Towne v. Eisner & the Definition of Income

Income Tax Rule Gain Financial

Income Tax

As counter-intuitive as it may seem, many of the most basic terms in tax law were being argued and debated as recently as one century ago. We tend to think of many terms in tax law – particularly very elementary terms such as “property” and “income” – as things which simply emerged with fixed definitions, presenting little or no controversy since their inception. Here at HTW, we know better: in fact, oftentimes the most elementary terms have been fraught with the greatest level of uncertainty. The average person may not realize it today, but the clarity of many of our essential tax law concepts is the result of an immense amount of mental energy on the part of our legal and political establishment.

The case of Towne v. Eisner (1918) is one example of such mental energy being expended to settle a seemingly simple term. In this case, the full breadth of the term “income” came under contention when a shareholder challenged the tax authorities on the issue of the taxability of stock dividend transactions. This case is significant for a number of reasons, but one reason for its significance stands out among others: through this case, the basic principle that income places someone in an advantageous position was firmly pinned down. This “principle of advantageous position,” to coin a phrase, is still at the heart of our definition of income today.

Let’s look at the (relatively simple) factual scenario of this case in greater detail.

Facts

After a company transferred $1.5 million in profits to its capital account, the taxpayer received a stock dividend consistent with his preexisting ownership stake in the company. The newly received stock had a value of roughly $417,450. The authorities contended that this stock dividend was income within the meaning of the tax law of 1913 – and that this construction of the term “income” within the tax law of 1913 was also consistent with the construction of the same term in the sixteenth amendment – and assessed a tax liability on the taxpayer. Though the taxpayer received additional shares, he did not take a cash dividend, and so the question before the court was whether a valid tax liability could be assessed given that the taxpayer was not actually placed in a financially superior or advantageous position following the stock dividend.

Law

The applicable law was the Revenue Act of 1913. This act contained an income tax provision which was freed from the traditional rule of apportionment present in previous eras. The taxpayer claimed that stock dividends fell outside of the definition of “income” as construed within this act.

Ruling

The court (the Supreme Court of the U.S.) ruled in favor of the taxpayer and threw out the tax liability assessed by the tax authorities. The court cited several earlier cases involving corporate stock dividends in its decision; the essential fact which decided the matter was that the taxpayer was not placed in a financially superior position by way of the transaction. What had occurred was merely a reissuing of stock certificates in order to properly reflect the proportional interests of the shareholder. The taxpayer did not actually “gain” anything from the transaction, he was not placed in a more advantageous position, and so the court ruled that it would be incorrect to say that the taxpayer had received taxable income.

As mentioned above, this basic principle has endured up to the present day and continues to inform our conception of taxable income. This principle informed the construction of the term “income” in various other contexts as well; for instance, the provisions of section 1031 of the tax code follow from the idea that gain should not be taxable if it were merely theoretical rather than actual. Again, though we may see this principle as self-evidently true today, this was not always so, and the case of Towne v. Eisner contributed mightily to the development of this principle.

Source

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Hylton v. United States & the Practical Difficulties of Apportionment

In early June of 1794, Congress passed a “carriage tax” aimed at carriages used for business purposes. The tax was to be collected annually for as long as the carriage owner maintained ownership of the carriage. The original Constitution of the U.S. recognized a distinction between direct taxes and indirect taxes, but it did not establish definitive guidelines for determining whether a new tax is direct or indirect. At the time of the adoption of the Constitution, it was established that poll taxes (or “capitation” taxes) and land taxes were direct taxes, but there was no formal mechanism for sorting a given tax into either category. Hence, though the authority of Congress to pass the carriage tax was never brought into question, what category the tax should be assigned was unclear.

Carriage Tax Constitution Law Amendment

Carriage Tax

In Hylton v. United States (1796), a suit was brought to collect a debt which was derived from the carriage tax. Hylton (the defendant in the original case) claimed that the carriage tax statute was unconstitutional. Hylton reasoned that the carriage tax was a direct tax and because the statute did not follow the rule of apportionment the tax had to be struck down under the Constitution. At the time of the suit, Hylton was in possession of 125 carriages.

