w- *W#‘ s“ ABSTRACT AN INQUIRY INTO THE DESIRABILITY AND FEASIBILITY OF MANDATORY PARTNERSHIP TAX TREATMENT FOR CLOSELY HELD CORPORATIONS by Glen Raymond Sanderson This study was undertaken to determine the desirability and feasibility of applying the partnership method of taxing business income to closely held corporations on a mandatory basis. This system, if adopted, would replace the regular corporate income tax system, as applied to closely held corporations, and Subchapter 8 of the Internal Revenue Code, the subchapter which gives certain closely held corporations the option to be taxed somewhat like partnerships. The specific objectives of the study were: (1) to examine the need for changing the existing system of taxing closely held corporations, (2) to determine the extent to which mandatory application cf the partnership tax method would correct the deficiencies of the existing system, and (3) to examine the major problems and issues involved in designing and implementing the mandatory partnership system. In examining both the existing system of taxing closely held corporations and the proposed mandatory partnership tax Glen R. Sanderson system, consideration was given to equity, administrative and compliance factors, and economic consequences. In addition, the constitutionality of the mandatory partnership approach was considered. The circumstances which prompted this study were: (1) apparent major inequities and administrative and compliance problems associated with applying the corporate tax method to closely held corporations: (2) the apparent failure of Subchapter S to mitigate these problems to a significant extent: (3) problems peculiar to Subchapter 8: and (4) the lack of serious consideration given to the mandatory part- nership approach. The analysis and conclusions contained in the study are based on an examination of basic sources of tax law; studies dealing with various aspects of federal income tax- ation and related areas; and statistical data compiled by the Internal Revenue Service, the Securities and Exchange Commission, and other organizations. Principal findings: The mandatory partnership approach clearly would provide a more equitable means of taxing the income of closely held corporations than that provided by the existing system of taxing closely held corporations, in terms of both horizontal equity and ability to pay. Most of the uncertainty and arbitrariness in tax Glen R. Sanderson determinations associated with the existing system--in areas such as unreasonable compensation, accumulated earnings, and loss of the Subchapter S election--could be eliminated by the adOption of the mandatory partnership system. How- ever, other administrative and compliance problems would be added by the mandatory system, including those associated with selecting corporations to be included in the mandatory system, applying the partnership tax method to closely held corporations with multiple classes of stock, and making the transition from the existing system. Although the economic effects of adopting the manda- tory partnership system are uncertain, the most probable effects appear to be the following: (1) less than a two percent change in total income tax receipts; (2) a slight net disincentive to form, work hard in, and expand small corporations owned by individuals in upper-middle and high personal tax brackets; (3) a significant reduction in the funds available after taxes to finance the growth of some small corporations; and (4) elimination of the incentive to hoard funds in closely held corporations for tax purposes. Legal precedents and Opinion are divided with respect to the constitutionality of mandatory partnership tax treat- ment for domestic closely held corporations. However, it does appear that the mandatory partnership system could be Glen R. Sanderson adOpted without a constitutional amendment. As a whole, the mandatory partnership system appears to be no less desirable nor feasible than the existing sys- tem. Certainly there are no obvious reasons for rejecting the mandatory partnership approach without further research. AN INQUIRY INTO THE DESIRABILITY AND FEASIBILITY OF MANDATORY PARTNERSHIP TAX TREATMENT FOR CLOSELY HELD CORPORATIONS BY Glen Raymond Sanderson A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1968 3Copyright by GLEN RAYMOND SANDERSON 1969. ii ACKNOWLEDGMENTS I wish to express my sincere appreciation to Professor Charles J. Gaa for his guidance and encouragement during this study. Also, I wish to thank Professor Gardner M. JOnes and Professor Denzel C. Cline, members of the thesis committee, for their helpful comments and interest. The financial support provided by Michigan State university, the American Accounting Association, and Ernst & Ernst during my tenure at Michigan State is gratefully aCknowledged. A special debt of gratitude is due Professor James Don Edwards, Chairman of the Department of Accounting and Financial Administration, for his help in obtaining this financial support and for the many other forms of assis- tance he provided. Finally, I wish to thank my parents and my wife for their assistance and encouragement. Glen R. Sanderson iii TABLE OF CONTENTS Page LIST OF TABLES O O O O O O I O O I O O O O O O O O O Viii CHAPTER: I. INTRODUCTION . . . . . . . . . . . . . . . . 1 Purpose of the Study . . . . . . . . . . 1 Background . . . . . . . . . . . . . . . 3 The Corporate Population . . . . . . . 3 Federal Income Taxation: An Overview . 7 Criteria and Problems . . . . . . . . . . ll Equity in Taxation . . . . . . . . . . 12 Administrative and Compliance Factors. 19 Economic Consequences . . . . . . . . 25 Constitutionality of Mandatory Part- nership Tax Treatment . . . . . . . . 28 Limitations on the Scope of the Study 0 O O O O O V. O 0‘ O O O O O O O 29 Method of Research . . . . . . . . . . 30 II. TREATMENT OF CLOSELY HELD CORPORATIONS UNDER THE CORPORATE INCOME TAX SYSTEM . . . . . . 31 Approaches to Tax Minimization . . . . . 31 Distributions of Current Corporate Earnings . . . . . . . . . . . . . . . . 32 iv TABLE OF CONTENTS (Continued) CHAPTER Retention of Corporate Income. . . . . Multiple Corporations . . . . . . . . A General Evaluation . . . . . . . . . III. INTEGRATION OF CORPORATE AND INDIVIDUAL INCOME TAXATION . . . . . . . . . . . . . Integration Methods . . . . . . . . . Integration and Closely Held Corpora- tions O O O O O O O O O O O O O O O O Integration and Publicly Held Corpora- tions O O O O O O O O O O O O O O O O IV. OPTIONAL VERSUS MANDATORY PARTNERSHIP TAX TREATMENT O O O O O O O O O O O O O O O O Background: Studies and Recommenda- tions O O O O O O O O O O O O O O O O Subchapter R . . . . . . . . . . . . . Subchapter S . . . . . . . . . . . . . Summary of Major Features . . . . . Analysis of Subchapter S . . . . . Problems Encountered under Sub- Chapter S O O O O O O O O O O O O Mandatory Partnership Tax Treatment. . V. CONSTITUTIONALITY OF THE MANDATORY AP- P ROAC H O O O O O O O O O O O O O O O O O Constitutionality of Federal Income Taxation, in General . . . . . . . . . V Page 38 49 54 59 59 68 69 75 75 83 87 87 91 95 102 109 110 TABLE OF CONTENTS (Continued) CHAPTER Page Taxation of Undistributed Corporate Income before Macomber. . . . . . . . . 114 Eisner v. Macomber, 252 0.8. 189 (1920) O O O O O O O O O O O O O O O O O 117 Taxation of Undistributed Corporate Income after Macomber . . . . . . . . . 124 Court Decisions and Interpretations after Macomber O O O O O O O O O O O O O 130 Conclusions . . . . . . . . . . . . . . 135 VI. THE MANDATORY SYSTEM: CLASSIFICATION OF CORPORATIONS AND ECONOMIC AND RELATED CON- SIDERATIONS O O O O O O O O O O O O O O O O 136 Corporations To Be Included in the Mandatory System . . . . . . . . . . . 136 Approaches to the Classification PrOblem O O O O O O O O O O O O O O 136 Corporations: Publicly Held and Privately Held . . . . . . . . . . . 143 Selection of Corporations . . . . . 156 Economic Effects and Related Considera— tions O O O O O O O O O O O O O O O O O 165 Effects on Incentives and Financial Capacity . . . . . . . . . . . . . . 165 Effects on Tax Revenue . . . . . . . 178 Elimination_of Corporate Surtax Exemption O O O O O O O O O O O O O 18 2 vi CHAPTER VII. VIII. TABLE OF CONTENTS (Continued) THE MANDATORY SYSTEM: TAX RULES. . . . . Pass-through of Receipts and Deduc- tions O O O O O O O O O O O O O O O O O Gross Income Components . . . . . . . . Deduction Components. . . . . . . . . . Capital Gains and Losses . . . . . . . Other Items Related to the Pass-through PIOblem O O O O O O O O O O O O O O O O Allowed Deductions . . . . . . . . . . Other Major Areas . . . . . . . . . . Conclusions . . . . . . . . . . . . . . Semi-public Corporations. . . . . . . . SUMMARY AND CONCLUSIONS . . . . . . . . . BIBLIOGRAPHY O O O O O O O O O O O O O O O O O O O vii Page 187 188 193 196 199 202 204 208' 225 226 228 235 LIST OF TABLES Number of Business Organizations by Form of Organization. . . . . . . . . . . . . . . Number of Corporations by Size of Total Assets in 1961 and 1963 . . . . . . . . . Range of Total Assets and Number of Share- holders of Central Two-thirds of Corpora- tions Whose Stock was Listed on Exchanges or Traded Over-the-Counter at the End of 1961. ._. . . . . . . . . . . . . . . . . Net Number of Stocks on Exchanges for Selected Years. . . . . . . . . . . . . . Examples of Actual Multiple Corporations cases O O O O O O O O O O O O O O O O O O viii Page 92 140 141 145 160 Eb- CHAPTER I INTRODUCTION Purpose of the Study Representative Mills, Chairman of the House Ways and Means Committee, has stated that one of the essential factors to be considered in any re-evaluation of the federal tax structure is its fairness between taxpayers, and that in pursuingthis objective, tax laws "must accord the same tax treatment to what is essentially the same type of operation irrespective of the form in which it is cast."1 One of the most flagrant violations of the above prin- ciple is that which can be found in the tax treatment ac- corded closely held corporations, as compared with the tax treatment accorded unincorporated business enterprises. Impending upon a number of factors--inc1uding the nature of tmsiness operations, individual tax brackets of shareholders, 1Excerpt from a speech delivered to the Tax Foundation (December, 1958), referred to in: U. S. House, Tax Revision ‘QC mpendium, papers submitted to the Committee on Ways and fihens (Washington, D. C.: Government Printing Office, 1959), Vol. III, p. 1700. ‘ . 