Our Changing Constitution

by Charles W. Pierson

X

IS THE FEDERAL CORPORATION TAX CONSTITUTIONAL?[1]

[Footnote 1: Since this chapter was first published in 1909 as an article in the Outlook magazine the specific question propounded in its title has been settled by the Supreme Court (Flint v. Stone Tracy Co., 220 U.S., 107). The paper is here reproduced, however, in the belief that its discussion of the principles of our dual system of Government is as pertinent now as it was before.]

The most noteworthy enactment of the sixty-first Congress from a legal point of view, to say nothing of its economic and political significance, was the Corporation Tax Act. That Act, forming §38 of the Tariff Law, provides—

That every corporation … organized for profit and having a capital stock represented by shares … shall be subject to pay annually a special excise tax with respect to the carrying on or doing business by such corporation … equivalent to one per centum upon the entire net income over and above five thousand dollars received by it from all sources, etc.

The act goes on to require the corporations to make periodical reports concerning their business and affairs, and confers on the Commissioner of Internal Revenue a visitorial power to examine and compel further returns.

The genesis of the act is interesting. The growing demand for more efficient regulation of the corporations, so pronounced during President Roosevelt's Administration, had foreshadowed such legislation. It remained, however, for President Taft to take the initiative and mould the shape which the legislation was to take.

In the course of the Senate debate on the new Tariff Act it had become apparent that an influential party in Congress, backed by strong sympathy outside, was bent upon passing a general income tax act. The previous Income Tax Law had been pronounced unconstitutional by the Supreme Court as violating the provision of the Constitution that all direct taxes must be apportioned among the states in proportion to population.[1] That decision, however, had been reached by a bare majority of five to four. It had overruled previous decisions and overturned doctrines that had been acquiesced in almost from the foundation of the Government. A strong party was in favor of enacting another income tax law and bringing the question again before the Court in the hope that the Court as then constituted might be induced to overrule or materially modify the doctrine of the Pollock case. The President and his advisers viewed such a proposal with disfavor. To their minds the proper way to establish the right of Congress to levy an income tax was by an amendment to the Constitution, not by an assault upon the Supreme Court. Accordingly on June 16, 1909, the President transmitted a message to Congress[2] recommending a constitutional amendment, and proposing, in order to meet the present need for more revenue, an excise tax on corporations. The proposal, coupled as it was with a suggestion that such an act might be made to serve for purposes of federal supervision and control as well as revenue, met with favor and was enacted into law.

[Footnote 1: Pollock vs. Farmers' Loan & Trust Co., 157 U.S., 429.]

[Footnote 2: Congressional Record, June 16, 1909, p. 3450.]

President Taft, himself an eminent constitutional lawyer, in his message recommending the law expressed full confidence in its constitutionality. The same view was taken by able lawyers who surrounded him in the capacity of advisers. The act is understood to have been drafted by Mr. Wickersham, the Attorney General, and vouched for by Senator Elihu Root and others of scarcely less authority in the domain of constitutional law.

Against opinions from such sources one takes the field with diffidence. I venture, however, to outline briefly some reasons for doubting the constitutionality of the act.

At the outset it is essential to determine the exact nature of the tax. Obviously it is not a tax upon income as income. If it were, it would be obnoxious to the decision in the Pollock case as imposing a direct tax without apportionment among the states. The language of the act, as well as the declarations of its sponsors, clearly indicate that it is intended, not as a direct tax on property, but as an excise tax on privilege. The phraseology of the act itself is—"A special excise tax with respect to the carrying on or doing business by such corporation," etc. Undoubtedly Congress has power to impose an excise tax upon occupation or business. This was expressly decided, in the case of the businesses of refining petroleum and refining sugar, by the Spreckels case,[1] referred to in President Taft's message. The message says:

The decision of the Supreme Court in the case of Spreckels Sugar Refining Company against McClain (192 U.S., 397) seems clearly to establish the principle that such a tax as this is an excise tax upon privilege and not a direct tax on property, and is within the federal power without apportionment according to population.

