Special Report: Corporate Tax Reform -- the Issues and the Choices

I. Introduction

 

A. Reduce Tax Burden on Corporate Income

B. Shifting Tax to Shareholder Level

C. Integration -- Deduction for Dividends

D. Summary of Proposals

II. Lower Burden on Corporate Income

A. Personal Service Income

B. Passive Income

C. Parity With Passthrough Investments

III. Eliminate Deferral of Shareholder Tax

IV. Senate Finance Approach -- Integration

V. Second-Level Tax

A. Inherited Property

B. Charitable Gifts

C. Tax-Exempt Investors

D. Foreign Investors

VI. Tax Preferences

VII. Conclusion

There is widespread support for reducing U.S. corporate rates at least to the level of corporate rates more prevalent in the developed world and perhaps to as low as 15 percent.¹ The primary goal is apparently to enhance the ability of the United States to attract investment. My motive here is to clarify what is at stake in choosing from among the proposals for corporate tax relief on the table, as best I can, without a full discussion of the complex details or the behavioral impacts of each proposal. I am not taking a position on whether reducing the rate on corporate income is desirable or on whether a rate cut, if enacted, should be offset by a reduction in corporate tax preferences or other possible revenue raisers. I also do not consider proposals that would lower individual rates as well, such as the House Republicans' "Better Way" blueprint for tax reform,² although I acknowledge that the results of the election make that reform possibility more viable than it seemed when I began this project. There are three key questions.

First: Is it necessary to reduce the tax burden on corporate income below the level that would be imposed by individual rates? Alternatively, would the goal of lower corporate taxes be satisfied even if the burden on corporate income is not less than that imposed by individual rates, as long as corporate taxes are reduced and the tax burden is shifted to the shareholder level?

Second: Is it essential to provide equivalent treatment for income earned by investors in passthrough entities? Is it important to create parity with passthrough investment regarding the treatment of debt obligations and tax-preferred income?

Third: Is it essential to collect a shareholder-level tax on corporate income in all, or at least most, circumstances? Until recently, the corporate tax alone was equal to the highest individual rate (it is still fairly close), which mitigates the concern that there may not be a second-level tax on shareholders. Since under the initiatives described below, corporations would pay much lower taxes and might pay no tax at all, the tax burden on corporate income would be significantly below individual rates unless distributions and sales are fully taxed.

For taxable individuals, the shareholder-level tax will be avoided if there is a step-up in basis at death under section 1014 or a charitable deduction for the fair market value of corporate stock without triggering gain on accumulated earnings. Further, tax-exempt institutions and foreign investors are generally not subject to full U.S. tax on dividends or the sale of shares.

I will first briefly describe how three approaches to corporate tax reduction now on the table deal with the above questions, and follow with a more detailed discussion of the issues, including the difficulty of collecting a shareholder-level tax and the treatment of tax preferences. The proposals are discussed in the order in which they gained attention, which I believe helps to shed light on the issues.

 

A. Reduce Tax Burden on Corporate Income

For the past decade or so, we have seriously considered a reduction in the corporate rate to a level significantly below individual rates, as is common in other advanced countries.³Although the relationship between the burden on corporate income and the tax on other income varies throughout the world, I will assume that the combined corporate and individual rate on distributed income will be equal to the top individual rate.

Under this assumption, if the top individual rate were roughly equivalent to 40 percent⁴ and the maximum tax on distributions 20 percent, as is true under current law, the corporate rate could be 25 percent. For example, if the corporation had $100 of taxable income, it would retain $75 after tax. If the $75 were distributed immediately, at a 20 percent rate the shareholder would pay tax of $15 and retain $60, as she would if the business entity were a passthrough and a 40 percent rate applied. To achieve this result, if the corporate rate is 15 percent and the highest individual rate is 40 percent, the tax on distributions would need to be about 29.5 percent for the highest-bracket individuals. In any event, this equivalence assumes an immediate taxable distribution of current earnings.

Putting aside the uncertainty that the second level of tax would be collected, under the rate structure just described, deferral of the tax on shareholders until distribution or sale by itself reduces the tax burden on corporate income below the burden on passthrough investors. This can remain true even if the combined tax rate on corporate income, when distributions are taxed, exceeds the individual rate applicable to passthrough investors. This would occur if earnings are accumulated for a sufficient period, which would depend on the applicable tax rates and the rate of return on investment.⁵

That favorable treatment of corporate income, matching the treatment provided by our trading partners, may seem consistent with the effort to encourage investment within the United States. But even if it is intended as part of the goal of corporate rate reduction, the challenge is to limit the benefit to business profits and not extend it to investment income and income from services. Moreover, if the tax on corporate income is reduced, it may be essential, at least for political reasons, to provide equivalent treatment for income earned by investors in passthrough entities. Acceptable solutions to these problems have not yet been found.

 

B. Shifting Tax to Shareholder Level

Inappropriate access to lower corporate rates and discrimination against passthroughs is no longer a problem if the burden on corporate income is not less than the level of individual rates. Some suggest that the goal of lower taxes on corporate income would be satisfied even if this is so, as long as corporate taxes are reduced (to 15 percent in the proposals discussed below) and the forgone tax on the corporation is shifted to the shareholder level.⁶ Recall that corporate income will be favored as long as the shareholder-level tax is deferred until dividend distribution or the sale of stock. Therefore, the challenge is to eliminate the benefit of deferral, regardless of whether income is immediately distributed, without disadvantaging the corporate form.

Current proposals described below potentially disadvantage corporations because they would eliminate deferred taxation of unrealized gains as well as current taxable income. This makes it essential to attempt to revise the treatment of passthrough investments to achieve current taxation of unrealized gains, as well. The proposals seek to level the playing field by, among other changes, limiting capital gain and eliminating the step-up in basis at death. While these changes may reflect sound policy, neither would seem feasible as part of corporate tax reform. I consider below whether it would be possible to directly match passthrough treatment by currently taxing shareholders only on corporate taxable income and not unrealized gains.

 

C. Integration -- Deduction for Dividends

The much-discussed proposal said to be forthcoming from the Senate Finance Committee for a dividend deduction adopts the classic integration approach of collecting an initial corporate-level tax, presumably at current rates.⁷ Under the Senate suggestion, if a corporation issues dividends at least equal to corporate income, the deduction for dividends paid would eliminate the corporate tax. Nevertheless, tax collection would be unaffected because the corporation would be required to withhold tax on the dividend at the corporate rate. In sum, the tax saved from the dividend deduction must be withheld from the distributed dividend.