1" .m- 2': 2 and how and when corporate income is distributed--the tax burden of shareholders of a given closely held corporation may be significantly higher or lower than it would be if the same Operations were taxed under an unincorporated legal form. This study is an attempt to determine the desirability and feasibility of adOpting one approach to removing the major differences between the tax treatment accorded closely held corporations and unincorporated business enterprises. In the approach to be considered, the partnership method of taxing business income is applied to closely held corporations on a mandatory basis. This system, if adopted, would re- place (1) the regular corporate income tax system, as ap- plied to closely held corporations, and (2) Subchapter S of the Internal Revenue Code, the Subchapter which gives certain closely held corporations the option to be taxed somewhat like partnerships. The specific objectives of this study are: (l) to examine the need for changing the existing system of taxing closely held corporations, (2) to determine the extent to which mandatory application of the partnership tax method would correct the deficiencies of the existing system, and (3) to examine the major problems and issues involved in de- signing and implementing the partnership system. In examining both the existing system of taxing closely held corporations and the proposed mandatory 3 partnership tax system, consideration is given to equity, administrative and compliance factors, and economic conse- quences. In addition, the issue of the constitutionality of mandatory partnership tax treatment is examined. These criteria and the tax methods mentioned above are explained in this chapter. The circumstances which prompted this study are: (1) the lack of serious consideration given to the mandatory requirement of the partnership approach and (2) the failure of Subchapter R, which gave certain proPrietorships and partnerships the option to be taxed like corporations, and Subchapter S to make a substantial contribution to the re- moval of inequities and certain administrative and compli— ance problems associated with the taxation of closely held business enterprises. Background The Corporate Papulation Business corporations are most heterogeneous as to financial size, nature of business activities, number of shareholders, and extent of separation of ownership and control. Nevertheless, except for a small percentage of corporations, the entire range of corporations may be split into two basic groups: widely held (public) corporations and closely held (private) corporations.' Corporations 4 which have numerous shareholders, but which are closely con- trolled by a few shareholders, comprise the small percentage that does not fall neatly into either of the two basic groups. Widely held (public) corporations. The most distinc- tive feature of publicly held corporations is the separation of ownership and control. The typical large, publicly held corporation is a separate economic entity, as well as a separate legal entity. Corporate attributes such as limita- tion of ownership liability, marketability of ownership interests, representative management, and continuity of organization life are all substantive aspects of this mode of organization. Although relatively few in number, publicly held cor- porations account for the bulk of corporate income and tax payments in the United States. In 1964, 5,886 corporations had assets in excess of-$25 million-~less than one-half of 1 percent of business corporations.2 This group, which in-. cludes substantially all of the major publicly held corpora- tions in the United States (parents and subsidiaries), reported 71 perCent of total corporate net income and paid 70 percent of the total corporate income tax collected in 20. S. Treasury Department, Internal Revenue Service, Statistics of Income, 1964, Corporation Income Tax Returns (Preliminary) with accounting periods ended July l964-June 196:0(Washington, D. C.: Government Printing Office, 1967), p. . 5 1964.3 In recent years, the stock of less than 2 percent of business corporations has been listed on a national or regional stock exchange or traded actively over-the-counter (see Chapter VI). Closely held (private) corporations. The most im- portant characteristic of private corporations is the unity of ownership and control. The 1abels--shareholders, offi- cers, and directors--as used in the typical private cor- poration cover essentially the same content: the interests of one or a few key shareholders who are the principal owners and controllers of the corporation. Private cor- porations are essentially prOprietorships or partnerships clothed in the legal form of a corporation. The dominant reason many owners of private corpora- tions choose the corporate form of organization is to reduce their tax burden. Of secondary importance is the feature of limited liability if the business fails. However, even the advantage of limited liability is restricted in that banks and other creditors frequently require the.principals of these corporations to guarantee personally the repayment of major loans. The feature of unrestricted transferability of ownership interests is also of limited value to these cor- porations--only a small percentage of private corporations 31bid. 3:8 ‘ On:- 0 III 1.? 6 are ever in a position to issue stock successfully to the public (see Chapter VI). Although smallness in financial size is not an es- sential feature of closely held (private) corporations, this characteristic usually follows from other character- istics. In 1964, 1,373,517 business corporations filed tax returns: of which, 94 percent had assets totaling less than $1 million.4 Based on statistics and estimates presented in Chapter VI of this study, only a small per-A centage of corporations with assets of less than $1 million have more than 25 shareholders; the vast majority has less than 10. The problems involved in classifying corporations according to number of shareholders, control, and financial size for purposes of determining which corporations would be :included in the mandatory partnership tax system are examined in Chapter VI. A shareholder limit of 25 and an asset limit of $1 million provide two general guidelines for de- lineating the principal group of corporations with which this study deals. More than 95 percent of business corpora- tions would be included in the mandatory partnership tax system considered in this study. Ibid. 7 Federal Income Taxation: .An Overview, Business income taxation. Two general methods of tax- ing the income earned in connection with a business enter- prise have dominated federal income tax laws since 1913: the corporate method and the individual method. Under the corporate method, the income of corporations is taxed at corporate rates and dividend distributions of income are taxed again as part of the personal income of shareholders. Under the individual method, on the other hand, proprietor- ships and partnerships are not taxed as business entities: rather, the entire income of these enterprises, whether distributed or not, is allocated to the owners to be taxed as part of their personal income. .For purposes of this study, the only significant ex- ceptions to this dichotomous system have been Subchapter R and.Subchapter S of the Internal Revenue Code. Subchapter R, which gave certain proprietorships and partnerships the option to be taxed like corporations was enacted in 1954.1 This provision was repealed in 1966 (to terminate in 1969), principally because it had been used by very few unincor- porated business enterprises.5 Subchapter S, which gives certain closely held corporations the option to be taxed 5U. S. Senate, Committee on Finance, Subchapters S and R of Cha ter 1 of the Internal.Revenue Code of 1954, S. Rept. 1007, 89th Cong., 2nd Sess., 1966, p. 9. 503i . , 2U": 46 0 ‘IR Olly I” {H f‘l: Pl 8 somewhat like partnerships, was enacted in 1958. In 1964, Subchapter S was used by 12 percent of all business cor- porations: the percentage using Subchapter S has been 1301938139 slightly.6 The main objective in enacting these provisions was to permit owners of small businesses to se- lect a legal form of organization without having to be unduly concerned about the tax consequences of the selec- 7 tion. These provisions are examined in Chapter IV. The corporate income tax. The modern series of cor- porate income tax laws began with the Corporate Excise Tax Act of 1909, which imposed a tax of 1 percent on the net income of corporations for the privilege of doing business 8 This income tax was enacted under the corporate form. under the guise of an excise tax to avoid the Supreme Court decision which ruled the Revenue Act of 1894 (the first major federal income tax law) was unconstitutional.9 6Statistics of Income, 1964, Corporation Income Tax Returns (Preliminary), op. cit., p. 41. 