[Footnote 1: Spreckels Sugar Refining Co. vs. McClain, 192 U.S., 397.]

What, then, is the privilege with respect to which the tax is imposed? Is it, like the tax involved in the Spreckels case, the privilege of doing the various kinds of business (manufacturing, mercantile, and the rest) in which the corporations subject to the operation of the law are engaged? Obviously not. No kind or kinds of business are specified in the act. The tax falls not only on corporations doing every conceivable kind of business, but also on the corporation that does no specific business whatever—the corporation which, in the language of an eminent judge, is merely "an incorporated gentleman of leisure."[1] Moreover, if the tax were merely upon the privilege of doing business, it would seem to be obnoxious to the cardinal principle of just taxation that taxes should be uniform. In other words, if the privilege of doing a business—say conducting a department store—were the thing taxed and the only thing taxed, the rule of uniformity would seem to require that a corporation and a copartnership conducting similar stores on opposite corners of the street should both be taxed. Nothing inconsistent with this view will be found in the Spreckels case. The party to that suit was, to be sure, a corporation, but the act under which the tax was imposed applied to individuals, firms, and corporations alike.

[Footnote 1: Vann, J., in People ex rel. vs. Roberts, 154 N.Y., 1.]

It must be concluded, therefore, that the tax is not upon the privilege of doing the businesses in which the various corporations in the land are engaged, but is rather a tax upon the privilege of doing business in a corporate capacity, or, in other words, upon the exercise of the corporate franchise. That this is so appears very clearly from the message of President Taft. He says:

This is an excise tax upon the privilege of doing business as an artificial entity and of freedom from a general partnership liability enjoyed by those who own the stock.

Assuming, then, that this is the real nature of the tax, is it constitutional?

Unquestionably Congress may tax corporations organized under federal laws upon their franchises; any sovereignty may tax the creatures of its creation for the privilege of exercising their franchises; but how about corporations chartered by the states and doing purely an intrastate business? A state confers on John Doe and his associates the privilege or franchise of doing business in a corporate capacity. Can Congress impose a tax on the exercise of that privilege or franchise? The power to tax involves the power to destroy.[1] If Congress can impose a tax of one per cent., it can impose a tax of ten per cent. or fifty per cent., and thus impair or destroy altogether the value of corporate charters for business purposes. Does Congress possess such a power? The Constitution puts no express limitation on the right of Congress to levy excises except that they shall be "uniform throughout the United States." But there are certain implied limitations inherent in our dual system of government. The sovereignty and independence of the separate states within their spheres are as complete as are the sovereignty and independence of the General Government within its sphere.[2] Neither may interfere with or encroach upon the other.

[Footnote 1: McCulloch vs. Maryland, 4 Wheat., 316.]

[Footnote 2: The Collector vs. Day, 11 Wall., 113, 124.]

The right to grant corporate charters for ordinary business purposes is an attribute of sovereignty belonging to the states, not to the General Government. The United States is a government of enumerated powers. The Constitution nowhere expressly confers upon Congress the right to grant corporate charters, and it is well settled that this right exists only in the limited class of cases where the granting of charters becomes incidental to some power expressly conferred on Congress, e.g., the power to establish a uniform currency, or the power to regulate interstate commerce. On the other hand, the right of the separate states to grant charters of incorporation is unquestionable. By the Tenth Amendment of the Constitution it is expressly provided: "The powers not delegated to the United States by the Constitution nor prohibited by it to the states are reserved to the states respectively or to the people." The Supreme Court long ago said: "A state may grant acts of incorporation for the attainment of those objects which are essential to the interests of society. This power is incident to sovereignty."[1]

[Footnote 1: Briscoe v. Bank of Kentucky, 11 Peters, 257, 317.]

The power to grant the franchise of corporate capacity being therefore inherent in the sovereignty of the states, will not a tax imposed by Congress upon the exercise of the franchise constitute an interference with the power? If so the tax is unconstitutional.

