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The discrimination against the use of the corporate form by the business man of moderate resources is not, to the writer's mind, beneficial. Indeed, it is possible, even probable, that some economically justifiable enterprises or extensions of enterprises that would be undertaken by such business man if they could operate under the corporate form may never be undertaken under the present discriminatory tax laws: competition from a smaller aggregate of nonincorporated concerns may be able to make use of the tax discrimination. In any case, the burden of proof of a sound reason for such discrimination seems to rest upon its advocates.

As indicated above, the only feasible way of eliminating a large part of the discrimination with respect to investors of moderate means is by narrowing the gap between the normal and corporation rates.

One other possible solution, however, deserves detailed attention. What are the objections to stripping aside the corporate veil in the manner indicated briefly in the section above. To many, it would be regrettable to eliminate the corporation tax, since they view it partly or wholly as a special business or corporation tax, justifiable entirely apart from the individual income tax. To be consistent they must also advocate the subjection of dividends to the normal tax in the hands of the shareholders. The writer has no sympathy with this point of view. The special "benefits" of the "privilege" of incorporation, if they remain with the corporation owners, should of course be revealed chiefly trough a higher rate of return on corporation capital than on non-corporation capital (after elimination of other factors not germane to the problem). The writer has seen no evidence of such a phenomenon and does not believe it exists. Much the same remarks apply to business in general, and the only excuses for a non-shiftable "business tax", in the writer's view, are the relative ease of collection and (this is particularly important with respect to state taxation) the impossibility of otherwise reaching certain nonresident interest.

It may well be impossible, under the constitution in its present form to require taxpayers to include in their income their distributed and undistributed shares in corporate earnings. A special memorandum should be obtained from a competent authority on this subject.

Where shares change hands during the year, it would probably prove too complex to require each holder to ascertain his fractional- year part of the earnings of the corporation. One might require the holder as of the end of the calendar year to be responsible for the entire year's earnings, and sellers throughout the year could act in the light of knowledge of this rule. This might not be much worse than the analogous situation that occurs under the taxation of dividends.

It would of course be necessary to require all corporations to report promptly after the close of the corporate year the net income per share.

Dispute with the tax authorities over the proper figure for the net income of a single corporation might require later adjustment of thousands of individual returns. The same problem exists at present with respect to partnerships, but each case involves only a few, or at the most, say tens of investors rather than hundreds or thousands.

This last point weighs so heavily with the writer that, although he would like to see the corporate veil abolished for taxing purposes, he cannot recommend it until some solution is found, which he does not at present see, to the administrative difficulties that such a plan seems to involve.

A few hypothetical examples may now serve to give point to the general considerations introduced at the beginning of this section.

Suppose that an individual A has available $40,000 in capital, on which he expects to earn 10 per cent annually before any allowance as salary to himself. Suppose that he plans to use this capital in some moderately small business, such as a local drug store, and is inclined to incorporate the business unless the income tax burden is heavier in this way. What must his calculations be.

If A is unmarried and no dependents and no other source of income, his total income tax if he does not incorporate will be $108 a year. /1/ If he incorporates and pays himself a salary of $3,000 a year, his yearly corporation tax will be $137,50 a year, and if he distributes the profits ($862.50) to himself at once as dividends, he pays a total personal tax of $68. /2/ Corporation tax and personal tax total $205.50. compared to $108 total tax under the unincorporated form. If he does not declare dividends, and some years later sells the corporation, in the year of sale he pays both normal tax and surtax on these accumulated dividends trough his liability to a tax on gain from sale of capital assets -- a tax which does not strike him if he starts, maintains, and sells the business under the unincorporated form. Clearly, the tax law is heavily weighted against the corporate form for small concerns owned by proprietors with no other sources of income.

FOOTNOTES
 
/1/ $4,000 minus the sum of $1,000 (personal exemption) and $300 (earned income credit), times 4 per cent (normal rate).

/2/ $3,000 salary minus personal exemption and income credit as above, times 4 per cent. The dividends pay no tax, as his total income is not large enough.

Let the terms of the problem be varied to this extent: suppose that A has taxable income from other sources as follows: salary $58,400; dividends from domestic, taxed corporations, $58,6000; interest from corporate bonds, $80,000; total, $197,000. /1/ (For simplicity's sake there are no deductible items; this does not invalidate the illustration for the purpose at hand.) He is, as before, considering whether to incorporate his new, little business. if he does not incorporate, his total income tax each year is $66,100. /2/ If he incorporates and pays himself a salary of $3,000 a year and at once distributes the profits as dividends,his total income tax is: personal, $85,987,13. /3/ corporate, $137,50; total, $86,124,63 (compared with $66,100 if he does not incorporate). Here there is virtually no discrimination against the corporate form. The absolute amount of difference in taxes as shown by the first example would of course mean less to the rich man in the second example, but is worth noting that the absolute amount it self has shrunk. In the first example the difference in tax was $97.50; in the second it is only $24.63.