7U. S. Senate, Committee on Finance, Technical Amend- ments Act of 1958, S. Rept. 1983, 85th Cong.,an Sess., C.B., 1958-3, p. 1008 8Act of 1909, 36 Stat. 11. 9Pollock v. Farmers' Loan 8 Trust Co., 158 0.8. 601, 3 AFTR 2602 (1895). The constitutional problem is examined in Chapter V. Federal income taxes were collected during the Civil.War; however, the Civil War tax acts have little, if any, relevance to modern income taxation. 9 Following adoption of the Sixteenth Amendment to the Constitution, the Corporation Excise Tax Act of 1909 was Superseded by the Revenue Act of 1913. The latter act Provided for a tax on both corporate income and individual income, including income from unincorporated business enter- Prises. Under the 1913 act, a 1-percent normal (base) tax was imposed on corporate income and on personal income: in addition, personal income was subject to graduated rates up to 7 percent . 1° Numerous revisions of corporate income tax laws have been enacted since 1913. The top corporate tax rate reached 12 percent during World War I, 40percent during World War II, and 52 percent during the Korean War. Current corporate tax rates (1967) are 22 percent of the first $25,000 of tax- able income and 48 percent thereafter. Corporate tax rates have been graduated mildly since 1936 as a concession to small business. In addition to the regular corporate income tax, a tax on undistributed corporate profits was imposed in 1936. This tax, which was intended to force corporations to distribute more of their income as dividends to be taxed at J'i‘ates applicable to individuals, was repealed in 1938, after it had been vigorously criticized as a deterrent to corporate growth. Also, the regular corporate income tax was loAct of 1913, 38 Stat. 114. 10 supplemented by an excess profits tax during World War I, world War II, and the Korean War.11 Relief from double taxation of dividends. Provisions designed to provide some relief from double taxation of cor- porate income distributed as dividends to individuals have been in and out of the tax laws since 1913. Prior to 1936, dividends were excluded from the individual normal tax, but not the surtax (which was the progressive element of the taxj, From 1936 to 1954, dividends were fully taxable as Personal income. From 1954 to 1964, the first $50 of divi- dends ($100 for joint returns) could be excluded from the individual income tax and 4 percent of taxable dividends received could be offset against the individual tax. Under thecurrent law (1967) the first $100 of dividends ($200 for jOiht returns) may be excluded from the individual tax. Thefie provisions are examined in Chapter II. Corporations (as shareholders) are, in general, permitted to deduct from gross income 85 percent of dividends received from domestic cOrporations.12 11U. S. Congress, Joint Economic Committee, The Feder- Eiggax System: Facts and Problems 1964, 88th Cong., 2nd Sess., 1964, pp. 49, 61-63, 265. 12 Ibid., pp. 45, 59. Certain affiliated groups of cor- Porations which either do not, or cannot, file consolidated téx returns may elect a loo-percent dividend received deduc- tion for intercompany dividends. I.R.C. (1954), sec. 243 (b). 11 The individual income tax. The individual income tax system also has been revised numerous times since its incep- tLon.in 1913. Among the principal and most durable general features of this system are the following: (1) taxation of personal income at progressive rates; (2) allowed deductions for: certain personal expenses, such as interest and state sales taxes, or in lieu of these deductions, an optional standard deduction (first in 1944, two kinds of standard deductions are now available): and (3) exemption of various inmounts of income from the individual income tax for personal Circumstances, most notably exemptions for the taxpayer, his sPOuse, and dependents. Other major developments include (1) income splitting for married couples (since 1948, before 1948, splitting was contingent upon whether or not the tax- PaYer resided in a state with community property laws) and (2) income averaging to avoid excessive taxation at progres— Si‘Ve rates of bunched income (since 1964).13 Criteria and Problems This section describes the Criteria used in evaluating the federal income tax system and applies these criteria to the taxation of closely held corporations for the purpose of Pointing out the major issues and problems that are examined 13 The Federal Tax System: Facts and Problems 1964, ‘OPO Cite, pp. 19-26, 233. 12 in this study. The viewpoint taken in this study is one of public policy. An attempt is made to give a balance emphasis to various criteria in examining both the existing system of taxing closely held corporations and the mandatory partner- ship tax system. Equity in Taxation Based on the preposition that individuals (natural Persons) ultimately receive all the income generated in the economy and bear all the taxes, equity, in the strict sense, deals principally with individuals. Determination of equity (or fairness) in the distribution of tax burden is based largely on the value judgments of society. Although there are no scientific or highly objective standards of equity, a few rough guidelines have been established. Among these ateethe pginciples of horizontal and vertical equity. Hori- zOutal equity requires that persons in similar circumstances be accorded similar tax treatment. Vertical equity requires that persons in different circumstances be accorded fair relative tax treatment. Vertical equity deals mainly with Proqressivity in taxation. Two general approaches to appraising an individual's circwmstances for purposes of distributing tax burden in an equitable manner have dominated the field of public finance fbr over fifty years: benefits received from the government and ability to pay. 13 Taxation based on benefits received involves viewing the government as a provider of services for which individu— als are taxed according to the amount of services (or bene- fits) they receive. The difficulty (or impossibility) of measuring individual receipt of benefits from national defense, foreign aid programs, and so forth, has precluded widespread adoption of benefits received as a base for raising large amounts of federal revenue. Moreover, taxa- tion based on benefits received would be in almost direct conflict with many welfare programs. The benefits approach has, however, been applied on a limited basis in certain federal programs such as Social Security and highway con- 8truction. This approach to taxation is best suited to the local level (city governments) where individual receipt of benefits from certain locally furnished services can be ap- Proximated. Ability to pay (as the principle is generally used; it has no precise meaning) has two aspects: (1) a quantitative asPect, a measure of an individual's command over resources that could be turned over to the government--income, pro- Perty, consumption, a combinationuof these, or some other imiex could be used; and (2) a qualitative aspect, some Inensure of individual sacrifice or hardship involved in QiVing up resources. Combining these two aspects, ability t0 pay may be regarded as the capacity to pay taxes without l4 undue hardship on the person paying. Although current income is only one measure of an in- dividual's command over resources, it is widely regarded as fine best single index of taxpaying capacity. The principal item thatcould supplement current income is wealth. However, wealth can be resolved into the accumulation of past income or"the expectationfifuture income. Moreover, federal gift and estate taxes supplement federal income taxes, with re- spect to wealth, by taxing certain transfers of large ac- cumulations of wealth. The sacrifice aspect of ability to pay has been used mainly to justify the taxation of personal income at progres- sive rates. Three basic propositions are involved in this juatification: (l) equality in taxation means equality of Sacrifice; (2) sacrifice in taxation consists of utility (Satisfaction) foregone; and (3) as personal income rises, tOtal utility derived from that income increases by de- creasing amounts. These three propositions together suggest that tax rates should be progressive to produce equality of Sacrifice in taxation. However, attempts to work these and Similar propositions into a rigorous approach to distributing tax burden according to individual sacrifiCe have been dis- credited and largely abandoned because of the numerous diffi- culties involved in measuring and comparing individual 15 sacrifice.l4 Nevertheless, the general notion that income produces diminishing marginal utility and that this dimunition supports progressive income taxation is widely accepted.]'5 Three general features of the federal individual in- cxnne tax system reflect the main properties of the ability- to-pay principle: (1) personal income as a gross measure Of an individual's command over resources-~what an individu- al could turn over to the government; (2) exemption of a Intnimum (or subsistence) level of income from taxation—- effected mainly through $600 exemptions for the taxpayer, his spouse, and children--to avoid producing real hardship in taxation; and (3) taxation of personal income at progres- Sive rates--an attempt to approximate some kind of reason- able distribution of individual sacrifice in taxation. In spite of numerous disagreements on how the principle °f ability to pay should be implemented--in setting tax rates, making allowances for personal circumstances, etc.