The justices of the Supreme Court – who all wrote their own opinion of the case – determined that the carriage tax was an indirect tax and that, consequently, Hylton was liable for the debt. The justices decided that there was no compelling reason to suppose that the carriage tax fell within the meaning of a direct tax as understood by the framers of the Constitution. The framers understood that poll taxes and taxes on land were “direct” taxes; this classification had a basis in the conditions present among the states at that time. Although the carriage tax may have been superficially dissimilar from other indirect taxes in some ways, the justices could not find that this level of dissimilarity warranted classification as a direct tax.

Hylton entered the case with one critical disadvantage: the practical difficulties of apportioning the carriage tax by population were such that classifying the tax as a direct tax would have led to absurd results. Carriage ownership varied greatly from state to state, and so the carriage tax would have imposed an unfair burden on certain states if it were apportioned as a direct tax. The federal government would have been compelled to adopt new and unusual measures in order to artificially correct the unfair burden created by such a tax. The justices all concurred that the unfair results and practical difficulties of apportionment provided sufficient grounds for classification as an indirect tax.

Because the carriage tax was a tax on personal property, the Hylton decision came to the fore nearly one hundred years after it was made during the case of Pollock v. Farmers’ Loan & Trust Co. (1895). The Pollock case ruled that a tax on income from personal property (and real property) was a direct tax and must follow the rule of apportionment; this ruling effectively overturned the decision made in Hylton. Those who objected to the Pollock decision predicated their objection on the fact that the decision made the imposition of a federal income tax a near impossibility. Implementing a federal income tax which followed the apportionment rule would have been excessively burdensome for the federal government for a number of reasons. The sixteenth amendment was drafted in order to bypass the sort of practical difficulties associated with apportionment which was discussed in Hylton.

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The Will of the People

Will People Tax Sixteenth Amendment

Will of the People

The phrase “the will of the people” has greater importance for Americans than it has for citizens of other states around the world. In large part, this stems from our deeply entrenched view of our system of government as a system which has developed entirely from the collective will of a free populace. The American public firmly believes that its governmental institutions are a direct extension of its collective will, a sort of living representation of its political voice. And to a good extent this view is accurate: our system has been informed by non-elite citizens to a considerably greater degree when compared with foreign systems across the globe. Though the history of these United States is much less egalitarian than most people care to appreciate, it is correct to say that the American project is more of a “popular” phenomenon than has been the case throughout most of history.

What most Americans do not realize, however, is that the will of the people can move society in any conceivable direction. Common perception tends to see the people’s collective will as an inherently benign force ceaselessly pushing our country in a way which maximizes our freedom and dispels injustice. But, as is often the case, common perception does not faithfully reflect reality. The will of the people is neither benign nor nefarious; it simply expresses whatever whims the people may have at a given moment. And if the people’s whims happen to push us toward less freedom or less justice – however that is defined – then that is precisely the direction we will be pushed in. Our constitution does not guarantee a certain quantum of freedom; as we learned in our prior installment, it provides that our lives may be encroached upon in any number of ways so long as the people’s will is expressed in the form of amendment.

This fact may come as a shock to many Americans. Our optimism tends to impart benevolent motives onto the public’s collective will in nearly every situation. What we have to understand, however, is that it makes little sense to ascribe any particular value to our collective will because our will can be shaped by just about any force imaginable – expediency, necessity, desire, passion. The sixteenth amendment did not simply address the practical difficulties associated with the apportionment requirement, it also expressed a public desire to ameliorate the widespread economic inequality which was present at the time of its passage. And it also enlarged the sovereignty of the federal government in relation to the states. It would be inaccurate to say that the results which followed the amendment were inherently just or proper; what is true is that these results were congruent with the collective sentiment of that era.

As we explore the sixteenth amendment in greater and greater detail, it is important for us to keep in mind that this amendment only represents the ability of our constitution to express the desires of the public, it is not an example of benevolent societal change.

In our next installment, we will discuss the case of Hylton v. United States (1796) and look at the impact that the ruling of this case had on the development of the sixteenth amendment.

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The Sixteenth Amendment & the Issue of State Sovereignty

Sixteenth Amendment Income Tax State Sovereignty

The Sixteenth Amendment

In the next several installments of Huddleston Tax Weekly, we will discuss in great detail some of the controversies which were stirred by the sixteenth amendment. As we’ve noted in previous installments of HTC, the sixteenth amendment to the U.S. Constitution was an act of awesome importance. Through this amendment, the Congress was freed of the various constraints on its taxing power which had existed since the founding of the country. The original U.S. Constitution expressly gave Congress the power to tax, but it also set certain restrictions on this taxing power; excise (indirect) taxes had to be uniformly imposed, and direct taxes had to be properly apportioned among the several states. Prior to the sixteenth amendment, judicial opinions on tax law often dealt with determining whether a given tax should be classified as either direct or indirect. The sixteenth amendment removed the necessity of making such determinations.