The Supreme Court has repeatedly held, that the National Government "cannot exercise its power of taxation so as to destroy the state governments or embarrass their lawful action."[1] In the case of California vs. Central Pacific R.R. Co.[2] the question was whether franchises granted to the Central Pacific Railroad Company by the United States were legitimate subjects of taxation by the State of California. The Supreme Court, in language frequently quoted in subsequent cases, discusses the nature and origin of franchises, concluding that a franchise is "a right, privilege, or power of public concern" existing and exercised by legislative authority. After enumerating various kinds of franchises, the Court remarks: "No persons can make themselves a body corporate and politic without legislative authority. Corporate capacity is a franchise." The Court continues:

In view of this description of the nature of a franchise, how can it be possible that a franchise granted by Congress can be subject to taxation by a state without the consent of Congress? Taxation is a burden and may be laid so heavily as to destroy the thing taxed or render it valueless. As Chief Justice Marshall said in McCulloch v. Maryland, "The power to tax involves the power to destroy."… It seems to us almost absurd to contend that a power given to a person or corporation by the United States may be subjected to taxation by a state. The power conferred emanates from and is a portion of the power of the government that confers it. To tax it is not only derogatory to the dignity but subversive of the powers of the government, and repugnant to its paramount sovereignty.

[Footnote 1: Railroad Company v. Peniston, 18 Wall., 5, 30.]

[Footnote 2: 127 U.S., 1.]

It is true that the Court was here discussing the right of a state to tax franchises granted by the United States, and not the converse of that question. The reasoning of the Court would seem, however, to apply with equal force to the right of the United States to tax a franchise granted by a state acting within the scope of its sovereign authority.

Patent rights and copyrights are special privileges or franchises granted by the sovereign or government, and under the United States Constitution the right to grant patents and copyrights is expressly conferred on Congress. It has been held repeatedly that patent rights and copyrights are not taxable by the states[1]. As said by the New York Court of Appeals in a case involving the power of the state to tax copyrights:[2]

To concede a right to tax them would be to concede a power to impede or burden the operation of the laws enacted by Congress to carry into execution a power vested in the National Government by the Constitution.

[Footnote 1: People ex rel. Edison, &c., Co., v. Assessors, 156 N.Y., 417; People ex rel. v. Roberts, 159 N.Y., 70; In Re Sheffield, 64 Fed. Rep., 833; Commonwealth v. Westinghouse, &c., Co., 151 Pa., 265.]

[Footnote 2: 159 N.Y., p. 75.]

Apparently the same rule would be applicable were the granting of patent rights, like the granting of ordinary corporate franchises, a prerogative reserved under our system of government to the states instead of being expressly conferred on the United States. By parity of reasoning, the Federal Government in that case would have no power to tax them.

It is familiar law, reiterated over and over again by the Supreme Court, that Congress cannot tax the means or instrumentalities employed by the states in exercising their powers and functions, any more than a state can tax the instrumentalities similarly employed by the General Government. Thus, it has been held that Congress cannot tax a municipal corporation (being a portion of the sovereign power of the state) upon its municipal revenues[1]; that Congress cannot impose a tax upon the salary of a judicial officer of a state[2]; that Congress cannot tax a bond given in pursuance of a state law to secure a liquor license.[3]

[Footnote 1: United States vs. Railroad Co., 17 Wall., 322.]

[Footnote 2: Collector v. Day, 11 Wall., 113.]

[Footnote 3: Ambrosini v. United States, 185 U.S., 1.]

In the light of these decisions it is not apparent how Congress can tax the franchises of those state corporations (and they are many and important) which perform some public or quasi-public function. A state, to carry out its purposes of internal improvement, charters an intrastate railway or ferry company with power to charge tolls and exercise the right of eminent domain. Is not the grant of corporate existence and privileges to such a corporation one of the means or instrumentalities employed by the state for carrying out its legitimate functions, and is not a tax by the Federal Government upon the exercise by such a corporation of its corporate powers an interference with such means or instrumentalities?

