTUAL SAVINGS INSTITUTIONS AND COMMERCIAL BANKS

George E. Lent1

Commercial banks have long contended that the Federal tax laws give mutual savings banks and savings and loan associations an unfair tax advantage in competing for savings amounts. This advantage was somewhat narrowed by the Revenue Act of 1951, which made these mutual savings institutions subject to Federal income tax, effective January 1, 1952. The commercial banks now maintain that the mutuals continue to enjoy undue tax benefits because of the liberality of the so-called bad-debt allowance which permits them to accumulate, tax free, reserves equal to 12 percent of deposits. This compares with a reserve allowance for commercial banks based on three times their average bad-debt experience during any consecutive 20-year period since 1927, applicable to eligible loans.

In addition, a serious question of equity arises in the use of the mutual tax provisions by certain stock building and loan associations chartered in several States. Such stock companies are mutual in name only, being akin to privately owned corporations operated for a profit. While enjoying special tax privileges, some have been acquired by holding companies whose shares are publicly traded.

I. RECENT HISTORY OF THE TAX PROVISIONS

Proposals to equalize the tax treatment of financial institutions can best be interpreted in the light of their legislative and administrative history. This is summarized below.

Mutual savings institutions

Prior to 1952, mutual savings banks and savings and loan associations enjoyed greater tax privileges than any other form of cooperative in that they were permitted to retain earnings, free of tax, în unallocated reserves. Although the law placed no restrictions on the eligibility of mutual savings banks, exemption of savings and loan associations had been limited to associations "substantially all the business of which is confined to making loans to members." This criterion has been fairly liberally interpreted.

The rapid postwar growth of these institutions appeared to present an increasing threat to the growth of commercial banks competing in the same market for savings. Their bad-debt allowances were limited and they were facing increased difficulties in meeting their expanding capital requirements through reinvested earnings and new capital stock issues.

1 Visiting professor of business economics and director of research, the Amos Tuck School of Business Administration, Dartmouth College. 2 Internal Revenue Code of 1954, sec. 7701 (a) (19).

The taxation of mutual savings institutions was first proposed by the Joint Staff on Internal Revenue Taxation in 1950. A staff report, written in collaboration with the Treasury Department staff, concluded that:

1. The income retained by these organizations and added to reserves and undivided profits is held for the private benefit of the organization and their members in the same way as the income of an ordinary, taxable corporation is held for the benefit of the corporation and its stockholders;

2. The exempt status of the mutual savings banks and the building and loan associations gives them an advantage in competing with taxpaying businesses, both in making loans and in soliciting the deposit of funds;

3. Income tax exemption is no longer necessary to foster the safety of the mutual savings banks and the building and loan associations; and

4. Increases in corporate income tax rates, since the mutual banks were first exempted in 1909, have given these organizations tax advantages greatly in excess of the advantages under their original exemptions and in terms of Federal revenues lost.

The staff also stated that these cooperative savings institutions had long lost the mutuality that characterized their original formation. Mutual savings banks do not invest their funds in loans to members, but in Government securities, corporate bonds, and stocks as well as mortgage loans in other communities. Even though borrowers from a savings and loan association qualify as members by subscribing for small amounts of stock, the interest income earned by the association is earned predominantly for the benefit of the investing members who put up the capital which the association loans out. In reply to the claim that an association itself has no taxable income because its receipts are paid out as dividends to members or accumulated for their benefit, the report stated that the individual member has no enforcible claim to a share of the reinvested earnings unless he remains in the organization until its dissolution. The staff suggested this was a more extreme concept of cooperative ownership than that used by farm cooperatives that are not exempt from tax.

The joint staff also pointed out that mutual savings institutions were already taxed by several of the States in which they were chartered, including New York State.

As part of its 1950 comprehensive revenue revision program, the Treasury proposed taxing the retained earnings of mutual savings banks and savings and loan associations on the same basis as commercial banks. After giving tentative approval, the Committee on Ways and Means finally rejected the proposal. The Senate Finance Committee also turned it down, but indicated its intention of reviewing more fully the tax exemption of all cooperatives. In 1951, the Ways and Means Committee again rejected the proposal, but the Finance Committee approved it as part of the Korean tax program. In recommending repeal of their tax exemption, the Finance Committee stated that few of these institutions had retained their mutuality, that mutual savings banks traditionally made loans to nonmembers, and that savings and loan associations were rapidly departing from the principle which guided their early formation, of limiting loans to members. The committee maintained that continuance of their taxfree treatment discriminated against other financial institutions competing in the same market for savings and loans. "So long as they are

3

3 U.S. Senate, Committee on Finance, "Report on the Revenue Act of 1951," pp. 22-29.

exempt from income tax," the report stated, "mutual savings banks enjoy the advantages of being able to finance their growth out of earnings without incurring the tax liabilities paid by ordinary corporations when they undertake to expand through the use of their

99

own reserves."