The full text of the sixteenth amendment is as follows: “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.” Clearly, this amendment was directly responsive to a number of judicial decisions which, through their treatment of certain forms of taxation, had curtailed the taxing function of Congress. For instance, the Pollock case ruled that taxes on income derived from real property and personal property (such as stocks and bonds) were direct and therefore subject to the apportionment requirement. Pollock and other judicial opinions made the imposition of a federal income tax a practical – though not theoretical – impossibility. By removing the apportionment requirement, the sixteenth amendment made the implementation of such a tax an exceedingly simple matter.

The potential impact of the sixteenth amendment on state sovereignty was an issue immediately recognized by both the legal profession and the political establishment. Since it allowed Congress to collect taxes on incomes from any conceivable source, it apparently encompassed state securities; and by taxing state securities the Congress would be effectively lessening the power of the states in relation to the federal government. In his 1919 essay entitled “Power of Congress to Tax State Securities Under the Sixteenth Amendment,” Albert Ritchie argued that the amendment did not actually extend to state securities because the amendment was never intended to grant any new taxing powers to the Congress; the amendment was merely designed to consolidate Congress’ existing taxing powers, and since the power to tax state securities had historically been considered unconstitutional, and the authors of the amendment were themselves wary of the taxing of state securities, it follows that the amendment could not have granted a new power to tax state securities.

At the time of its publication, this essay by Mr. Ritchie must’ve had a great appeal. If taken solely on its words, the sixteenth amendment undoubtedly encompassed state securities, and it certainly raised the sovereignty of the federal government in relation to the states. But Mr. Ritchie’s reasoning involves looking behind the plain text of the amendment and considering the larger historical context in which this amendment was birthed. Given the conclusions to which it led, this reasoning certainly would’ve found plenty of open ears in 1919.

But Mr. Ritchie’s argument had at least one major weakness: it failed to recognize that the limited nature of state sovereignty has always been an established constitutional principle. As Mr. Harry Hubbard pointed out in his Harvard Law Review article entitled “The Sixteenth Amendment” in 1920, there is no constitutional basis for the notion that either the states or the federal government must have a certain degree of sovereignty. The Constitution provides that state sovereignty may be reduced if the people so desire with the power of amendment. The only principle which cannot be amended is the right of each state to have equal political representation. Thus, if the states choose to enlarge the role of the federal government through a constitutional amendment there is no higher authority which can be invoked to bar such a choice.

Mr. Hubbard argued that, given this reality, the sixteenth amendment was intended to cover state securities. The text did not need to specifically mention state securities in order to address any sort of historical trend against this type of taxation; if the amendment reduced state sovereignty simultaneously at the time that it consolidated Congress’ taxing power then this would have been a natural extension of the will of the people. We may like to suppose that, past a certain point, state sovereignty may not be encroached upon. But there is actually no constitutional foundation for this supposition. State sovereignty may be an ideal, but it is not unassailable and is very much subject to transformation depending on the whims of the public. In the end, the authors must have been aware of the amendment’s impact on state sovereignty, and it follows that any reduction in state sovereignty was fully permissible because these authors were merely acting as instruments of the people.

References

Hubbard, Harry. “The Sixteenth Amendment.” Harvard Law Review, Vol. 33, No. 6 (April, 1920), 794-812.

Ritchie, Albert C. “Power of Congress to Tax State Securities Under the Sixteenth Amendment.” American Bar Association Journal, Vol. 5, No. 4 (October, 1919), 602-613.

Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429 (1895)

Hylton v. United States, 3 U.S. 171 (1796)

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The Tariff Which Shook History

Tariff Rate Act Morrill Tax

Morrill Tariff

As has been noted previously, substantive changes in tax policy are often closely tied to big changes in the social order. And the tie is not unidirectional, resulting solely from a tendency for tax measures to provoke heated reaction from a population. Sometimes a social change – such as a war – can massively alter the tax policy of a state. In the historical process, tax policy is both an active agent and a reactive agent, both a cause and an effect.