-- this principle is still the most widely accepted standard of equity in the United States.16 The observations of two \ 14For an analysis of various sacrifice theories, see: Richard A. Musgrave, The Theory of Public Finance (New York: M[CGraw-Hill Book Company, Inc., 1959), Chapter 5. 15Dan Throop Smith, Federal Tax Reform (New York: M[CGra'w-Hill Book Company, Inc., 1961), p. 13. 16For a critical minority viewpoint, see: Louis 16 authorities in the field of public finance serve to substanti- ate this point: My observation is that the majority of citizens and legislators in the United States and other democratic countries accept ability to pay as a guiding principle of taxation and interpret it as justifying progressivity. They talk and act as if they believe that progressive taxation is needed to maintain a proper relation between the sacri- fices of individual taxpayers and to give recog- nition to social priorities in the use of income and wealth. Without assuming that some such beliefs are widely accepted, I find it hard to account for political discourse on taxation or for revenue legislation.17 The principle of distribution of tax burden on the basis of ability to pay is the one which conforms most closely with the generally accepted standards of equity . . . . The principle that accepted standards of equity require that persons who have the same ability to pay should pay equal amounts of taxes and that persons who have greater ability should pay more to the government than those who are less well off is today almost universally accepted.18 The tax treatment accorded unincorporated business enterprises (disregarding Subchapter R) has been well ac- Cepted among students of taxation because it conforms to the general pattern of progressive taxation based on \ Eisenstein, The Ideologies of Taxation (New York: Ronald Press Company, 1961), Chapter II. 17Richard Goode, The Individual Income Tax, Studies 0f Government Finance (Washington, D. C.: Brookings Institution, 1964). p. 19. 18John F. Due, Government Finance: An Economic All. alysis (3rd ed.: Homewood, Illinois: Richard D. Irwin, Inc., 1963), p. 110. 17 individual ability to pay. Moreover, business income a1- located to proprietors and partners is taxed in essentially the same manner as most other types of individual income, such as salaries and wages. On the other hand, the tax treatment accorded corporations (disregarding Subchapter S) , has been the recipient of considerable criticism, principally because corporate income is taxed largely without regard to shareholder ability to pay and because only distributed in- come is taxed directly to shareholders. A few arguments have, however, been advanced to justify the taxation of corporations as separate entities. First, it has been contended that the corporate income tax is based on corporate ability to pay. This argument involves a con- fnsion of terms. Ability to pay, however imprecise the prin- ciple may be, clearly has no application to corporations. one of the principal aspects of ability to pay is sacrifice; inanimate objects, such as corporations, do not experience sacrifice.19 Moreover, since individuals ultimately bear all the taxes paid by a corporation, there is little to be gained, in terms of equity, by creating a separate rationale fer corporate ability to pay. Another argument is that a special tax on the corporate form of doing business is appropriate because corporations 19Richard Goode, The Corporation Income Tax (New York: thn Wiley 8 Sons, Inc., 1951), pp. 32-37. 18 enjoy special privileges and benefits, which are granted and protected by the government. This rationale may justify a small gross receipts tax or a similar tax, but it does not justify the corporate income tax. Use of net income as a measure of benefits received is inconsistent in that unprofit- able corporations, which also benefit from incorporation, are not: taxed. Moreover, the relationship between benefits received from incorporation and corporate profitability has never been established, nor does it appear that any recog- nized attempt has ever been made to establish this relation- ship.20 The above arguments have, at times, been advanced to jUStify the taxation of all corporations as separate entities. other, more subtle arguments, have been advanced to justify the taxation of large, publicly held corporations as separate entities. These arguments and problems associated with re- vising the tax treatment accorded publicly held corporations to bring it into line with shareholder ability to pay, are eXamined briefly in Chapter III. The lack of a widely accepted rationale for taxing cOrporations as separate entities has led to various pro- Pcsals for integrating (or coordinating) corporate and 20Tax Foundation, Inc., Reexamining the Federal Cor- Qation Income Tax (New York: Tax Foundation, Inc., 1958) , P. 12. 19 personal income taxation--the partnership method and the dividend received credit are two of these methods. Inte- gration methods are examined in Chapter III, along with ‘their suitability for closely held and publicly held cor- porations. The taxation of publicly held corporations is examined in Chapter III only insofar as it is necessary to (distinguish between problems peculiar to these organizations and those peculiar to closely held corporations. This study does not attempt to examine the need for revising the tax tzreatment accorded publicly held corporations. The case for taxing closely held corporations like Partnerships, on a mandatory basis, rests principally on equity: (1) horizontal equity, with shareholders of closely lleeLd corporations and owners of unincorporated business eenterprises viewed as individuals in similar positions, aind (2) ability to pay, which specifies the kind of similar 'tiax treatment to be accorded to individuals whose incomes differ. Equity considerations are examined further in chapter IV. mnistrative and Cgpliance Factors Insofar as possible, a tax system should be simple, c-‘-ertain, convenient, and economical in administration. In Farticular, tax laws should be easy to understand and comply ‘Vith on the part of taxpayers and easy to enforce on the part 20 of the government. Among the major indicators of'poorly written tax laws, or poorly enforced tax laws, or both are the following: (1) high (relative to the tax paid) compli- ance or collection costs; (2) a prevalence of opportunities for either successful tax avoidance or tax evasion; (3) an inordinate amount of litigation, reopening of tax deter- minations of past years, and other unresolved tax determinations: and (4) low taxpayer morale, which may be manifested by an extreme game-like or adversary relation- ship with the government, or by the belief that tax deter- minations are, in general, made on an arbitrary or capricious basis. In this connection, the amount or bur- den of the tax, as well as the opinions of taxpayers about the fairness with which the burden is distributed, also may affect significantly many aspects of taxpayer compliance. With respect to ease of taxpayer compliance, the Internal Revenue Code contains some of the most complex tax Provisions in the United States. Most of the complexity can be attributed to the following: (1) the need to prescribe numerous rules stating how, when, and to what ex- tent, various items are to be included in the determination Of taxable income; (2) hardship relief provisions--retire- Inent income credit, head-of-the-household tax rates, etc.; (3) special tax treatment accorded certain types of organi- zations—-real estate investment trusts, certain corporations 21 engaged in foreign operations, farm cooperatives, etc.; and (4) lOOphole plugging. Many of these complexities have re- sulted from spot reactions to special situations, rather than long-term policy develOpments; non-revenue use of the ‘tax laws (e.g., investment tax credit to stimulate invest- ‘ment); special provisions begetting special provisions (e.g., flannel funds begetting real estate investment trusts); and numerous political, social, and economic forces. The practical orientation of this study necessitates that much of the existing complexity of the Code--such as that pertaining to hardship relief provisions and to special tax treatment accorded various types Of income--be accepted. Tax simplification is a subject that has received a lot of good wishes and lip service in general. However, based upon the record of Congress and the informed Opinions of many tax authorities, there appears to be very little chance that any Significant degree of simplification will be brought about in the foreseeable future. Neither the existing system of taxing closely held corporations nor the mandatory partner- Ship tax system considered in this study is composed of simple tax rules. The administrative and compliance problems examined in this study are outlined below. Many of these problems are interrelated with equity considerations. The corporate tax method. Closely held corporations 22 have always provided poor subject matter for application of the corporate income tax method. The principal reason for tJiis is that there is no effective separation of ownership and control in these corporations. Usually closely held corporations are owned and managed by a few individuals who are the principal corporate officers. The combination of (1) unity of interest of management and ownership and (2) the relative ease with which the income and dividend policy of closely held corporations can be controlled provides considerable incentive and Opportunity for tax avoidance. [Most of the provisions currently contained in the Internal Revenue Code to restrict tax avoidance practices associated With the corporate form have been designed for and applied almost exclusively to closely held corporations. The pre- valence Of tax avoidance practices among these corporations, coupled with counteractions by the Internal Revenue Service, has produced one Of the most arbitrary and game-like admin- istrative climates in the field of federal income taxationJ These tax avoidance practices and counteractions are ex- amined in Chapter II. Optional partnership tax treatment. Subchapter S, Vmich gives certain closely held corporations the Option to he taxed somewhat like partnerships, also has presented many administrative and compliance problems, including the fol- lowing: (1) increased complexity in tax considerations "VO’ in‘ 1 1 ml! I.