Despite this equivalence, it is suggested that the Financial Accounting Standards Board will treat the withheld amount as a shareholder-level tax, thereby reducing or eliminating the corporate tax burden and shifting the burden to shareholders. The reduction in corporate taxes would increase reported earnings per share and apparently reduce the undesirability of investment in the United States. Smoke and mirrors, perhaps, but apparently people believe it will work.

Two caveats may be noted. If earnings are accumulated, the current high corporate rate will apply. Further, if the marginal shareholder rate exceeds the corporate rate, ending deferral and matching the treatment of passthroughs would occur only if all income were distributed currently. Perhaps allowing a dividend reinvestment plan (DRIP), which, as discussed below, would allow corporations to declare dividends without an actual distribution, would cause all corporate income to be deemed distributed as dividends. This would eliminate corporate tax and impose higher shareholder rates, if applicable.

 

D. Summary of Proposals

To sum up, we seem to have at least three approaches to corporate rate relief.

1. Reduce the corporate rate to below the top individual rate. Because deferral of the additional tax on shareholders until distributions would favor corporate investment, the challenge is to limit the benefit to business profits (not investment income and income from services) and to find a way to provide equivalent treatment for business earnings from a passthrough entity.

2. Reduce corporate rates but eliminate the benefit of deferral of the shareholder-level tax regardless of the timing of distributions. If there is no benefit to corporate-level investment, inappropriate exploitation of the lower corporate rate is not a concern. The challenge is to not disfavor corporate investment, which could occur if we eliminate deferred taxation of unrealized gains in addition to taxable corporate income.

3. Eliminate deferral by collecting current corporate tax at a level roughly equivalent to individual rates but allow a deduction for dividends paid. If income is distributed as a dividend, corporate tax declines because the tax is said to be imposed on shareholders.

The first approach is required if we want to reduce the burden on corporate income below the level that would be imposed if individual rates applied. If the goal of corporate tax reduction is met even if an equivalent tax burden is shifted to shareholders, a dividend deduction seems the simplest route if it is accepted that the requirement that an amount equivalent to the corporation's tax saving be withheld upon distribution does not make the withheld amount a corporate tax. Also, it may be important for it to be possible to avoid corporate tax and thereby eliminate deferral, even if income is accumulated.

I next discuss these three approaches in more detail, followed by an examination of the difficulty of collecting a shareholder-level tax and the alternative approaches to tax-preferred income.

Although the increase in the top marginal individual rate to a level above the corporate rate makes the calculation more complex than it was in 1986, under current law, if the distribution of after-tax income to shareholders is taxable, the combined burden on corporate income is generally higher than the burden on passthrough investors. Thus, there is an increasing trend for closely held businesses to operate as passthroughs by using a partnership, limited liability company, or subchapter S corporation.⁸

However, if the corporate rate is reduced and the shareholder tax is deferred until the distribution or sale of shares, adopting a corporate form might result in lower taxes than using a passthrough. Even if the combined tax rate on corporate income is equal to the individual rates applied to passthrough investors, because the tax on distributions is deferred, it would not eliminate the full benefit of the lower corporate rate. In those circumstances, the lower corporate rate, combined with deferring the distribution tax, offers an opportunity to reinvest earnings within a corporation to earn a permanent higher rate of return.⁹ If earnings are retained in even lower-taxed foreign subsidiaries, the advantage is increased.

To illustrate that the benefit of reducing corporate rates can be described as taxing the return on reinvested earnings at the lower corporate rate, suppose the corporate rate is 25 percent, distributions and gain on sales are subject to a 20 percent tax, and income from passthrough entities is subject to individual rates up to a maximum of 40 percent. If a corporation earned $100 and immediately distributed the after-tax income of $75, shareholders would retain $60 after tax, identical to the amount retained from a similar passthrough investment.

Suppose, however, those earnings are reinvested for two years.¹⁰ If the after-tax $60 earned by the passthrough were reinvested at a 6 percent after-tax rate of return (a pretax return of 10 percent subject to a 40 percent tax), the accumulation after two years would be $67.42. However, if the corporation reinvested the $75 of after-tax earnings for two years at a 7.5 percent after-tax rate of return (a pretax return of 10 percent subject to a 25 percent tax), the shareholder would retain $69.34 from a distribution at that time. The difference is the higher rate of return on reinvested earnings, not the tax differential on the initial $100.

Thus, at the end of two years, the corporation, at a 7.5 percent return, would accumulate $86.67. If it distributed that amount and a 20 percent tax applied, the shareholder would retain $69.34. However, if the corporation earned only a 6 percent after-tax return (instead of 7.5 percent), because the tax rate on those earnings was 40 percent, the assumed individual rate, the corporation would accumulate only $84.27, and the shareholder would retain only $67.42 after the 20 percent tax on the distribution, just as she would from a passthrough investment.

In sum, as I attempted to explain in the earlier Tax Notes article,¹¹ the advantage to the corporate form is that the tax burden on the return from reinvestment of corporate earnings (note: not the return on capital contributions) is permanently limited to the corporate-level tax, even if those earnings are later distributed (and apparently taxed to shareholders). Perhaps that favorable treatment of corporate income, matching the treatment provided by our trading partners, is consistent with the effort to encourage investment within the United States, even if it encourages accumulation at the corporate level.

However, because the lower rate does not apply to personal service and investment income earned directly, the challenge is to prevent abuse, particularly by closely held business or high-income taxpayers, who will attempt to extend the advantage of the lower corporate rate to passive income or to earnings attributable to personal services.¹² On the other hand, it also seems politically necessary to offer an equivalent advantage to passthrough entities. These issues are considered in turn.

 

A. Personal Service Income

There is clear precedent for denying a lower corporate rate to income from personal services. Thus, the current marginal rates below 35 percent on corporate income do not apply to qualified personal service corporations.¹³ Further, the special capital gains treatment for small business stock excludes any trade or business in which the principal asset is the reputation or skill of one or more employees.¹⁴ This exception from access to special lower rates should continue.