In most cases, it is not too difficult to determine the impact which a change in tax policy has had on society. The assessment of most changes is rather straightforward. The Morrill Tariff of 1861 – named after its sponsor, Vermont politician Justin S. Morrill – stands out among tax law because it defies this trend: although there can be no argument against its general importance, there is considerable controversy as to its specific role in history. Historians are divided as to what role the tariff act played in furthering the secessionist sentiment among Southern states: was the tariff a point of only minor irritation for Southern states? Or was it a matter of major frustration which caused Southern states to view secession as a necessary solution rather than a possibility?

The thing which is certain about the Morrill Tariff is that it raised rates substantially. In the years just preceding the Morrill act, American tariff rates had been unusually low by global standards. Between 1857 and 1860, the U.S. had average rates of approximately 17 percent overall and 21 percent on dutiable items. By 1865, the Morrill Tariff had increased these rates to 38 percent and 48 percent, respectively. Aside from bringing U.S. rates closer to global averages, the Morrill act also provided means to ameliorate the financial woes plaguing the U.S. Treasury.

Support for the Morrill act tended to vary according to political and sectional affiliation. The vast majority of Republicans voted in favor of the act and the clear majority of Democrats opposed it; there was an unmistakable sectional division as well, with every lawmaker from the Southern states except one voting against the act.

Historians who believe that the Morrill Tariff played only a minor role in furthering sectional hostility emphasize the element of time in the adoption of the act. The development of the tariff had begun well before any state had seceded from the union, but not until several states had withdrawn was the tariff act able to succeed in Congress. Historians point to this fact and infer that the tariff had only minimal significance given that a number of states had already decided to secede.

However, on the other side of the issue, historians emphasize that tariff revision had been a heated topic of discussion well before any state declared secession. The South had a clear interest in embracing free trade given the nature of its economy; Southerners also generally felt that they lacked the proper representation in the federal government which was necessary to ensure an equitable outcome. What’s more, the Morrill Tariff was mentioned specifically as a source of displeasure by the conventions of both Georgia and South Carolina; the tariff was even discussed in South Carolina’s secession ordinance.

The precise role of the tariff in promoting secession (and ultimately the War Between the States) will likely be debated for many years to come. Both sides of the matter have facts on which to rest their case; about which there can be no debate, however, is the fact that the tariff must be regarded among the most consequential in U.S. history.

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Armory v. Delamirie & the Evolution of Property Rights

Property Possession Right Law Priority

The Property Right of Possession

The evolution of our law is truly an amazing phenomenon. It is equal parts humbling and awe-inspiring to contemplate that many foundational legal concepts trace their origin to cases which occurred hundreds of years ago. To the casual observer, it may seem as though our law emerged just recently all at once as a finished product, the miraculous outcome of one act of divine intervention; in actuality, our system has come about through an exceedingly slow, gradual process of revision and refinement transpiring over the course of many centuries.

Take, for example, the very basic idea that a person who finds an object establishes some type of claim of ownership to the object. Colloquially, this principle is referred to as the rule of “finders, keepers.” This simple notion was not created by an American jurist, nor was it created within living memory. In point of fact, this idea first acquired legal significance through the famous English case of Armory v. Delamirie which was heard in 1722. Armory formally established the principle that a finder acquires a form of legal title by way of possession.

Facts

Armory (plaintiff) was the helper of a chimney sweep. While on the job, he found a jewel composed of gems embedded in a ring. Armory took the jewel to a goldsmith (Delamirie, the defendant) to have it appraised. The goldsmith’s apprentice took the gems from the ring so as to weigh them separately. The apprentice gave Armory an estimation of their value and then returned the ring without the gems. The apprentice made an offer for the jewel but Armory declined. Armory demanded that the gems be returned inside the sockets of the ring in the same condition as when they were initially brought to the goldsmith’s shop. The apprentice did not comply – presumably on the excuse that he “lost” the gems – and subsequently Armory brought a suit against the goldsmith (via respondeat superior) for the return of the jewel.

The issue before the court was whether Armory had a superior title to the jewel despite the fact that he was not the true owner. That is, whether the title he acquired through finding the jewel was sufficient to warrant the return of the jewel from the goldsmith.

Law

In the hierarchy of ownership, the present possessor (or finder) has a superior title against everyone except the true owner.