“ w 23 iurvolved in selecting a legal form of organization for a snuall business; (2)fidifficulties in tax management for those who use the election--e.g., the Subchapter S election will be terminated if the corporation's stock is transferred to (one shareholder who does not consent to the election; and (3) use of the Subchapter S election for tax avoidance pur- Poses. Subchapter S is examined in Chapters IV and VII. The mandatory system. Mandatory application of a part- nership tax system to closely held corporations would elimi- nate much Of the uncertainty and arbitrariness in tax determinations which characterize the existing system of taxing closely held corporations, both under the corporate tax method and Subchapter 8. However, the mandatory system would present other problems. One prevalent tax avoidance practice that would be eliminated is the retention of cor- porate income under the corporate tax method to avoid higher Personal income taxes at the shareholder level. Among the administrative problems that would be added by the mandatory System are the following: establishing criteria for dis- tinguishing between closely held (private) corporations and Widely held (public) corporations; determining what to do with those that do not fall neatly into either category; and setting-up provisions to keep corporations from avoiding the Mandatory system if they find it advantageous to do so. These problems are examined in Chapters IV, VI, VII. 24 Another problem considered in this study is the nature cof the partnership tax treatment to be provided under the mandatory system. In general, the partnership method of 'taxing business income calls for allocating all the income (whether distributed or not) or loss to the owners to be included in the determination of their individual tax li- abilities. Both Subchapter S and Subchapter K (the regular jpartnership tax system) accomplish this basic Objective. However, these subchapters contain two different sets of rules for determining and allocating income or loss. Al- though the tax rules contained in neither subchapter could be applied, without modification, to closely held corpora- tions on a mandatory basis (as explained in Chapter VII), these subchapters contain rules from which the bulk of those used in a mandatory system could be selected. This study does not, however, attempt to select or 'formulate the specific rules that would make up the manda- tory partnership tax system; writing a tax system is a committee prOject requiring a host Of experts in various fields. This study does provide a broad outline Of the tax rules that would be suitable for the mandatory partnership tax system. These rules and procedures are discussed in Chapters VI and VII. C. a L. .18" Ayn be eve *5 C26 ='~.€ 1.; SC)" p u y ME '~ 25 Economic Consequences Among the economic criteria by which a tax system may be evaluated are: amount and stability of the revenue yield; how the system contributes to stability in the economy; and effects of the system on prices, wages, incentives, capital formation (or growth), and a number of other items. Many of these effects are frequently lumped into the phrase, impact Of the tax. Imposition Of minimal restraints on economic growth is one of the most important Objectives Of tax policy. Neutrality in taxation, which, in general, means that taxes should not be used to influence consumption, investment, or other economic decisions, is frequently cited as another desirable Objective. However, the present level of income taxes precludes any significant degree of neutrality; this is especially the case in many aspects Of business decision making. Moreover, the investment tax credit, accelerated depreciation, and percentage depletion in the petroleum in- dustry are just a few of the examples in which the govern- nmnt has abandoned the neutrality Objective. Although this study deals with both the corporate and the individual income tax systems, as applied to closely held corporations, an examination of how these systems affect the economy as a whole is beyond the scope Of this Study. There are a number Of studies in the field of public Emce ' m the t siderec' facts on 29.: ‘ 0h. ‘1‘ eh. 26 finance that deal with these matters.21 Moreover the changes ix: the tax treatment accorded closely held corporations con- sidered in this study are not likely to have significant ef- fects on the economy as a whole. The economic considerations treated in this study are limited principally to the following: (1) effects on incen- tives of individuals to form, work in, and expand closely held business enterprises; (2) effects on incentives of individuals to invest in closely held business enterprises; (3) effects on the availability of funds after taxes to finance the growth of small businesses; and (4) estimated change in total tax revenue resulting from the adoption of the mandatory partnership tax system. These topics are ex- amined in Chapter VI. Related to both the determination of economic effects and equity in taxation is the question of the incidence of the tax--who ultimately bears the tax? There is substanti- al agreement among economists that individual income taxes are, in general, borne by those who pay them, including the individual taxes paid by owners of unincorporated busi- ness enterprises. On the other hand, there is substantial 21See: Marian Krzyzaniak, ed., Effects of Corporation lfigpme Tax (Detroit: Wayne State University Press, 1966); kade, The Corpgration Income Tax, and The Individual Income 33$, Op. cit.; and Musgrave, OE. cit. 27 disagreement among economists on the extent to which the corporate income tax is borne by shareholders, shifted for- ward in the form Of higher prices to consumers, or shifted backward in the form Of lower wages and other factor pay- ments.22 The uncertain incidence of the corporate income tax is not crucial to the findingsos‘this study for the following reasons: (1) over half “of all closely held corporations pay little or no corporate income taxes year after year (ex- plained in Chapter II). (2) Many, if not most, closely held corporations which pay a significant amount of corporate income taxes are used, in part, to avoid higher personal in- come taxes at the shareholder level. If the latter corpora- tions are able. to shift all or part of the corporate income taxes paid, the serious inequity associated with using the corporate form to avoid higher personal income taxes is merely intensified. (3) Most of the incidence uncertainty Pertains to taxes paid by large, publicly held corporations, which are in a position to administer prices and signifi- cantly influence other aspects of factor and output markets. The fact that closely held corporations (which are predomi- nately small busineSses) compete mainly with unincorporated 22An examination of various theories and studies of cor- POrate tax incidence is beyond the scope of this study. hese theories and studies are examined in the works cited in ’1. 21, above. on no 3» l to (nth \t 28 business enterprises (which do not pay corporate taxes) lends strong support to the assumption that closely held corpora- tions are not able to shift a substantial portion Of the corporate taxes they pay. For purposes of this study, it is assumed that both corporate and individual taxes applicable to the closely held corporations are borne by shareholders. Constitutionalikty gerandgtpry Partnership Tax Treatment Another issue examined in this study is the constitu- tionality of taxing closely held corporations like partner- ships on a mandatory basis. Various interpretations of the Sixteenth Amendment and of a few landmark court cases indi- Cate that it would be unconstitutional to tax corporations in this manner; other interpretations indicate the Opposite. In this connection, it should be noted that Subchapter 8 d0“ not raise the question of constitutionality; the 8PEN-a1 tax treatment provided by this subchapter is Op- tional and all shareholders must consent to the election before it can be used. .: The only mandatory partnership tax t”fitment presently prescribed by the Code is that applied ‘30 Certain closely held foreign corporations.23 The latter, hoFever, offers no clear precedent for similar tax treatment f<31” domestic corpOrations. The constitutional issue is ex- . 6“lined in Ct@ter V. \ 231.R.c. (1954), secs. 551-58, 951-64. 