It is more difficult, however, to prevent individuals from paying themselves less-than-reasonable compensation to maximize low-taxed corporate income if they are corporate shareholder-employees of a business not designated as a personal service corporation and they are providing personal services to customers. One approach is to not recognize the possibility of profits derived from capital investment in the business in those circumstances. Thus, all income of a general partner, except to the extent it is from specified passive sources such as interest or rents, is considered income from self-employment.¹⁵ In 1997, to prevent individuals from avoiding self-employment tax by claiming limited partner status, the IRS issued proposed regulations that would have treated anyone who performs 500 hours of service as a general partner.¹⁶ In 2005 the staff of the Joint Committee on Taxation proposed treating all partners and shareholders of subchapter S corporations like general partners unless they did not materially participate in the business.¹⁷ Those efforts did not succeed.

In contrast, subchapter S corporations and partnerships are only required by the code to recognize the reasonable value of personal services by family members, which, although it requires difficult measurement, does allow for capital income.¹⁸ An alternative that does not require that reasonable compensation be measured would be to determine the value of services by subtracting a reasonable rate of return on capital. For purposes of their dual income tax, the Nordic countries use this approach, applying a fixed statutory rate of return to capital to separate higher-taxed labor income from lower-taxed income from capital.¹⁹Under that approach, the lower corporate rate would be limited to a specified return on capital.

 

B. Passive Income

High-income individuals should not be able to incorporate their investments to avoid individual-level tax on portfolio investments. Also, the reduced corporate rate should not apply to investment earnings of an active business corporation that retains profits beyond the needs of the business. Although specific solutions to those potential abuses now exist in the form of the penalty taxes on so-called personal holding companies²⁰ and on earnings accumulated in excess of the reasonable needs of the business,²¹ rather than relying on reinvigorating those complex and easily avoided provisions, it would be preferable to deny the lower rate to any passive income regardless of the circumstances. The code already distinguishes passive from active income in several situations.²²

Recall that the advantage of the lower corporate rate is limited to the return on reinvested earnings. The earlier example illustrated that even if the corporate rate is lower than the rate applied to passthroughs, the results from a corporate or passthrough investment are equivalent if the return on reinvested earnings does not benefit from the lower corporate rate. Thus, taxing investment income at the equivalent of individual rates does not penalize corporations even though corporate income is subject to a second-level tax on distributions. It just provides equivalent treatment to passive income earned by passthroughs.²³ Because taxing passive income at individual rates only levels the playing field, it seems best not to try to identify circumstances in which taxing passive income at lower rates might not be considered abusive.

 

C. Parity With Passthrough Investments

Proposals for corporate rate reduction have raised concerns about the comparable burden on investors in passthrough entities who are potentially subject to higher individual rates. This is a particular fear if the revenue cost of the corporate rate cut is offset by curtailment of tax preferences, which could affect all investors -- even those who are not enjoying the lower rates. As one commentator put it, "Before corporate tax reform becomes reality . . . the riddle of what to do with passthrough businesses must be resolved."²⁴

Treasury Secretary Jacob Lew has suggested that a small business could obtain the advantage of corporate rates simply by choosing to organize as a C corporation rather than a passthrough.²⁵ I believe this is misguided. The post-1986 regime, under which it is most often cost-effective for a closely held business to operate as a passthrough (including an S corporation), is much preferable to the complexity, distortion, and potential abuse under prior law when the use of a C corporation often made more sense. The desire for equal treatment should not require a return to that world.

The Finance Committee working group report considered several alternatives to provide tax relief to passthroughs, including targeted tax benefits (as proposed by the Obama administration), a business equivalency rate, and a flow-through business deduction applying only to active passthrough business income.²⁶

As for additional tax benefits for passthroughs, the Obama administration proposals include expanding section 179 for small business to permit expensing of up to $1 million of business equipment; cash accounting for businesses with up to $25 million in gross receipts; and expansion of the health insurance tax credit for small business.²⁷ The working group report notes that those changes would provide little relief for a service-oriented business, which might have little in the way of depreciable equipment and would already be able to use cash accounting because of the absence of inventory.²⁸

The business equivalency rate would tax all active business income at the same rate regardless of the form of the business. However, that would be too generous to passthroughs, because distributions of previously taxed income from passthrough entities, unlike distributions from C corporations, are not subject to a second-level tax. The working group report expresses that concern, as well as the high revenue cost, as objections to this approach.²⁹

The final idea considered by the working group, a deduction applying only to active business income, would be similarly excessive. As illustrated in the earlier example, assuming the combined rate on corporate income is equal to the individual rate and that distributions are taxable, the only advantage of a corporate rate cut would be the lower rate of tax on the earnings produced by the reinvestment of after-tax active business income.³⁰Corporate return on contributed capital is eventually taxed in full at individual rates, even if distribution is deferred.

In the example, if the tax rate on the return from the reinvestment of the $60 of business profits by the passthrough was decreased to 25 percent, the assumed corporate rate, the accumulation, at a 7.5 percent after-tax rate, would be increased from $67.42 to $69.34, identical to the investment in corporate form. Thus, to achieve equivalent treatment of passthroughs, we need to identify earnings from the reinvestment of business profits and limit the tax rate on those earnings to no more than the corporate rate, similar to the way we treat capital gains for individuals. By focusing only on the rate of tax applied to the return on reinvested earnings, we can provide the benefit of lower corporate rates to passthroughs at a much lower cost. Of course, the difficulty of understanding why this is so is a significant barrier to acceptance of the idea. For a discussion of how this proposal might be implemented, see my earlier Tax Notes article concerning the tax treatment of passthrough entities.³¹

Eric Toder and Alan D. Viard, as well as Harry Grubert and Rosanne Altshuler, propose reducing corporate rates to 15 percent and replacing the eliminated corporate tax by increased taxes at the shareholder level.³² To eliminate the benefit of deferral, the shareholder tax would be designed to equal the present value of the tax that would be collected on an immediate distribution of income, regardless of the timing of distributions or the sale of shares. The assumption behind those proposals is that the goal of lower corporate taxes would be satisfied, even if the burden on corporate income would not be less than the level of individual rates, as long as corporate taxes are reduced and the tax burden is shifted to the shareholder level.