Ruling

The court (The Court of King’s Bench) ruled in favor of Armory. Since he found the jewel, Armory’s title was superior to all but the true owner; and since the true owner was unknown this effectively gave Armory true ownership. The court ordered Delamirie to pay Armory for the jewel at the highest possible estimation of the jewel’s value in the absence of any contradictory evidence as to the jewel’s value.

The importance of possession in acquiring property rights was understood prior to the case of Armory v. Delamirie; in fact, the rule of “finders, keepers” has existed in some form since ancient Rome. But it was Armory which caused this old idea to be codified in our common law. The fact that our common law was heavily impacted by a chimney sweep helper’s stroke of good fortune is nothing less than remarkable.

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Thought of the Day: What’s in a Tax?

What’s in a tax?

Divested of all misleading associations and stripped of any false labels, what does a tax truly represent?

Tax History Policy Interest Taxation

Tax Policy

In these last several months, Huddleston Tax Weekly has covered a wide range of topics. We’ve looked at tax measures from eras far removed from our own: we’ve examined the Tea Act which fueled our revolutionary fervor; we looked at the tax acts passed by the Confederacy in its struggle against the North; we even covered the geld, a medieval tax which provides a glimpse into the formation of the English nation. We’ve also touched on topical issues, such as Apple’s EU tax bill and the tax instituted in Vancouver designed to stabilize the real estate market. Our treatment of these many issues has vastly increased our understanding of the role of taxes in history and in our current society.

If there were a single lesson to be drawn from all of the many issues we have covered in these recent months, the lesson would be: tax policy is shaped by the competing interests of distinct groups. Taxes are not developed through a completely rational process in which the interests of every relevant group are considered carefully; in a very real sense, taxes are developed through a competitive process, and the end result usually involves certain groups having a more favored position than others. This is not the most pleasant revelation, but it is one which accurately reflects reality. It may do more to serve the ego of our society to suppose that tax policy is strictly the outcome of reasoned, sensible debate among lawmakers, but this does not mean that such a supposition is any reflection of the truth.

Of course, there are undoubtedly plenty of other lessons to be drawn from the issues we have discussed, and in future installments of Huddleston Tax Weekly we will do our best to cover these lessons. But for now, it is important to understand what taxes represent at a very basic level. Behind all the number crunching, the box checking, the empty bureaucracy, the abstruse terminology and the lofty rhetoric, a tax is a tool utilized to further the interests of a particular group. A tax can be created for any number of reasons: a tax may be used to generate funds for war; a tax may be implemented in order to stabilize a specific market; or a tax may be forcibly imposed by an occupying entity, as was the case with the geld. But no matter what the reason is for its creation, it is clear that any given tax is an extension of a specific interest group.

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Taxation in the Confederacy

Confederate Tax Act Revenue Taxation

Taxation in the Confederacy

Taxation in the Confederate States of America is a subject not often studied by either professional academics or laypeople. This is not at all surprising: there is a natural tendency to avoid giving deep attention to things considered deplorable, and since the legacy of the Confederacy is construed as wretched by so many people, it follows that a great many are ignorant of the details of Confederate society. Today, we will go against natural tendency and take a look at the tax acts passed by the rebel government in its attempt to raise revenue for the war.

Revenue derived from taxation made up only a very small part of the war fund for the South. In total, taxes constituted roughly 8.2 percent of the war account; this is less than half of the percentage contributed by taxes for the Union. Compared to the North, the Confederacy was slow to impose a “direct” tax on its population in large part because of its strong commitment to state’s rights and opposition to centralized government. As we will explore in detail below, the Confederate Congress passed two tax measures during the course of the war; neither of these measures generated sufficient income, and by the end of the war it was evident that financial trouble had played a substantial role in the demise of the South.

War Tax of 1861

At the beginning of the war, the Confederate government relied on tax revenue derived from international trade (i.e. tariffs and taxes on exports) and financial contributions from private citizens. These sources of funding started off well, but by the close of 1861 both had dried up almost entirely. The collapse of these sources prompted the Confederacy to impose a “War Tax” which was passed in August of 1861. The War Tax consisted of taxes on a number of items identified by the Treasury and a tax on real property greater than $500 in value.

In its first year (1862) of operation, the War Tax contributed a measly 5 percent of total war revenue. Not only was the tax relatively gentle in its basic terms, collection proved to be much more difficult than Confederate lawmakers had anticipated.