The committee bill was attacked on the Senate floor by those who felt that it did violence to the mutual character of these institutions. They charged that the new provision not only threatened their solvency, but also conflicted with State and Federal regulatory law.* (The Chairman of the Federal Home Loan Bank supported this view.) The Senate then amended the bill to provide tax-free allowances of up to 15 percent of net income when surplus, undivided profits, and reserves were less than 10 percent of deposits at the end of the taxable year. The conference committee agreed to the present provision, which is based on reserves of 12 percent of deposits, and this was approved by Congress.

The 1951 act, then, provided for the taxation of these institutions on their income remaining after expenses, dividends (interest) to depositors, and certain amounts placed in reserves. They are permitted deductions for additions to bad-debt reserves equal to the lesser of (a) their income before bad-debt allowances, or (b) the excess of 12 percent of deposits at the end of the year over their surplus, undivided profits, and reserves at the beginning of the year.5

Commercial bank bad-debt allowances

Commercial banks are permitted a reasonable allowance for baddebt losses under the reserve method, or they may write off losses as they occur. In 1947, the Internal Revenue Service established as a reasonable allowance an amount based on each bank's average loss experience for the 20-year period ending in the taxable year, with a maximum reserve of three times this amount. As this 20-year period moved away from the depression, the declining loss experienced threatened to reduce these allowances; many banks were approaching their ceiling and others had already reached it. For this reason, the bad-debt formula was revised in 1954 so as to permit banks to use a bad-debt ratio based on any consecutive 20-year period beginning after 1927, effective for taxable years beginning after December 31, 1953.7 Slightly over half of all commercial banks are on the reserve basis, but these account for 87 percent of total bank resources. The other banks, mostly small in size, employ the specific chargeoff method. Impact of the 1951 tax

In considering future legislation it would be useful to review the effects of the 1951 tax on the operation of mutual savings institutions. In 1956, the latest year for which Treasury data are available, mutual savings banks and savings and loan associations increased their surplus and reserves by approximately $500 million at a total tax cost

4 Congressional Record, vol. 97, pp. 11,840-11,906.

5 "Surplus, undivided profits, and reserves" is defined as the amount by which the total assets exceed the total liabilities, including total deposits and withdrawable accounts. Mimeo. Coll. No. 6209, C.B. 1947-2.

7 Rev. Ruling 54-148 (Í.R.B. No. 17, Apr. 26, 1954).

8 The following data_were derived from: U.S. Treasury Department, "Statistics of Income, 1956"; Savings Bank Trust Co., "Savings Bank Fact Book, 1958"; U.S. Savings & Loan League, "Savings and Loan Fact Book, 1959"; Federal Home Loan Bank Board, "Combined Financial Statements (1958)."

47060-59-pt. 3-16

of $8 million. This is an effective tax rate of 1.6 percent. While only 1 out of 5 building and loan associations paid any tax (amounting to $6.8 million), 7 out of 10 mutual savings banks were subject to tax, mostly in modest amounts.

The relatively greater incidence on mutual savings banks can be explained by the higher ratio of their reserves and surplus to deposits. In 1956, their reserves averaged 9.8 percent of deposits, somewhat closer to the 12-percent limit than the 7.7-percent ratio for savings and loan companies. In general, small savings and loan associations had larger ratios and were more subject to tax than large companies. The taxability of mutual savings banks did not vary with the size of the bank.

Imposition of the Federal income tax was immediately followed by a substantial reduction in earnings retained by mutual savings banks, from about 30 percent of their net operating income to about 15 percent in 1957 and 1958. Savings and loan associations have reduced the proportion of income retained more gradually, from approximately 33 percent in 1951 to about 25 percent in 1957. Currently, savings and loan associations retain almost twice the proportion of earnings retained by mutual savings banks.

The low taxes paid by mutual savings banks are partly explained by their increased holdings of tax-exempt securities. Between 1951 and 1954, their tax-exempt investments increased fourfold, from $150 to $600 million, and by the end of 1958 reached $800 million. They have leveled off at about 2 percent of their total investments, against only 0.6 percent in 1951. Savings and loan associations are generally barred from investing in State and municipal securities.

The newly enacted tax pressure has combined with rising interest rates to increase the average rates paid on savings deposits since 1950. Between 1950 and 1958, mutual savings banks have lifted their average interest rates from 2.1 to 3.2 percent, and savings and loan associations increased theirs from 2.5 to 3.5 percent. During the same period, commercial banks more than doubled their rates, from an average of 0.9 to 2.1 percent, but they remained substantially below rates of mutual institutions.

II. THE TAX DIFFERENTIAL AND COMPETITION FOR SAVINGS

Commercial banks claim that preferential tax treatment of mutual savings institutions has placed them at competitive disadvantage in attracting savings. Between 1950 and 1957, individuals' savings accounts in commercial banks increased only 51 percent, compared with an increase of 116 percent in the savings accounts of mutual institutions. However, while savings accounts of savings and loan associations increased threefold, the increase for mutual savings banks (58 percent) was comparable with that for commercial banks.

In contrast to the objective of mutual savings banks and savings and loan associations to encourage thrift, commercial banks have taken an ambivalent attitude toward savings deposits. Probably most commercial bankers have been satisfied to confine their activities to the traditional commercial deposit and loan functions, leaving savings to the specialized institutions. Perhaps as many as 20 percent of all commercial banks either do not accept savings accounts or pay no