Toder and Viard would tax shareholders holding publicly traded stock at individual rates on dividend distributions and the increase in value of their holdings (mark-to-market), with a credit for the U.S. corporate tax.³³ The credit would not be refundable, but it could be used to offset taxes on unrelated income and carried forward if unused. Grubert and Altshuler propose taxing dividends and the sale of stock at the individual rate, without credit for the corporate tax, with an interest charge on extraordinary dividends and the sale of shares to compensate for deferral.³⁴

Taxing shareholders on corporate income as if it were distributed currently eliminates the benefit to corporate-level investment and removes the concern that there may be inappropriate exploitation of the lower corporate rate. The proposals just described, however, could disadvantage the corporate form because they would eliminate deferred taxation of unrealized gains, as well. Mark-to-market would subject unrealized gains to current tax. Similarly, because the interest charge would apply to the entire gain on sales, regardless of when realized at the corporate level, it would effectively seek to tax unrealized gains as they occur. This would create a potential advantage for passthroughs, which would continue to defer tax on unrealized gains. The challenge for these proposals is to eliminate the benefit of deferral without creating a disadvantage to the corporate form.

Grubert and Altshuler attempt to solve the problem by eliminating capital gain treatment and subjecting all dispositions, not just dispositions of corporate shares, to the interest charge regime.³⁵ Toder and Viard would extend mark-to-market treatment to owners of other publicly traded financial assets and to derivatives of all instruments subject to the mark-to-market regime.³⁶ They would not, however, seek to tax gains on passthrough investments on an accrual basis, deeming mark-to-market too difficult for non-traded instruments.³⁷ Both proposals would also eliminate the step-up at death by taxing unrealized gains at the time of a bequest.³⁸

These proposals are complex and untested. Further, the interest charge requires several assumptions, which means it can only approximate immediate taxation.³⁹ Also, Toder and Viard do not attempt to tax unrealized gains in passthroughs, advantaging that form. Finally, in my view, neither the repeal of section 1014 nor the proposed limit on capital gain is feasible as part of corporate tax reform.

Parity can be achieved more directly if we could pass through corporate income to shareholders each year. We have generally thought that allocating income to shareholders, as we do for partners, was not administrable, in part because of the likelihood of significant share transfers during the year. It may be noted, however, that the next discussed dividend deduction proposal is likely to allow corporations to declare constructive dividends (a DRIP) which, because there would be no actual distribution, would require the allocation of earnings.⁴⁰ Further, most companies would probably do so because the constructive dividend would increase basis and reduce tax on sales. If that treatment -- which, like actual dividends, allocates earnings to the shareholder on the record date rather than the shareholder on the date earned -- is deemed both equitable and feasible if elected, could it not be made mandatory? Thus, it may be worth considering whether the allocation of earnings to shareholders currently would actually be more complicated than the proposed alternatives.

Lower corporate taxes, accompanied by equality of treatment between corporations and passthroughs, could be achieved without much of the complexity inherent in the two previously described approaches if it were possible, consistent with the goal of corporate rate reduction, to turn to what is referred to as integration. Under this approach, first proposed at least 40 years ago,⁴¹ the ultimate burden on corporate income would be determined by individual rates, but corporate-level tax would be payable currently, presumably at current rates.

Under the most common form of integration, the corporate tax is effectively treated as a withholding tax that can offset the individual tax. For example, if the corporate rate were 35 percent, a corporation that had taxable income of $100 would pay $35 in tax. If it distributed the after-tax income of $65, the dividend to the shareholder would be grossed up or increased by the tax associated with the distribution. Therefore, the dividend to the shareholder would be $100, and the shareholder would get a credit for the corporate tax ($35) as an offset to her individual tax. If the shareholder's marginal rate were 40 percent, she would pay an additional $5 and retain $60 after tax, as she would if $100 of income were earned in a passthrough entity. If the shareholder's marginal rate were less than 35 percent, she could be entitled to a refund. The American Law Institute study recommended this approach.⁴²

The Finance Committee is considering a different but economically equivalent approach, a corporate deduction for dividends paid,⁴³ which similarly would minimize deferral by collecting current corporate tax at a level roughly equivalent to individual rates. Under the Senate suggestion, if a corporation declares dividends at least equal to corporate income, the deduction for dividends paid would eliminate the corporate tax. However, the tax avoided by the dividend deduction would have to be withheld from the distributed dividend. Therefore, tax collection from the corporation would not be affected.

In the above example, the deduction for dividends paid would allow the corporation to distribute the entire taxable income of $100. Because the dividend would be subject to withholding, presumably at 35 percent, the shareholder would receive $65. The tax withheld would be available to offset the shareholder's tax on dividends. Thus, a shareholder whose marginal rate was 40 percent would owe a $40 tax on the dividend. However, because $35 has been withheld, she need pay only an additional $5, leaving her with $60, the amount she would retain from a passthrough investment earning $100. Taxable shareholders subject to a lower marginal rate would effectively be entitled to a partial refund of the withheld tax.

The working group report notes that a dividend deduction would make taxation of dividends equivalent to interest and promote progressivity because income would be taxed at the shareholder's rate rather than a uniform corporate rate.⁴⁴ Because corporate income is eventually taxable only at the individual level, the distortions of the current system regarding choice of entity or debt or equity financing would be mitigated. Under this approach, taxation of corporate income would generally match the treatment of passthroughs, something that is very difficult to achieve under the initiatives discussed earlier.

We have, however, generally thought of integration as imposing an initial high corporate tax, which could deter investment in the United States. Moreover, the dividend deduction, as noted above, would not reduce tax collection at the corporate level, because the tax saved must be withheld from the distribution. Nevertheless, despite the equivalence to the more common form of integration, which allows shareholders a credit for the corporate tax, it is suggested that FASB might treat the withheld amount as a shareholder-level tax, not a corporate tax.⁴⁵ The reduction in corporate taxes would increase reported earnings per share and apparently reduce the undesirability of investment in the United States, achieving the goal of corporate rate reduction without favoring corporate investment over passthroughs.

Note, however, that if earnings are accumulated, the current high corporate rate will apply. Further, to the extent that marginal shareholder rates exceed the corporate rate, ending deferral and matching the treatment of passthroughs would occur only if all income were distributed currently. Although, under current law, undistributed corporate income may also be taxed at lower than the top individual rate, deferral of the shareholder tax is of more concern when the corporate rate is considerably below the top individual rate and the combined tax rate on corporate income is not significantly higher than the top marginal rate, as it is today.