29 Limitations on the Scope of the Study In addition to limitations noted previously, an exami- nation Of the following is beyond the scOpe Of this study: (1) relationships between federal income taxation and other forms of taxation; (2) theoretical deficiencies of statutory concepts Of taxable income as compared with various economic and accounting concepts of income; (3) non-tax reasons for selecting an incorporated or unincorporated legal form of business organization (including considerations such as .limiting the liability of owners, ethical codes of various Professions, and state tax laws); (4) problems associated twith classifying joint ventures, groups, pools, syndicates, and similar organizations for tax purposes (these organiza- 'ti°n8 are classified for tax purposes as either partnerships Or corporations, depending upon whether the legal and Opera- 'tifig Characteristics of the organizational form in question '“OSt Closely resemble those of a partnership or a corpora- ‘tion); and (5) special forms Of tax treatment accorded ‘cfirtain types of organizations (including real estate in- Vestment trusts, certain banks and insurance companies, non- Pl‘ofit organizations, small business investment companies, “humal funds, farm cooperatives, businesses engaged in fc>I'eign Operations, and others). Even though most of the areas listed above are related directly or indirectly to the subject matter at hand, it - ,A.. "‘l u: 2‘“ :b. I 1! z 30 would be virtually impossible to consider all of these peri- pheral areas in this study. In addition, consideration of these peripheral areas would detract considerably from the main theme of this study. For the foregoing reasOns, this study is conducted largely within the framework of existing tax laws and deals almost exclusively with what may be regarded as ordinary businesses-~i.e., profit-making enterprises organized as corporations, general partnerships, or prOprietorships; engaged solely in domestic Operations which do not call for a special tax classification of the organization. One ex- ception to the ordinary business limitation is the in- clusion in this study of domestic personal holding companies (defined in the next chapter). wod of Research The analysis and conclusions contained in this study are based on an examination of the following: (1) basic 8<>urces Of tax law (Internal Revenue Code, Treasury Regu- lations, court cases, Congressional hearings, etc.); (2) Studies dealing with various aspects of federal income taxa- tion (including equity, administrative and compliance prob- lems, economic effects, and constitutionality); and (3) s‘tatistical data gathered by the Internal Revenue Service, the Securities and Exchange Commission, and other organiza- tions. CHAPTER II TREATMENT OF CLOSELY HELD CORPORATIONS UNDER THE CORPORATE INCOME TAX SYSTEM This chapter examines the major problems involved in a~3E>plying the corporate income tax method to closely held corporations. Primary consideration is given to tax avoid- ance and certainty (or finality) in tax determinations. The purpose of this chapter is to establish, in part, the need for considering a different system of taxing closely he 1d corporations . moaches to Tax Minimization Although it is frequently assumed that the double taxa- tion of business income under the corporate tax method imposes a higher tax burden on shareholders of closely held ecorporations than on proprietors and partners in similar eeonomic circumstances, this is not necessarily the case. w‘hether the tax burden of shareholders of a given closely held corporation is higher or lower than it would be if the 3eme operations were conducted under an unincorpOrated busi- Iless form is dependent upon a number Of factors. Among these factors are the nature of business activities, how and when 31 32 corporate income is distributed , and individual tax brackets of shareholders. Shareholders of closely held corporations have considerable latitude in arranging the best combination of corporate and individual income taxes to minimize their aggregate tax burden. There are three general approaches to minimizing the tax burden of shareholders of closely held corporations: (1) distribution of current corporate earnings in the form of expense payments to shareholders to reduce corporate in- COme and thereby avoid the corporate tax on the income dis- tributed; (2) retention of corporate income to avoid higher personal income taxes at the shareholder level; and (3) use of multiple corporations to have all or a greater portion of c=<>rporate income taxed at 22 percent, rather than 48 percent. In the following sections these general approaches are dis- ‘3Iassed first, and then the countermeasures used by the Inter- Pal Revenue Service are examined. Tax planning measures e(ammon to all businesses (adjusting depreciation lives, etc.) are not discussed in this study. P\istributions of Current Corporate Earnings Since dividend distributions of corporate income are taxed first at the corporate level and again at the share- hOlder level (i.e., the amount exceeding the $100 dividend e)cclusion), careful tax planning calls for keeping dividend distributions of current earnings to a minimum, regardless ‘7 h u I 33 whether shareholders are in high or low tax brackets. The principal way the corporate tax on these distributions can be avoided is by making the distributions in the form of expense payments to shareholders, which are deductible in computing corporate income, rather than in the form of dividends, which are non-deductible. Although any kind Of valid business expense payment to shareholders will serve to avoid double taxation of the income distributed, these payments are usually made in one Or more of the following forms: (1) salaries, bonuses, and Other compensation paid to Officer-shareholders (the most Common form); (2) interest paid to shareholders who lend money to the corporation rather than contribute capital for additional stock; and (3) rent paid to shareholders (e.g., one practice is to incorporate part of a business and lease the unincorporated assets to the incorporated part of the business) . Once the amount or percentage of corporate in- Qcame that is to be distributed on a current basis has been determined (as explained below), expense payments can be arranged accordingly. These payments must, of course, at least maintain the appearance of valid business expenses, 01:- they may be disallowed by the Internal Revenue Service (discussed below) . The amount or percentage of current corporate earn- ings that should be distributed as expense payments for tax 34 minimization is determined, in large part, by the individual tax brackets Of shareholders. Current corporate tax rates are 22 percent Of the first $25,000 of income and 48 percent of the excess; individual rates range from 14 to 70 percent. Individuals in the lower individual tax brackets usually E ind it advantageous to eliminate substantially all of the income at the corporate level and pay little or no corporate taxes, even though in many cases the expense payments re- ceived by the shareholders must be immediately reinvested in the corporation for business purposes. The prevalence of this siphoning process is indicated by the following statistics: in 1962, 1,195,614 corporations had assets totaling less than $1 million; of which, 69 per- cent reported a net loss, equal receipts and deductions, or taxable income of less than $5,000.1 For the same group, the total compensation paid to corporate Officers was equal to approximately twice the total net income of the group. D:i.vidend distributions in cash or other property (excluding s"took dividends) amounted to only 9 percent of total net income before deducting" compensation paid to officers.2 \ S 1U. S. Treasury Department,-Revenue Service, \‘hatistics of Incomeu 1962, Corpora ion ncome Tax Returns, 1th accounting periods ended July l962-June 1963. (Washing- On, D. C.: Government Printing Office, 1966), p. 206. Q 21bid., p. 58. These figures include data for 122,856 Orporations that filed under Subchapter S in 1962. Data for chhapter S corporations are reported in essentially the same no {W I! l H 35 Countermeasures. To restrict the above practices, the Internal Service has sought to disallow (as corporate deduc- tions) salaries, interest, and other payments to shareholders to the extent that these payments have been judged to be dis- guised dividends. A brief review of the areas of ”unreason- able compensation" and "thin capitalization" will serve to point out (1) the problems involved in distinguishing between valid expense payments and disquised dividends and (2) how these problems are restricted to closely held corporations. Unreasonable compensation. With respect to the dis- allowance of excessive compensation, section 162(a) of the <3de permits a taxpayer (including a corporation) to deduct "a reasonable allowance for salaries or other compensation 15<>r personal services actually rendered."3 Unfortunately, ‘311ere are no objective standards for determining the reason- El1>lesness of compensation. One study involving an analysis of over 700 court cases dealing with unreasonable compensa- tion, lists over thirty criteria which have been used in attempting to settle disputes between taXpayers and the \ Inanner as that for corporations subject to the corporate tax Inethod. 3I.R.c. (1954), sec. 162(a) (1). 36 . 4 . . :Internal Revenue Serv1ce. Among these criteria are the xmature of duties performed by officer-shareholders, size of hnisiness, compensation of officers in comparable positions 111 other businesses, training of the officers, amount of time required, and general living conditions in a particu- lar locality. 5 The same study is prefaced with the following observa- tions: While there is nothing in either the Code or the Regulations thereunder that limits the application of this Section [l62(a) above]. . . the question is primarily directed against the officer-stockholders of the closely held corporation. . . . This is because in such com- panies it is often quite easy for the officer- stockholders to control the payment of amounts to themselves, which amounts, in whole or in part, might be construed under the facts in the case as being dividends even though labeled throughout the company's records as compensation. 