In any discussion of the right of Congress to tax the agencies of or franchises granted by a state, the distinction must be borne in mind between a tax upon property acquired by means of the franchise from the state and a tax upon the exercise of the franchise itself. The former tax may be perfectly valid where the latter would be unconstitutional. Thus, the Supreme Court has upheld a tax by a state upon the real and personal property (as distinct from the franchises) of a railway company chartered by Congress for private gain, while conceding that the state could not tax the franchises, because to do so would be a direct obstruction to federal powers.[1]

[Footnote 1: Union Pacific Railroad Company vs. Peniston, 18 Wall., 5.]

It remains to notice briefly one or two Supreme Court decisions which are relied upon by the sponsors of the new tax law. Reference has already been made to the decision in the Spreckels case[1] which upheld the validity of the tax imposed by the War Revenue Act of 1898 upon the gross receipts of corporations engaged in the businesses of refining petroleum and refining sugar. The Court held the tax to be an excise tax "in respect of the carrying on or doing the business of refining sugar," and such it obviously was. It was not a tax upon the privilege or franchise of doing business in a corporate capacity, like the tax now under debate. On the contrary, the act expressly applied to "every person, firm, corporation, or company carrying on or doing the business of refining sugar…." The case, therefore, has no bearing on the point we are discussing. Had the act applied only to corporations, a different question would have been involved.

[Footnote 1: Spreckels Sugar Refining Co. vs. McClain. 192 U.S., 397.]

The case of Veazie Bank vs. Fenno,[1] upholding the statute which taxed out of existence the circulation of the state banks, has frequently been cited as an authority sustaining the right of Congress to levy a tax upon a franchise or privilege granted by a state. It is true that in that case the eminent counsel for the bank (Messrs. Reverdy Johnson and Caleb Cushing) argued unsuccessfully "that the act imposing the tax impaired a franchise granted by the state, and that Congress had no power to pass any law which could do that;"[2] and that two justices dissented on that ground. The conclusive answer to this argument, was, however, that the power of the states to grant the particular right or privilege in question was subordinate to powers expressly conferred on Congress by the Constitution; that Congress was given power under the Constitution to provide a currency for the whole country, and the act in question was legislation appropriate to that end. The case does not hold that Congress has any general power to tax franchises or privileges granted by a state.

[Footnote 1: 8 Wall., 533.]

[Footnote 2: See 8 Wall., p. 535.]

The scope of this chapter does not admit of further reference to the decisions. It is strongly urged, however, that none of them, rightly construed, will be found to sustain the right of the General Government to impose a tax upon the exercise of franchises granted by a state in the exercise of its independent sovereignty, and that such a decision would mark a new departure in our jurisprudence.

In the debates in Congress over the bill many good lawyers appear to have assumed, somewhat too hastily, that the tax in question was an excise tax on business or occupation like that involved in the Spreckels case, and that the only constitutional question, therefore, was one of classification under the provision of the Constitution that excises shall be uniform throughout the United States. No less eminent a constitutional lawyer than Senator Bailey of Texas, in a colloquy with the junior Senator from New York, put the matter thus:[1]

Mr. Root: May I ask the Senator from Texas if I am right in inferring from the statement which he has just made that he does not seriously question the constitutional power of the Congress to impose this tax on corporations?

Mr. Bailey: Mr. President, I answer the Senator frankly that I do not…. I think the rule was and is that Congress can levy any tax it pleases except an export tax. Of course a direct tax must be apportioned and an indirect tax must be uniform. But the uniformity rule simply requires that wherever the subject of taxation is found, the tax shall operate equally upon it.

I believe that Congress can tax all red-headed men engaged in a given line of business if it pleases…. I have no doubt if the tax fell upon every red-headed man in Massachusetts the same as in Mississippi or Texas and all other states, the law imposing such a tax would be perfectly valid.

[Footnote 1: Congressional Record for July 6, 1909, pp. 4251 to 4252.]

The difficulty with this reasoning is that it overlooks the fact that the privilege of being red-headed is not a franchise granted by a sovereign state. From the viewpoint of constitutional law it may well be that Congress can tax a privilege conferred by the gods where it would be powerless to tax a franchise granted by the Legislature of New Jersey.