There would, however, be pressure to distribute taxable income. Shareholders subject to a low marginal rate could claim a partial refund of the withheld tax. Further, a dividend would reduce gain on sales for all shareholders. The pressure would increase if a deduction were allowed only for dividends paid out of current income. Still, corporate managers might prefer to retain earnings to reinvest in the business.

To accommodate these diverse interests, the ALI proposed a DRIP whereby dividends are automatically reinvested in the corporation but are deemed to be distributed and taxable.⁴⁶Toder and Viard make a similar suggestion.⁴⁷ A DRIP would allow both a tax refund for lower-bracket shareholders and an increase in basis, which would reduce gain on sales for all shareholders, without an actual distribution of earnings. A DRIP, combined with a limit on the deductibility of dividends to current earnings, would encourage all corporate income to be deemed to be currently distributed as dividends, which would both eliminate corporate tax and impose higher shareholder rates, if applicable.

Unlike current law, in which the corporate rate is still relatively close to the individual rate, under the proposals considered here, which reduce the level of corporate tax (perhaps to zero under the dividend deduction proposal), in the absence of a shareholder-level tax on corporate distributions, the ultimate burden on corporate income would not be comparable to the tax at the individual rate. Therefore, to prevent taxpayers from permanently escaping additional tax on earnings retained in the corporation, the second tax on distributed income should be as certain as feasible.

Distributions are not fully taxed if the shareholder is tax-exempt or is the beneficiary of a treaty as a nonresident. Heirs of individuals who hold onto stock until death can step up the basis of the stock to FMV at death, which will enable the heir to avoid tax on accumulated income. Tax on built-in gain can also be avoided when stock is donated to charity. Thus, full taxation of corporate income requires reducing the step-up in basis at death and the deduction for charitable contributions by the amount of undistributed earnings, as well as addressing the treatment of tax-exempt and foreign shareholders.

 

A. Inherited Property

Step-up in basis does not apply to what the code refers to as "income in respect of a decedent," which is generally income that a decedent was entitled to before death but was not includable in computing her taxable income.⁴⁸ Examples include salary, distributions from an IRA, income from a Series E U.S. savings bond, and gain on stock sold during lifetime but for which payment had not been received before death. Because basis is reduced below FMV by the amount of income in respect of a decedent, this income is subject to tax in the hands of the heir.

Income from a passthrough entity is taxed when earned, regardless of whether it is distributed. In fact, payments to a retiring or deceased partner, other than in liquidation of the partner's interest in property, are considered income in respect of a decedent.⁴⁹Similarly, the decedent earned her share of the corporation's undistributed income before death, and it should be taxed to her or her heirs when distributed. Although increasing the basis of the stock to FMV at death would not affect the treatment of dividends, the increased basis could be used to reduce gain or increase the loss on the sale of shares. This would effectively enable the heir to avoid tax on accumulated income.

The Toder-Viard and Grubert-Altshuler studies suggested replacing step-up basis under section 1014 with the constructive realization of gain at the time of a bequest.⁵⁰ On the other hand, the ALI integration study would have retained section 1014 but reduced the basis step-up by the decedent's share of undistributed corporate income at the time of death.⁵¹ The treatment of stock in a domestic international sales corporation⁵² and a passive foreign investment company⁵³ are directly analogous. While repeal of section 1014 is, in my view, sound policy, the more modest ALI approach has the advantage of precedent, which makes it more likely to be enacted. The ALI study recognized that the allocation of earnings may face administrative difficulties, particularly if the company is not closely held,⁵⁴ but the DISC provision assumed the issue can be handled.⁵⁵

 

B. Charitable Gifts

Because the code usually measures charitable contributions of property by FMV, any built-in gains would escape tax. If this rule applied to contributions of corporate stock, there would be no individual-level tax on undistributed corporate earnings at the time of the gift. Unless charities were to become taxable on dividends and the sale of corporate stock at full individual rates, this income would never be fully taxed. The same considerations that would deny a full step-up in basis at death suggest that the deduction for a charitable gift be reduced by undistributed earnings.

Alternatively, to cover situations in which no charitable deduction is available, it would be preferable if a charitable contribution would trigger a tax as if the undistributed earnings were in fact distributed. Contributors may also prefer this approach. Thus, reducing the charitable deduction by the amount of undistributed earnings could indirectly tax the undistributed earnings at full ordinary rates. However, corporate distributions may be taxed at a lower rate, as under the first proposal discussed above. In these circumstances, the contributor would prefer the alternative, which would trigger a tax on the undistributed earnings at this lower rate while leaving the amount of the charitable deduction unchanged. Those considerations suggest that taxing undistributed income at the time of the gift might be preferable to reducing the charitable deduction by that amount.

 

C. Tax-Exempt Investors

Corporate tax reform would likely result in significant change in the treatment of tax-exempt investors. Tax-exempt investors probably own more than 40 percent of corporate equity, with by far the largest share in tax-preferred retirement savings, including employer-sponsored plans, 401(k) plans, and IRAs.⁵⁶ Substantial stock is also owned by charitable endowments, principally by universities, healthcare organizations, and private foundations. Although their investment income is generally not subject to tax, tax-exempt shareholders indirectly bear the burden of the corporate tax. Moreover, tax-exempt organizations directly engaged in business as sole proprietors or partners pay a similar tax on unrelated business income, which serves to mitigate any incentive to avoid corporate investment.⁵⁷

The ability to earn a tax-free return on investments is clearly intended as the primary incentive to increase retirement savings, which might suggest that the indirect burden on corporate equity investment is inconsistent with that goal. Thus, a reduction or even elimination of corporate tax under the described proposals might be appropriate, at least for retirement savings. Grubert and Altshuler suggest that reducing taxes on tax-exempts would increase progressivity because of the status of participants in retirement plans and the beneficiaries of charitable and educational institutions as compared with others who enjoy dividends and capital gains.⁵⁸ Revenue shortfall, in their view, should be made up by increased taxes on other shareholders.

On the other hand, the Finance Committee would effectively tax dividends at the corporate rate by treating withholding on dividends to tax-exempts as a nonrefundable final tax.⁵⁹Also, the working group report suggested that interest payments by corporations to tax-exempts be subject to a similar withholding regime.⁶⁰ Under current law, because interest, unlike dividends, is deductible by the corporation, there is no tax on corporate debt investment by tax-exempts, in contrast to the indirect burden on equity investments. The Senate approach would achieve parity between debt and equity -- another goal of corporate tax reform -- and tend to increase the effective tax on tax-exempts unless they responded by shunning corporate debt.