FOOTNOTES
 
/1/ The precise amounts used in this example are of no particular significance; the general order of magnitude is the important point.

/2/ Income as above, plus $4,000, gives $201,000. Subtract $1,000 personal exemption, and surtax is $80,500. Subtract, further, dividends, and earned income credit of $1,400, and normal tax is $5,600.

/3/ Income as above, plus $3,000, plus $862,50 corporate dividends, gives $200,862.50. Subtract $1,000 personal exemption, and surtax is $80,427.13. Subtract, further, dividends ($59,462.50) and earned income credit of $1,400, and normal tax is $5,560.

Indeed, under the lower surtaxes and higher normal taxes in force under the 1932 Revenue Act, there was a point in total income from business, $98,963, beyond which the total tax was less under the corporate form than under the unincorporated form. /1/ Furthermore, if, in the second example here. A declares himself no dividends, he avoids the surtax rate (53 per cent) on this amount ($862.50) and thus saves, for the time being $457.13, thus swinging the balance definitely in favor of the corporate form. True, this will later be caught as a capital gain when he sells the corporation, but this may be some time removed, and, although it is not a consideration to be ignored, it is, as previously indicated, not precisely calculable, as the amount of tax he will later pay on this account depends upon a number of things, including his total income at that time and the tax rates in force.

The problem may now be varied slightly by supposing that the wealthy man's entire income is to come from his business, which will show a net profit (before deduction for his own salary) of $201,000. if he does not incorporate, his yearly tax is $88,444. /2/ If he does

FOOTNOTES
 
/1/ Carl Shoup. "Tax Corporation Tax and the Normal Tax," Bulletin of National Tax Association. Volume XIX, No. 4., January, 1934, p. 107.

/2/ Business profit, less personal exemption ($1,000) gives $80,500 surtax; and less, further, earned income credit ($1,400) gives $7,944 normal tax.

incorporate and allows himself a salary of $20,000 a year and declares all profits at once in dividends, his total yearly tax in $92,901.13. /1/ Although the absolute difference in tax burden is greater than in the first example above, the percentage difference in tax payable is much less. It is possible, there-fore, to say that, as the income increases, the relative difference in burden as between the incorporated and unincorporated form of business grows less, and, as shown, the difference may indeed turn in favor of the corporation for the immediate period under consideration.

The general conclusion to which the writer comes is this; the difference between the normal tax and the corporation tax constitutes a decided influence discouraging the small business man from incorporating his individual proprietorship. "small business man" can be taken to mean, in general, one whose total income is less than $30,000. Wealthier man in business either; (a) are not influenced by the difference in rates, because this is largely counterbalanced by the fact that the surtax on dividends is paid on the business earnings AFTER the corporation tax has been deducted while the surtax on proprietorship's income is paid

FOOTNOTE
 
/1/ Corporation tax 13.75 per cent of $181,000 or $24,887.50; individual tax; salary, ($20,000) plus dividends ($156,112.50). less personal exemption (1,000) gives surtax of $67,309.63; and less, further, dividends and earned income credit ($1,400), gives normal tax of $704.

before deducting any amount payable as normal tax; or (b) cannot predict future events (especially changes in tax rates) accurately enough to allow for the tax influence.

The partnership faces the same problem with respect to the particular point at issue as the individual proprietorship, and the answer for partner is the same as for the individual proprietor.

If the normal rate were 8 per cent, and if surtax were levied only upon the surtax net income after deduction of normal tax payable, the total tax in the three hypothetical cases above would be as follows:


                         Unincorporated      Incorporated
                         ______________      ____________
          (a)              $   216.00          $   273.50 
          (b)               85,764.00           85,791.03 
          (c)               87,967.36           92,858.89 

For the reader's convenience in comparison, the total tax under the present law, as shown in these hypothetical cases, is repeated here:

                         Unincorporated       Incorporated     
                         ____________        ____________
          (a)              $   108.00          $   205.50 
          (b)               86,100.00           86,124.63 
          (c)               88,444.00           92,901.13
 

The writer is much less concerned over the apparent discrepancy
shown under (c) in the first group above than over the difference
shown under (a) in the second group below, for reasons already given.

(b) Gains in One Year and Losses in Another. -- An individual
proprietorship or partnership may have a loss one year and a gain the
next (or vice versa), but the loss cannot be used, under the present
law, to offset the gain, even in part, This offsetting privilege was
first restricted by the 1932 Revenue Act and then repealed by the
National Industry Recovery Act of 1933. On the other hand, under the
corporate from the loss and gain my, in effect, be offset as concerns
the personal surtax. Thus, suppose a firm gains $100,000 in 1935 and
losses $100,000 in 1936. If it is unincorporated, the owners must
include the $100,000 gain of 1935 in their personal income statement,
to be taxed under both the normal rates and the surtax rates, but can
gain no reduction in tax liability as concerns the $100,000 loss. If
the concern is incorporated, and pays no dividends during the period
in question, it pays corporation tax on the $100.000 gain, and can
gain no reduction in tax liability as concerns the $100,000 loss;
but, as the net profits over the two-year period are zero, there are
no dividends to be paid from the results of the two years' business,
and no surtax to be paid.