Agricultural Produce Tax of 1863

In response to the lackluster performance of the tax act of 1861, the Confederate Congress passed the Tithe Act – otherwise known as the Tax-in-Kind – in April of 1863. On top of the taxes imposed by the War Tax, the Tithe Act placed a tax of 10 percent on agricultural produce. The Tithe Act was referred to as the “tax-in-kind” because it was not paid in currency but with physical goods; under this act, 10 percent of the actual produce of plantation owners was handed over directly to the government, not 10 percent of their profits. Though it was plagued by implementation difficulties of its own, the produce tax was relatively successful and contributed a substantial portion of overall tax revenue in the remaining years of the conflict.

Controversy surrounded the tax-in-kind because it was interpreted as a direct tax by the Confederate Congress. Though they were in rebellion against the Union, the lawmakers of the Confederate Congress still adhered to the constitutional principle of apportionment for direct taxes and so many felt the Tithe Act unacceptable on this principle. The financial condition of the South ultimately tipped the scales and the act was passed out of sheer necessity.

References

Richard Burdekin and Farrokh Langdana, “War Finance in the Southern Confederacy, 1861-1865,” Explorations in Economic History, Vol. 30, No. 3, July 1993.

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A Quick Look at the Tea Act of 1773

British Tea Act Parliament America Company

The Tea Act of 1773

It has been noted before on Huddleston Tax Weekly that there is a strong tendency in contemporary society to associate taxes with things which are mundane, dull and boring. We’ve also noted that these associations are based on the conditions of our society at the present moment and would make little sense if based on conditions from previous eras. Throughout the bulk of recorded history, taxes have been closely tied to a host of exciting and oftentimes frightening things. With few exceptions, substantive changes in tax policy have accompanied sweeping changes to the existing social order, and the Tea Act of 1773 does not stray from this general rule.

As we will see, the significance of the Tea Act of 1773 stems mostly from the way it was received by the American colonists of the British Empire. The purpose of the act was not simply to generate revenue, but to provide confirmation of the power of the British Parliament to directly tax the American colonies. The act not only failed to achieve its intended goals but also sparked a reaction which ultimately altered the entire course of world history.

Historical Setting

The passing of the Tea Act was surrounded by a number of important political and business phenomena. One of the most pressing concerns of the British Parliament during this (pre-revolutionary) era was to have its power to tax the American colonies fully accepted by American colonists. This concern was among the driving forces behind the so-called Townshend Acts. The Townshend Acts consisted of a series of measures which dealt with a variety of issues relating to the administration of the American colonies. The first of these acts – the Revenue Act of 1767, also referred to simply as the Townshend Act – imposed a tax on tea (and several other items) imported to the colonies. The act forbade the colonists to purchase tea from any supplier other than Great Britain.

The Revenue Act was met with serious opposition from the American colonists who swiftly condemned the measure as a piece of blatant tyranny. Thenceforth the aim to legitimize the taxing power of the British Parliament over its colonies intensified.

Before the Tea Act, the British East India Company had been directed to sell its tea exclusively in London. Tea from the company which did make it to North America did so only through outside merchants who specialized in international sales. By the time the tea reached the market for American consumers, markups and the tax imposed by the Revenue Act made the tea an unattractive buy. As a consequence of these policies, an underground market developed in which foreign (Dutch) tea was smuggled into the colonies and sold at much lower prices. In addition to legitimizing the Parliament’s taxing power, the Tea Act was also passed with the aim of improving the financial condition of the East India Company and shutting down the flow of smuggled foreign tea.

The act contained these terms: the East India Company had the ability to ship its tea directly to North America; the company was no longer bound to sell its tea exclusively in London; duties on tea charged in Britain which were shipped out for international sale would either be refunded when exiting the country or not imposed; and finally, those receiving the company’s tea were required to pay a deposit up front following delivery.

Colonial Reaction

The British lawmakers in the Parliament had reason to believe that the Tea Act would produce favorable results: the tea sold by the East India Company was of higher quality than Dutch tea, and since its price had been lowered, the lawmakers could sensibly infer that the smuggled Dutch tea would lose its competitive advantage. Unfortunately for the British lawmakers, the act would be opposed not only by those colonists who continued to reject Parliament’s ability to lay the tax of the Revenue Act, but also by colonial merchants and underground businessmen who had a financial interest in preventing the ascendancy of the East India Company.