Other proposals would achieve parity while maintaining the current effective tax burden on tax-exempts by offsetting an increased tax on interest payments with a reduction in the burden on dividends from the current rate of 35 percent. Explicitly with this goal in mind, Toder and Viard propose a 15 percent corporate tax (which would indirectly tax equity investment) and a 15 percent final withholding tax on interest.⁶¹ The ALI study followed a similar route. It suggested that the withholding tax be refundable and would have imposed a uniform tax on interest and dividends, as well as on sales of all corporate instruments.⁶²

Although those proposals would increase the burden for tax-exempts on interest from corporations, none would affect interest from other payers or other forms of passive income. That would clearly affect investment strategy, perhaps unwisely.⁶³ Moreover, tax-exempts would presumably attempt to avoid the burden on dividends and interest by investing in derivatives. Therefore, I believe it is necessary to consider whether all investment income of these institutions should be equally taxed.

This can include an examination of whether to tax gain on the sale of corporate instruments by tax-exempts, as only the ALI study (of all the proposals considered here) has proposed.⁶⁴Because taxing sales may be difficult, it raises a potential conflict of interest between tax-exempts and other shareholders. Under the Senate approach, because of withholding, dividend distributions would not result in significant additional tax and could result in a refund to lower-bracket taxpayers. Dividends would also reduce gain on the sale of shares, which would be larger if earnings are retained. Therefore, as discussed above, the code would likely allow a DRIP, whereby earnings would be deemed distributed to shareholders and reinvested in the corporation, thereby increasing basis and reducing potential gain. Taxable shareholders would seem to favor at least deemed distribution of all corporate income.

If their gains on sales are not subject to tax, however, tax-exempts would oppose dividends and would be harmed by a DRIP, which could impose a final withholding tax and offer an unneeded basis increase. That would create a conflict of interest between tax-exempts and other shareholders. However, tax-exempts would likely respond by owning derivatives of corporate stock rather than the stock itself. Therefore, gain on derivatives must be taxable if the expected revenue from tax-exempts is to be achieved.

Because corporate tax reform will require that current rules be modified, it seems to be a good occasion to reexamine the justification for the tax exemption of investment income. In this context, I have argued that limiting the exemption for investment income of tax-exempts, at least those that do not involve retirement savings, might be desirable. Thus, several commentators, including me, have questioned the unlimited subsidy for accumulation of large endowments.⁶⁵ Further, I believe that all mutual organizations should be taxed on investment income as some are today.⁶⁶ It is also unclear why section 501(c)(4) (social welfare) organizations, for which the charitable deduction is viewed as inappropriate, deserve an exemption for investment income, which helps only those entities that accumulate rather than spend income currently.⁶⁷

 

D. Foreign Investors

The possibility of avoiding the tax on distributions could also arise for nonresident investors, who may own more than 25 percent of corporate equity.⁶⁸ Nonresidents are subject to withholding at 30 percent on dividends not effectively connected to a U.S. business, which is higher than the dividend rate applicable to U.S. persons.⁶⁹ However, tax treaties lower the rate, most often to 15 percent (the statutory rate for most U.S. taxpayers) for portfolio investors and 5 percent or even 0 percent for direct investment.⁷⁰

While foreign investors would bear the burden of the 15 percent corporate tax they recommend, apparently, neither Toder and Viard nor Grubert and Altshuler would impose an additional tax on distributions or sales by foreign investors.⁷¹ In contrast, foreign investors would continue to pay full individual rates on passthrough investments. However, the ALI study suggests that to replace the corporate-level tax, unless modified by treaty, foreign investors should be subject to tax on dividends at the highest individual rate, which would be offset by the available credit.⁷² The Finance Committee working group report discusses the possibility of making withholding nonrefundable for foreign investors. The result would be that in the absence of a treaty, foreign investors would be taxed on distributions at the corporate rate.⁷³ Again, this raises the concern that foreign investors would substitute investment in derivatives for direct investment in corporate stock.

Tax-preferred income, like debt obligations, is not uniformly treated under current law.⁷⁴For passthrough entities, tax-preferred income retains favorable status at the investor level. On the other hand, tax-preferred income earned by a C corporation is taxed at the shareholder level upon distribution or sale. Under current law, however, tax-preferred income is subject only to the reduced shareholder-level tax. Because the dividend deduction proposed by the Finance Committee would be limited to taxable income, it would have the effect of fully taxing preference income at individual rates.

The ALI integration study did not resolve the difference in treatment between corporations and passthroughs. It would in general fully tax tax-preferred income distributed to shareholders (as is the case with corporations) but would allow an election to pass through taxable tax credits and fully tax-exempt income (for example, state bond interest or percentage depletion) to shareholders.⁷⁵ However, this potential parity with passthroughs would not apply to timing preferences, probably because it would create unacceptable complexity.⁷⁶

Revenue concerns, and perhaps the feeling that once income is distributed the preference is unnecessary or undeserved, suggest continuing to tax shareholders on distributions of untaxed income. On the other hand, parity with passthroughs and the desirability of retaining the full benefit of the preference suggest no tax at the shareholder level, as well. Because the ALI and the Finance Committee would effectively treat distributions to come first from taxable income to the extent thereof, they would in many cases match the passthrough result, although presumably not in all cases.

A lower corporate rate is promoted as an incentive to increase U.S. investment. However, even if offset by increased shareholder tax, as long as the shareholder tax is effectively deferred until distribution or sale, a low corporate rate will most likely reduce the tax burden on corporate income as compared with taxes paid by investors in passthrough entities.

This raises two opposite concerns. First is the risk of abuse from extension of the advantage of the low corporate rate to income from services or passive investment, which would not be easy to prevent. Second is the desire to provide equivalent treatment to passthrough and corporate investors. Passthrough investors can be given an equivalent advantage by applying the low corporate rate only to earnings produced by the reinvestment of business profits. Applying the rate to all earnings is too generous. However, this is difficult to understand and possibly not easy to implement.

