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to be generous with the money of their stockholders even for such laudable purposes.

It is concluded, therefore, that corporations are not en-* titled to deduct from their gross income for the purpose of the income tax the amount of contributions made to religious, charitable, scientific, or educational corporations or associations, although such contributions may be made to the Red Cross or other war activities.

DANIEL C. ROPER,

Commissioner of Internal Revenue.
Approved May 24, 1919:
CARTER GLASS,

Secretary of the Treasury.

BUSINESS PROCEDURE 1458. Profit-sharing contracts. It is not unusual for the compensation of an employee to be contingent upon the amount of profits of the business or of a given department of the business. Unfortunately a great majority of the contracts providing for contingent compensation are so worded as to raise the question as to whether the compensation is to be based on the profits before or after the deduction of the Federal income and excess profits taxes. The interpretation of a given contract depends, of course, upon its wording and the surround'ing circumstances. It is not within the scope of this article to interpret any of the various forms of contracts. In so far as Federal taxes are concerned, the employer is justified in considering the amount of compensation to be paid to the employee as an expense of the year in which the services were rendered, which he may deduct in arriving at his taxable net income.

If the contract is held to mean that the compensation is to be based upon the profits after the deduction of Federal income and excess profits taxes, we are confronted with the following condition: The tax which is to be based upon the profits, less the contingent fee, cannot be determined until the fee is determined. The fee, on the other hand, is based upon the profits less the tax, and consequently cannot be determined until the tax is determined.

| 1459. The following form of contract and formula have been submitted by a subscriber as a method of solving this apparently unsolvable problem. The contract with the employee should contain the following provision:

To determine the exact amount of your fee, we intend to regard the fee as part of the cost of manufacture (or as an expense of the business), and therefore any taxes, computation of which depends upon the ascertainment of net income, would be computed on a basis which would include the deduction

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of fee as a part of the cost of manufacture (or as an expense

the business) from the gross receipts, notwithstanding the Fact that the exact amount of fee would depend in turn upon the ascertainment of the amount of such taxes. In the determination of this fee contingent, the following formula is to be used:

1460. 1. Where the contingent fee is based upon the profits of the entire business.

Let X equal the tax to be paid
Let Z equal fee
Let A equal the total profits
Assume fee is 20% of profits
Then (1) .2 (A-X) = 2
(2) AX

= 5 Z

(3) A-5 Z = X Assume value for Z and substitute in 7, getting a trial value for X.

Subtract assumed value of 2 from A and figure tax. If this does not equal X, try another value for Z.

|| 1461. II. If the contingent fee is based upon the profits
on one department.
Let X equal the total tax to be paid
Let Y equal the tax to be paid on Department No. 1 profits
Let Z equal fee
Let A equal the total profits
Let B equal the profits on Department No. 1
Assume Bonus equals 10% of profits of Department No. 1
Then (1) .1 (B--Y)=Z (multiplying by 10)

(2) B-Y= 10 Z (transpose),
(3) B-10 Z=Y

Y
(4)

or (multiply by X).
X

A-Z
X (

BZ)
(5) Y

(add 2 and 5). A-Z

X (B-Z)
(6) B--10 Z

(multiply by A--Z).
(A-2)
(A–Z) (B—10Z)
(7)

B-Z Assume a value for 2 and substitute in 7, getting a trial value for X.

Subtract assumed value of Z from (a) and figure tax.

If this does not equal tax, try another value for Z.

B-Z

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= Z.

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1462. The application of Formula I is illustrated by th following example:

Case 1. The profits of a business conducted by an individual for the year 1918 amount to $200,000, of which an employee is to receive 20% after the payment of income tax. The formula to be used is

A---5 Z = X It is necessary to assume a trial value for Z. We should endeavor to make the trial value as close to the true value as possible.

We know that the maximum amount of the fee would be 20% of $200,000, or $40,000. We also know that the tax on in income of $200,000 is $101,030, leaving a net of $98,970. The minimum amount of the fee would therefore be 20% of $98,970, or $19,794.

The fee will therefore be between $19,794 and $40,000. We may select as our first trial the amount of $20,000. We then have

$200,000_$100,000 = $100,000 but on the basis of a $20,000, the tax [on $180,000] would be $87,430. This indicates that we have selected too small a fee. We next try Z as being equal to $22,000—

$200,000-$110,000 = $90,000 The tax on $178,000 ($200,000-$22,000] is $86,070, indicating that our estimate is still too low. We next try $23,000

$200,000-$115,000 = $85,000 The tax on $177,000 ($200,000—$23,000] is $85,390, indicating that our estimate is slightly excessive.