After the act was passed, the East India Company sent a number of ships to America in the hope of unloading its tea on the market; none of these ships was to unload its cargo successfully. Most famously, the ships which arrived at the ports in Boston were raided by irate colonists who tossed the company’s tea into the harbor. This incident came to be known as the “Boston Tea Party,” though it was referred to as the “Destruction of the Tea” in its own time. The colonial stance on the Parliament’s ability to impose taxes was clear, and the stage was set for the massive insurrection which was to eventually give birth to the sovereignty of the States.

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Bailey v. Drexel Furniture Co. & the Child Labor Tax Law of 1919

Drexel Child Labor Tax Law Constitutional Penalty

Supreme Court

To most contemporary Americans, exploitative child labor practices seem like an ancient, prehistoric phenomenon far removed from the context of advanced civilization. But, crazy though it sounds to modern ears, such practices sadly occurred on a fairly regular basis in the not too distant past of our society. In fact, our society was grappling for ways to combat this problem less than 100 years ago. In 1919, Congress addressed this issue through its Child Labor Tax Law. The law imposed a tax of 10 percent on the net profits of companies which employed children (as defined by the age limits of the law).

With the Child Labor Tax Law, the Congress was attempting to curtail child labor by regulating business through its taxing power. In effect, Congress was “punishing” businesses for exploiting the labor of children through the tax.

One curious result of constitutional restrictions on government power is that occasionally good laws are thrown out. Obviously, no one in 1919 disputed the desirability of a law which aimed to prevent abusive child labor practices; the issue which arose in Bailey v. Drexel Furniture Co. (1922) was whether the Congress went beyond the bounds of its constitutionally delineated authority by using a “tax” to stop unethical behavior. As we will see, the Bailey case illustrates the difficulty involved with maintaining restrictions on government power even when such power is being tailored for good ends.

Facts

Drexel (plaintiff in original suit and respondent in appellate case) was a furniture manufacturing company which employed a child under the age of 14 during the 1919 tax year. In agreement with the Tax Law, Bailey (the tax collector for the government) assessed a tax of $6,312.79 for such behavior. Drexel paid the full amount and then sued for recovery.

Drexel argued that the tax was a covert “penalty” designed to punish undesirable behavior and that the law was therefore an unconstitutional attempt to regulate business. The government argued that the levying of the tax was fully consistent with its broad taxing powers as prescribed by Article One of the Constitution.

Law

The Congress has the power to lay and collect taxes as outlined by the Constitution. However, this power is not unlimited and when the Congress attempts to step beyond its bounds such attempts must be struck down.

Ruling

The Supreme Court ruled in favor of Drexel (as did the lower court). Although no issue was raised as to the desirability of the Tax Law, the court reasoned that the tax created by the law was in fact a disguised penalty and it was therefore impermissible. The court defined a “tax” as a source of revenue for the government, while a penalty is a punishment intended to deter certain behavior. Penalizing unethical behavior is not a function of the taxing power of the Congress but should be addressed through the criminal law of individual states.

The decision in Bailey was controversial in part because other taxes aimed at curtailing (or in some sense penalizing) certain behavior had been upheld. For instance, excise taxes on drugs and firearms have not been regarded as improper attempts by the Congress to regulate business. But the court in Bailey recognized that an overly broad reading of Congress’ taxing power could result in the obfuscation of its proper function and unfairly reduce the power of the states.

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(800) 376-1785
40 Lake Bellevue Suite 100, Bellevue, WA 98005

Huddleston Tax CPAs & accountants provide tax preparation, tax planning, business coaching, Quickbooks consulting, bookkeeping, payroll and business valuation services for small business. We serve Seattle, Bellevue, Redmond, Tacoma, Everett, Kent, Kirkland, Bothell, Lynnwood, Mill Creek, Shoreline, Kenmore, Lake Forest Park, Mountlake Terrace, Renton, Tukwila, Federal Way, Burien, Seatac, Mercer Island, West Seattle, Auburn, Snohomish and Mukilteo. We have a few meeting locations. Call to meet John Huddleston, J.D., LL.M., CPA, Tawni Berg, CPA, Jennifer Zhou, CPA, Jessica Chisholm, CPA or Chuck McClure, CPA. Member WSCPA.