Lowering corporate rates but eliminating deferral of the shareholder-level tax would avoid these problems because it would not advantage corporate investment. This is said to be consistent with the goal of corporate tax relief because it would shift the tax burden to shareholders. However, the methods proposed to end deferral -- mark-to-market or an interest charge to compensate for deferral -- are untested and complex. Much of the complexity arises because these proposals would currently tax unrealized gains, not just corporate taxable income, requiring an effort to avoid favoring passthroughs. Perhaps it would be simpler each year to tax only undistributed corporate income at the shareholder level even though this has thus far been rejected as too complex.

A deduction for dividends paid would avoid much of the deferral problem because it would initially impose corporate tax, presumably at the current rate. This tax is not refunded, even if the dividend paid deduction reduces corporate taxable income, because an equivalent amount must be withheld from the dividend. Still, it is claimed that the goal of corporate tax relief would be met because the accountants would treat the withheld tax as imposed on shareholders. An advantage to the corporate form remains if the corporate rate is lower than the top marginal rate, unless there is a strong motivation to "distribute" all income currently, perhaps through a DRIP. A DRIP would allow corporations to reinvest earnings in the business without being subject to corporate tax.

Shifting the tax burden to shareholders is not fully accomplished unless all corporate income is fully taxed to shareholders. For individuals, this requires that the deduction for charitable contributions of appreciated stock and the step-up in basis at death under section 1014 be reduced by the amount of undistributed earnings. The latter seems easier to achieve since it would match the treatment of passthrough earnings and has previously been adopted in special corporate situations.

Most proposals would seek to at least retain the current burden on tax-exempt investors, now imposed indirectly by the corporate tax, by subjecting dividends to tax. To achieve parity between debt and equity, most would tax interest paid by corporations as well, perhaps offsetting the tax on interest by reducing the tax on dividends. Comparable treatment of foreign investors is not as widely supported.

Taxing the sale of corporate instruments by tax-exempt shareholders, particularly foreign investors, is more difficult, and it is not suggested by any of the proposals now on the table. Further, imposing a tax on interest paid by corporations but not on interest from other payers or other forms of passive income would disrupt the investment practices of tax-exempts. Tax-exempts are likely to switch to investment in derivatives to avoid any withholding tax on interest and dividends. This suggests that a reexamination of the overall taxation of investment returns to tax-exempts is essential.

Tax-preferred income earned by passthroughs now retains its status at the investor level, but all corporate income is taxed to shareholders when distributed. If shareholder taxes are increased, tax-exempt income could be more heavily taxed than it is today. There seems to be no movement to parity, but the Finance Committee proposal might offer equivalent treatment in many circumstances because, like the ALI proposal, it would treat distributions to shareholders to come first out of taxable income.

¹See Harry Grubert and Rosanne Altshuler, "Shifting the Burden of Taxation From the Corporate to the Personal Level and Getting the Corporate Tax Rate Down to 15 Percent," 69 Nat'l Tax J. 643, 643-645 (2016). See also H.R. 3970, 110th Cong. (2008) (then-House Ways and Means Committee Chair Charles B. Rangel introduced the bill, which would have reduced the top corporate marginal rate to 30.5 percent).

² Tax Reform Task Force, "A Better Way: Our Vision for a Confident America" (June 24, 2016) . This proposal is described as a cash-flow consumption tax and is a modification of a VAT.

³ Daniel I. Halperin, "Mitigating the Potential Inequity of Reducing Corporate Rates," Tax Notes, Feb. 1, 2010, p. 641 .

⁴ Ignoring the tax on net investment income tax under section 1411.

⁵ Halperin, supra note 3, at 648 (Table 4).

⁶ Grubert and Altshuler, supra note 1, at 645; and Eric Toder and Alan D. Viard, "Replacing Corporate Tax Revenues With a Mark-To-Market Tax on Shareholder Income," 69 Nat'l Tax J.701, 702 (2016).

⁷ Statement by Senate Finance Committee Chair Orrin G. Hatch, R-Utah (May 17, 2016) . See Finance Committee, "The Business Income Tax Bipartisan Tax Working Group Report," at 35-36 (July 8, 2015) (working group report).

⁸ Mark P. Keightley, "Business Organizational Choices: Taxation and Responses to Legislative Changes," Congressional Research Service (Aug. 6, 2009) .

⁹ Halperin, supra note 3, at 646-648.

¹⁰ For readers who prefer algebra to numerical examples, the significance of the rate of tax on reinvested earnings can be illustrated as follows:

If corporate earnings (E) were currently distributed after payment of a corporate tax (at rate c), subject to a distribution tax (at rate d), the shareholder could invest the proceeds for y years to produce the following amount after paying annual taxes (at the personal rate p):

 

E(1-c)(1-d)[1+r(1-p)]y.

If, however, corporate earnings were reinvested for y years before being distributed to shareholders, the net after-tax amount would be:

E(1-c)[1+r(1-c)]y (1-d).

The only difference between these amounts would be because of the difference between p (the personal rate) and c (the corporate rate).

¹¹ Halperin, supra note 3.

¹² For more detail on these issues, see id. at 650-653.

¹³Sections 448(d)(2) and 11(b)(2).

¹⁴Section 1202 and 1202(e)(3)(A). Also excluded from section 1202 are banking, insurance, farming, extraction industries, and hotels.

¹⁵Section 1402(a)(1), (2), and (3). See Joint Committee on Taxation, "Options to Improve Tax Compliance and Reform Tax Expenditures," JCS-02-05, at 95 (Jan. 27, 2005) .

¹⁶ REG-209824-96 . See comments of New York State Bar Association Section of Taxation (Mar. 1997) .

¹⁷ JCS-02-05, supra note 15, at 99.

¹⁸Sections 704(e)(2) and 1366(e).

¹⁹See Peter Birch Sorensen, "The Nordic Dual Income Tax: Principles, Practices, and Relevance for Canada," 55 Can. Tax J. 557 (2007); and Vesa Kanniainen, Seppo Kari, and Jouko Yla-Liedenpohja, "Nordic Dual Income Taxation of Entrepreneurs," 14 Int'l Tax Public Fin. 407 (2007).

²⁰Section 541.

²¹Section 531.

²²See sections 1362(d)(3)(C) (subchapter S), 543(a) (personal holding company), 1244(c)(1)(C) (ordinary loss on disposition of small business stock), 1297(b) (passive foreign investment company), and 954(c) (subpart F).