We are now certain that the correct amount of the fee is between $22,000 and $23,000. We may now obtain a fairly accurate solution upon the next trial if we study the results of our two previous trials.

We find that by increasing our fee $1,000, we decreased the true tax by $680, and decreased the value of X by $5,000.

Our final trial will be $22,910 (a decrease of $90 from $23,000). Then

$200,000-$114,550 = $85,450 The tax on $177,090 [$200,000—$22,910] is $85,451.20, which is sufficiently accurate for all practical purposes.

|| 1463. The application of Formula II is illustrated by the following example: A corporation has profits of $300,000, of which $100,000 is from Department No. 1. A is entitled to 10% of the profits of Department No. 1. The invested capital of the corporation is $1,000,000. The corporation was in existence in the prewar period, but earned less than 10% of its invested capital.

The maximum amount of the fee would be 10% of $100,00 or $10,000.

The tax, including income tax, on an income of $300,000 would be $174,448. One-third of this, 'or $58,149,33, is chargeable against Department No. 1, leaving the net income for that department as $41,850.67. The minimum fee would therefore be $4,185.07. The formula to be used is (A–Z) (B-10 Z)

= X

B-Z
Assuming the fee to be $5,000 we have:
($300,000—$5,000) ($100,000—$50,000)

= X
($100,000—$5,000)
$295,000 x $50,000

$155,263.15

$95,000
The tax on an income of $295,000 ($300,000—$5,000) amounts
to $170,328, indicating that our fee is too large.
We then try Z as 4,500. Then
($300,000-$4,500) ($100,000-$45,000)

X
($100,000-$4,500)
$295,500 X $55,000

$170,162.82

$95,500 The tax on $295,500 ($300,000—$4,500) is $170,750, which shows that our fee is still too large.

We observe that a decrease of $500 in the amount of the
fee increases the tax $412 and increases the value of x by
$14,899.67. Our final trial will be $4,480. Then
($300,000-$4,480) ($100,000-$44,800)

= X
($100,000—$4,480)
$295,520 X $55,200

$170,777.84
$95,520

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The tax on the income of $295,520 is $170,756.48, indicating that the fee of $4,480 is approximately correct.

1464. Preferred stock vs. bonds and notes. A great deal has been written since 1917 about the relative advantage of financing by means of the sale of preferred stock as compared with the sale of bonds or notes. It may safely be said that the average corporation is able to sell its mortgage bonds at from one to two, per cent, and its unsecured notes approximately one per cent better than its preferred stock. That is, if a corporation is able to sell its 7% preferred stock at par, it should be able to sell its mortgage bonds on a 5 or 6% basis and its unsecured notes on a 6% basis.

At first glance it would appear advisable to issue bonds or notes and thereby leave a greater amount available for distribution among the stockholders. There are, however, two factors to consider: first, the effect of this on the corporation's mercantile credit, and, second, how this would affect its taxes. It is up to each concern to decide whether this would affect its mercantile credit to the extent of the amount of money it would save by issuing bonds instead of preferred stock.

|| 1465. In 1909 and the following years corporations were converting their preferred stock into various kinds of debenture bonds. The purpose of this was to enable the corporation to deduct the interest in arriving at the amount of its taxable income. In these years there was an excise tax on the net income, and the amount of invested capital in no way affected this tax. Those corporations which continued to finance themselves by means of preferred stock instead of bonds are considerably better off at present. This is illustrated by the following examples:

A corporation had the privilege of issuing bonds or preferred stock when it organized. We will take up each case separately. Common Stock

. $1,000,000 Bonds—7%

1,000,000 Net income before deduction of mortgage interest.. 500,000

|| 1466. Under the 1917 law this corporation is entitled to an exemption of 9% of its invested capital, plus the specific exemption of $3,000 in computing its excess profits tax. Net income as above..

.$500,000 Interest on bonds..

70,000

Net income
15% of invested capital.
Less exemption

-$430,000
$150,000

93,000

Amount subject to tax at 20%..

$57,000 Amount of tax....

$11,400 15% to 20% of invested capital subject to tax at rate of 25%.

50,000 Amount of tax at this rate.

12,500 20% to 25% of invested capital, subject to tax at rate of 35%..

50,000 Amount of tax at this rate.

17,500

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