6 Thin capitalization. A ”thin corporation" is one financed by a high ratio of debt to equity capital supplied ‘33? the shareholders of the corporation. The main purpose of thin capitalization is to maximize the interest deduction for \ Tbsi 4Crawford C. Halsey and Maurice E. Peloubet, Federal- i$~£5ation and Unreasonable Compensation (New York: Ronald 33888 Company, 1964). PP. 2-l7. 51bid. 6 Ibid.] p. 1-2. 37 distributions of current corporate earnings to shareholders. The interest deduction of a corporation that is too “thinly" capitalized may be disallowed and treated as a dividend to the extent that the Internal Revenue Service is able to sus- tain the case that all or part of the debt capital is in reality equity capital. What determines whether capital is debt or equity? According to one leading case: "There is no one charac- teristic, not even exclusion (of shareholder-creditors) from management, which can be said to be decisive in the deter- mination of whether obligations are risk investments in the corporation or debts."7 Some of the characteristics that have been relied upon to sustain the case that debt is in recz-ility equity capital are: interest rates dependent upon earnings, lack of a definite debt maturity date, subordina- tion of debt held by shareholders to claims of other credi- tors, and switching of stock into debt. With respect to an at=ceptable ratio of debt to equity, the courts have never 8 a~dhered to any given ratio. In general, the higher the ratio of debt to equity capital held by shareholders, the In<>re likely the interest deduction will be challenged by the II‘lternal Revenue Service. 7John Kelley Co. v. Commissioner, 326 0.5. 521 (1946). I. - 8Martin M' Lore, M Cafiiialization, Tax Practitioners' abrary (New York: Ronald Press Company, 1958), pp, 11-31. 38 One study of cases involving the thin corporation prob- lem has pointed out the extent to which this problem is limited to closely held corporations: This corporation is strictly a problem of closely held corporations. There is no problem of this corporation in a truly widely held corporation, since it is practically impossible for hundreds or thousands of stockholders to hold the corporation's debt in proportion to their stockholdings. Furthermore, the courts are more apt to question the motives of a few stockholders in absolute control of their close corporation, than to scrutinize the motives of a large number of unrelated stockholder- creditors of a large and widely held corporation.9 li¥etention of Corporate Income As opposed to individuals in low tax brackets, who ‘JESILally find it advantageous to avoid the corporate income tliizc, those in high tax brackets frequently find the corpor- ate income tax a desirable alternative to higher personal jLIltzome taxes. Through careful tax planning, substantial in“(aunts of income may be retained and accumulated in closely held corporations, where it may be shielded from personal tax rates that are higher than corporate rates. Corporate income accumulated in this manner may sub- sequently be distributed or disposed of in one or a combina- tion of three basic ways for tax minimization: \ 91bido' Pp. 3-4. 39 1. The income may be distributed as dividends during years in which shareholders have incurred losses (which may be offset against the dividends) or during years in which shareholders receive small amounts of income from other sources (e.g., after they retire). 2. The accumulated income may be distributed to share- holders as long-term capital gain (which is subject to a maximum tax of 25 percent). Long-term capital gain (on stock held over 6 months) may be realized by the selling the corporate stock or by fully or partially liquidating the cor- Poration (under certain conditions). Income retained in the corporation--to the extent that this income has increased the value of the stock sold or is received as liquidation Proceeds--is thereby converted into long-term capital gain. 3. The accumulated income may not be distributed. Sliareholders may retain the corporate stock until they die; in which case, the stock will enter their estates at current I'i‘altket value, and no individual income taxes will be paid on the income retained in the corporation. In addition, heirs ITecteive the stock with -a tax basis that includes the é‘DPreciation . 10 Countermeasures. The code contains two special penalty 1:aztes which may be imposed on corporations which have \ 10 I.R.C. (1954), sec. 1014. v”! r" '1’ ‘K 40 improperly accumulated income to avoid higher taxes at the shareholders level: the personal holding company tax and the accumulated earnings tax. The purpose of these taxes is to force a greater distribution of corporate income to be taxed to shareholders as ordinary income. In addition, the Code contains several provisions to restrict the prac- tice of distributing accumulated corporate income as long- term capital gain. Personal holding company tax. The specific function Of this tax can best be explained in light of two practices Which were common prior toql934, the year in which the first Personal holding company provisions were enacted: (1) Some Wealthy individuals transferred substantial amount of income Producing property (stock, bonds, capyrights, etc.) to cor- Porations which they or their close associates wholly owned. Itlooms was received by and accumulated in these corporate Bl‘lells, where it was taxed at corporate rates that were <=Qtlsiderably lower than the individual rates applicable to income received by theowners of the corporations. (2) SOllie successful entertainers and other individuals with l"igh personal-service income formed private corporations, had these corporations contract to sell their services, and then worked for these corporations for nominal salaries. The differences between the fees received by these cor- porations and the salaries paid to the talented persons 41 were accumulated in the corporations. In both of the above cases, the ultimate objective was to distribute or dispose of the accumulated income in one or a combination of the three ways described above.11 To curtail these practices, a heavy penalty tax has been imposed upon the undistributed income of personal hold- ing companies. Under the current law, a corporation is considered a personal holding company if it satisfies two basic requirements: (1) it is more than 50 percent owned, directly or indirectly, by not more than five individuals; and (2) at least 60 percent of its gross income consists of Personal holding company income, which includes dividends, interest, some types of royalties, certain rental income, and certain personal-service income.]'2 A corporation may be a personal holding company in some years and not in others, depending upon whether it satisfies the twofold definition 3"t-ated above. The personal holding company tax is 70 percent 11Harry J. Rudick, ”Section 102 and Personal Holding (:CMmpany Provisions of the Internal Revenue Code," Yale Law 515555221 IL (December, 1939), pp. 171-205, Certain financial 121.3.c. (1954), secs. 542-43. institutions--including banks, life insurance companies, and st finance companies--and certain foreign corporations are not subject to this tax. 42 of undistributed personal holding company income.13 The personal holding company provisions have not elim- inated, but merely limited the extent to which, the closely held corporate form may be used as a device for shielding investment income and personal-service income from high per- . sonal tax rates. A corporation whose gross income consists of 59 percent personal holding company income is not a per- sonal holding company, nor is a corporation that fails to satisfy any of several other requirements pertaining to certain kinds of income or to corporate ownership; arranging corporate affairs to fail to satisfy the statutory defini- tion of a personal holding company is a common tax-planning maneuver in this area. Accumulated earnings tax. Sections 531-37 of the Code sI>ecify that a penalty tax may be imposed on a corporation that improperly accumulates earnings for the purpose of a‘7oiding the individual income tax on shareholders. These provisions apply to all domestic, profit-making corporations, other than personal holding companies. Evidence of intent t0 avoid the individual tax may be provided by (l) accumu- lation of earnings beyond the reasonable needs of the \ 13I.R.C. (1954), sec. 541. Several complicated steps Eire involved in computing this tax. These steps are ex- I3lained in most standard tax reference manuals. 43 .business or (2) use of the corporation as a mere holding or :investment company. The latter is considered prima facie evidence of intent to avoid the individual tax.14 However, extensive use of a corporation as a holding device will, in mméy cases, result in the corporation being classified as a Exersonal holding company. Thus, the reasonableness of ac- cnmmulations of earnings for business purposes is the prin- <:ipal issue involved in imposing this tax. The accumulated earnings tax is 27-1/2 percent of the iiirst $100,000 of accumulated taxable income and 38-1/2 per- Cent of the excess.15 "Accumulated taxable income” is not ‘tflae same as the balance of the retained earnings account; Several special adjustments must be made to convert retained earnings into "accumulated taxable income."16 Nevertheless, for expository purposes, it is useful to think of accumulated i=£axable income as being the balance of the retained earnings Eiccount, as reduced by the accumulated earnings credit, which is the. larger of (l) the amount of retained earnings required to meet the reasonable needs of the business or (2) $100,000 4 I.R.C. (1954), sec. 533. 