²³See supra text accompanying note 10. Algebraic proof follows:

Assume the combined rate on corporate income equals the tax rate on passthrough income:

(1 - t_c)(1 - t_d) = (1 - t_p) where t_c, t_d, and t_p are the tax rates on corporate earnings, corporate dividends, and passthrough income, respectively. If reinvested corporate income (I) is taxed a rate t_r, we will have equivalence between corporate and passthrough income over the course of a subsequent period of years if and only if t_r = t_p(passthrough rate). I(1 - t_c)(1 - t_d)(1 - t_r)ⁿ (coprorate income) = I(1 - t_p)(1 - t_p)ⁿ (passthrough income)

Since (1 - t_c)(1 - t_d) = (1 - t_p), this happens when t_r = t_p.

²⁴ Edward D. Kleinbard, "Why Corporate Tax Reform Can Happen," Tax Notes, Apr. 6, 2015, p. 91 .

²⁵See Lindsey McPherson, "Budget Lacks Small Business Relief, W&M Republicans Say," Tax Notes, Feb. 9, 2015, p. 694, at 694-695 (describing Lew's testimony at a February 3, 2015, Ways and Means Committee hearing).

²⁶ Working group report, supra note 7, at 22-32.

²⁷ Treasury, "General Explanation of the Administration's Fiscal Year 2016 Revenue Proposals," at 40 (Feb. 2015) .

²⁸ Working group report, supra note 7, at 29.

²⁹Id. at 27.

³⁰See supra text accompanying note 10.

³¹ Halperin, "Corporate Rate Reduction and Fairness to Passthrough Entities," Tax Notes,June 15, 2015, p. 1299 .

³² Grubert and Altshuler, supra note 1; and Toder and Viard, supra note 6.

³³ Toder and Viard, supra note 6, at 710-711. To reduce the volatility of the tax base, they recommend "smoothing" of shareholder income over several years. Id. at 719. The proposal would limit the credit to U.S. shareholders for U.S. tax paid by U.S. domestic companies. Grubert and Altshuler question whether this would encourage U.S. investment. See Grubert and Altshuler, supra note 1, at 652. Michael J. Graetz and Alvin C. Warren Jr. are more hopeful that it might. Graetz and Warren, "Integration of Corporate and Shareholder Taxes," 69 Nat'l Tax J. 677, 681 and 691 (2016).

³⁴ Grubert and Altshuler, supra note 1, at 658-662. Investors could elect mark-to-market instead. Id. at 660.

³⁵Id. at 658.

³⁶ Toder and Viard, supra note 6, at 714.

³⁷Id. at 712.

³⁸Id.; Grubert and Altshuler, supra note 1, at 659.

³⁹See Grubert and Altshuler, supra note 1, at 663-665.

⁴⁰ The most detailed proposals for integration in the United States -- a reporter's study by Warren based on the ALI project and a Treasury study (led by Graetz) under President George H.W. Bush -- are set forth in Integration of the U.S. Corporate and Individual Income Taxes: The Treasury Department and American Law Institute Reports (Tax Analysts 1998) [hereinafter ALI]. The reference in the text is to ALI at 699.

⁴¹See Graetz and Warren, supra note 33, at 679.

⁴² ALI, supra note 40, at 609-610.

⁴³See working group report, supra note 7, at 35-37.

⁴⁴Id. at 35-36. If the credit were nonrefundable as the report suggests, corporate income would not be taxed at individual rates unless the credit was fully used, perhaps to offset the tax on other taxable income.

⁴⁵See id. at 37 and 60 n.32.

⁴⁶ ALI, supra note 40, at 699-700.

⁴⁷ Toder and Viard, supra note 6, at 711.

⁴⁸See sections 691 and 1014(c); see also reg. section 1.691(a)-1(b).

⁴⁹Sections 753 and 736(a).

⁵⁰ Toder and Viard, supra note 6, at 712; and Grubert and Altshuler, supra note 1, at 659.

⁵¹ ALI, supra note 40, at 705-706.

⁵²Section 1014(d).

⁵³Section 1291(e)(1), referring to section 1246(e) as in effect before the enactment of the American Jobs Creation Act of 2004.

⁵⁴ ALI, supra note 40, at 705-706.

⁵⁵See reg. section 1.995-4(e).

⁵⁶ Steven M. Rosenthal and Lydia Austin, "The Dwindling Taxable Share of U.S. Corporate Stock," Tax Notes, May 16, 2016, p. 923, at 927-928 .

⁵⁷Sections 511(a) and 512. See Henry Hansmann, "Unfair Competition and the Unrelated Business Income Tax," 75 Va. L. Rev. 605, 610-615 (1989).

⁵⁸ Grubert and Altshuler, supra note 1, at 670.

⁵⁹ Working group report, supra note 7, at 37.

⁶⁰Id.

⁶¹ Toder and Viard, supra note 6, at 717-718.

⁶² ALI, supra note 40, at 730-731.

⁶³See Grubert and Altshuler, supra note 1, at 657.

⁶⁴ ALI, supra note 40, at 730-731.

⁶⁵See, e.g., Halperin, "Tax Policy and Endowments: Is Excessive Accumulation Subsidized?" 67 Exempt Org. Tax Rev. 17, 25 (2011); and Henry Hansmann, "Why Do Universities Have Endowments?" 19 J. Legal Stud. 3 (1990).

⁶⁶ Halperin, "Income Taxation of Mutual Nonprofits," 59 Tax Law Rev. 133, 165-166 (2006).

⁶⁷ Halperin, "The Tax Exemption Under Section 501(c)(4)," Urban Institute (May 2014).

⁶⁸ Rosenthal and Austin, supra note 56, at 928.

⁶⁹Section 871.

⁷⁰ The statutory withholding tax on foreign investors is 30 percent, and this remained unchanged in 2003 when the rate of tax on dividends was reduced to 15 percent. Tax treaties, which apply to a substantial majority of foreign investment, reduce the withholding rate, most commonly to 15 percent for portfolio investment and 5 percent for direct investment. Section 1441(a); reg. section 1.1441-1; and Publication 901, "U.S. Tax Treaties," at 35-36 (2009) .

⁷¹See Grubert and Altshuler, supra note 1, at 670.

⁷² ALI, supra note 40, at 752-753.

⁷³ Working group report, supra note 7, at 37.

⁷⁴ Graetz and Warren, supra note 33, at 687.

⁷⁵ ALI, supra note 40, at 685-688.

⁷⁶Id. at 652-653.