15 I.R.C. (1954, sec. 531. 16 . . ; An eXplanatlon of the steps involved in computing this tax can be found in most standard tax reference manuals. 44 the minimum accumulated earnings credit.17 In general, a corporation may accumulate $100,000 of current and past tax- able income without incurring any liability for the accumu- lated earnings tax. Unlike the personal holding company tax, which a cor- poration is supposed to determine and pay with its regular corporate income tax if the tax is required, the accumulated earnings tax is levied as a result of audit by the Internal Revenue Service. Another important difference between these taxes is that the accumulated earnings tax is imposed on the basis of subjective standards (intent to avoid, reflected 13)! unreasonable accumulations); whereas the personal holding <=cmmpany tax is imposed on the basis of objective standards (<3.g., the 60 percent personal holding company income test). The element of intent is irrelevant in determining whether ‘311e personal holding company tax is to be imposed. Accumulated earnings (penalty) tax provisions, although JPie-vised several times since their inception, have remained :111 the tax laws since 1921. Under section 102 of the 1939 (:CMie, there was no minimum accumulated earnings credit and tflhe burden of proving the reasonableness of retaining a given amount of corporate income was on the corporation. In 17 I.R.C. (1954), sec. 535. 45 ancidition, under section 102, the immediacy test was gen- eezrally applied. According to this test, funds not required ifcar current business operations were being unreasonably ac- <:\1mulated if not distributed by the end of the year.18 Complaints that section 102 was being administered ar- bitrarily with the result that many small corporations were :frarced either to distribute funds needed in the business or tx: pay the proposed deficiency to avoid eXpensive litigation, Encompted several important changes in the accumulated earn- iJigs tax provisions. The 1954 Code contained three important Cflnanges: (1) exemption of a minimum amount of accumulated earnings from the penalty tax—-$60,000 in 1954 (raised to $100,000 in 1958); (2) shift of the burden of proof concern- .ing the reasonableness of the income retained from the cor- IPOration to the Internal Revenue Service-~this is presently the usual case; and (3) broadening of the reasonableness Principle to include not only current business needs, but also reasonably anticipated (future) needs of the business.19 Some students of taxation maintain that these changes 18Stanley S. Weithorn and Roger Noall, Penalty Taxes gijccumulated Earnings and Personal Holding Companies, Practicing Law Institute Tax Monographs (New York: Prac- ticing Law Institute, 1963): PP. 1-5, 42-46. 19U. S. Senate Committee on Finance, Internal Revenue Sgde of 1954, S. Rept. 1622, 83rd Cong., 2nd Sess., 1954, pp. 68-70. 46 reduced substantially the effectiveness of these provisions; others maintain the current provisions and their administra- ‘trion are still too harsh. Certainly, exemption of a given amount of accumulated income ($100,000) from the tax provides amn.open invitation to accumulate to that amount and incentive to use multiple corporations to obtain multiple $100,000 czredits. Who, in reality, has the burden of proof regarding tflhe reasonableness of income accumulations is usually a moot czuestion, when each party is trying to discredit the conten- taions of the other party. Expansion of the reasonableness 'test to include reasonably anticipated (future) needs of the lausiness has definitely expanded opportunities for extensive litigation. What constitutes the current and reasonably anticipated (future) needs of a business? The following items or a com- bination of them may justify retention of income: (1) cur- rent operating expenses; (2) low liquid position; (3) reserve for a pending law suit; and (4) fairly definite plans for replacement of equipment, or additions to plant and equip- ment, or product diversification, or acquisition of another business, or a host of other items. On the other hand, conditions such as the following are likely to cast doubt on the reasonableness of the amount of income retained: (1) loans to shareholders (2) investments in securities or pro- perties which are substantially unrelated to the corporation's 47 x I Jregular business activities; (3) vagueness of plans for re- ;placements of or additions to business plant and equipment; sand (4) retention of income to provide against unrealistic liazards.20 The extreme subjectivity involved in applying the ac- <:umulated earnings tax has been described by two tax at- torneys as follows : The answering, preparation for trial, trial and briefing of a section 531 case extends one across the waterfront of human existence. Almost any- thing imaginable is relevant when you are dealing with such items as “reasonable needs“ and “intent- to avoid shareholder-taxes."21 " Although not specifically stated in the Code or the Regulations, the accumulated earnings tax has been applied almost exclusively to closely held corporations. The Senate Finance Committee Report issued in connection with the 1954 Code noted that the tax had been imposed on corporations only where 50 percent or more of the stock was held by a limited group.22 There is one well-known case in which this tax has been imposed on a publicly held corporation. The corporation in question had approximately 2,000 shareholders; however, 20Weithorn and Noall, op. cit., pp. 12-42. 21Edward L. Newberger and Wallace E. Whitmore, "Accumulated Earnings Tax Cases," The Tax Executive, XVIII (January, 1966), p. 149. 22Internal Revenue Code of 1954, S. Rept. 1622, op. cit., p. 69. 48 ssix shareholders controlled about two-thirds of the shares.23 Capital gain distributions. Subchapter C of the Code <=ontains a maze of provisions designed to curtaflQDthe prac- 1:ice of distributing accumulated corporate income as long- t:erm.capital gain through the use of devious forms of stock Jredemptions, corporate liquidations, and other forms of (:orporate distributions. Preferred stock bailout rules Iprovide a good example of the general nature of these pro- ‘risions. fA bailout works as follows: a corporation issues a: non-taxable stock dividend on common stock (paid in pre- :ferred stock) to shareholders who sell the preferred stock (at.a gain (ordinarily a capital gain) to a third party (a financial institution or other intermediary) from whom the corporation redeems the stock. Under section 306 of the Code, the gain (all or part of it) on the sale of the stock by the shareholders may be treated as ordinary income on the grounds that the transaction is "essentially equivalent to a dividend." In the bailout example, the case is relatively clear as to the real nature of the transaction. On the other hand, the variety of ways in which corporate distributions 23 Trico Products Corp. v. Commissioner, 137 F. 2d 424 (2d Cir. 1943), cert. denied, 320 U. S. 799 (1944). 49 ruay be made (in particular, by closely held corporations) laave presented the courts with some formidable problems in attempting to settle disputes over the real nature of waarious corporate distributions.24 Closely held and public- lly held corporations have little in common with respect to (opportunity and incentive to make unorthodox income distri- butions . Multiple Corporations A practice which enhances the tax savings on corporate income is the use of two or more corporations to obtain mul- ‘tiple surtax exemptions to keep all or a large portion of corporate income in the lower corporate bracket. Current corporate rates consist of a 22 percent normal tax and a 26 percent surtax; in general, each corporation is permitted one $25,000 surtax exemption. A maximum annual tax savings of $6,500 (26 percent of $25,000).may be gtained for each additional corporation. In 1962, when the corporate normal rate was 30 percent and the surtax was 22 percent, a maximum annual savings of $5,500 (22 percent of $25,000) could have been obtained for 24 For an analysis of cases in this area, see: Paul D. Seghers, William J. Reinhart, and Selwyn Nimaroff, Essentially Equivalent to a Dividend, Tax Practitioners' Library, (New York: Ronald Press Company, 1960). 50 «each additional corporation. In that year, 724,903 corpora- 'tions had both assets of less than $1 million and taxable in- «come. Only 13 percent of these.corporations reported taxable income in excess of $25,000.25 The use of multiple cor- porations probably accounted, in large part, for this low percentage. Countermeasures. The intent of Congress in enacting .and maintaining the corporate surtax exemption has been to provide tax relief for small (incorporated) businesses. (:ongress and the Internal Revenue Service have, however, (encountered numerous problems in seeking to limit the bene- fits of the exemption to "small businesses.“ Several pro- ‘viSions have been added to the Code to curtail the practice of dividing an economic entity into a series of artificial legal entities for the principal purpose of obtaining multiple surtax exemptions. Sections 1561—63 of the Code (initiated with the Revenue Act of 1964) provide that certain controlled groups of corporations may elect to take either (1) only one $25,000 surtax exemption for the entire group or (2) one surtax exemption for each corporation and pay an additional 6 percent tax on the first $25,000 of income of each 25Statistics of IncomeJ 1962, Corporation Income Tax Returns, op. cit., pp. 206-7. 51