(c) Dividends and Partially Exempt Interest. -- With respect to
dividends and partially exempt interest, the 1934 law has made a
change that places the partnership on the same basis as a corporation
and therefore necessarily places it at a disadvantage compared to the
individual proprietorship.

Suppose a partnership composed of two partners each having a
one-half interest in the business loses $10,000 from its regular
business operations but receives $15,000 in dividends from domestic
corporations subject to taxation. Suppose that one of the partners, a
single man with no dependents, receives $6,000 in fees from another
activity. The net income of the partnership is $5,000, of which
$2,500 must be returned by A in his individual tax statement. His
total personal income is thus $8,500, and the surtax payable, after
the $1,000 personal exemption, is $155. It is with respect to the
normal tax that the change from the former law appears. Under the
revenue acts prior to that of 1934, the partner could deduct from
$7,500 (the amount subject to surtax) his share of the dividends
received by the partnership ($7,500), and he would thus have no
normal tax to pa. Under the 1934 Act (Section 184) he may use only
his proportionate share of the dividends "not in excess of the net
income of the partnership." Therefore be may use as a credit only
one-half of $5,000 (net income of the partnership), or $2,500.
Subtracted from $7,500, this leaves $5,000. From this is subtracted
the earned income credit, and the balance is subject the normal tax.

If the partnership is changed to a corporation and the other
terms of the problem remain the same the result with respect to the
point under discussion is the same. The corporation pays no tax,
since it has no net taxable income (the dividend item is entered as a
part of gross income, but is taken out as a deduction under Section
23(p)). However, it has an addition to surplus of $5,000, which it
may distribute as a dividend. If it does so, the stockholder in
question shows a net income of $8,500 (fee $6,000; dividend $2,500).
On this he pays surtax of $155, (after deducting $1,000 personal
exemption), and from $7,500 he subtracts $2,500 as a credit for
normal-tax purposes, leaving $5,000. After subtraction of the earned
credit, the balance is subject to normal tax.

If the person in question owns an individual proprietorship half
the size of the corporation, the result for him is the same as it
used to be in the partnership situation. In terms of the example
above, his business loss is $5,000, and has receives $7,500 in
dividends, and $6,000 in fees. His net income is $8,500. Of this,
$7,500 is subject to surtax and none to normal tax (the dividend
credit equaling the $7,500).

(d) Charitable, etc., Contributions. -- With respect to
charitable and similar contributions (Section 23(o)), Section 183 of
the 1934 Revenue Act has taken a step that places the partnership is
a different position from that of the individual proprietorship, yet
not in the same position as a corporation.

Suppose a partner has an income of $10,000 from fees (activity
not connected with the partnership), while the partnership, in which
he has a one-half interest, has a net income of $8,000 before
deducting a gift of $3,000 to a charitable organization. Such
contribution are in general allowable as deductions only to an amount
not exceeding 15 per cent of the taxpayer's net income as computed
before any much deduction. Prior to the 1934 Revenue Act. the 15 per
cent limitation was applied to the individual's total income and not
to the partnership income. Trust the individual, showing a net income
of $14,000 before deduction of the contribution, could deduct up to
15 per cent of $14,000, or $2,100, and, as his proportionate share of
the contribution of $3,000 would be $1,500, he could deduct all of
it, leaving him with a net income of $12,500. Under the 1934 Act, the
15 per cent limitation is applied to the partnership income. Thus the
limitation becomes 15 per cent of $8,000, or $1,200; the partnership
net income becomes $6,800; the partner's share becomes $3,400; which,
added to his $10,000 other income, gives #13,400 net income, compared
with $12,500 under the former law.

The effect is not always to increase the partner's income. If
the partner has no net income other than from the partnership, the
change is without effect. If he has a negative income which is more
than entirely offset by his share of the partnership income, the
change results in less tax payable than formerly. Thus, if he loses
by theft a diamond ring, uninsured, worth $1,000, and has no income
aside from the partnership, he could deduct only $450 for the
charitable contribution under the former law ($4,000 less $1,000
equals $3,000; 15 per cent of $3,000 is $450); under the present law
he gets the benefit of $600 (one-half of the $1,200 allowed the
partnership). However, since his ordinary income cannot, under the
present law, be more than offset (beyond $2,000) by losses from sale
of property, the cases of negative income to be offset by partnership
income will be rare. In general, therefore, the new provision
increases the tax liability of partners in general when the
partnership make a contribution. The practical effect of this may not
be important, as partners will in many instance doubtless take care
to contribute as individuals rather than through the partnership.

(e) Capital Gains and Losses. -- Losses from the sale of capital
assets can be used only to reduce gains from the sale of capital
assets, except that an additional $2,000of losses may be used to
offset other income. Thus a taxpayer who operates an individual
proprietorship which nets him $10,000, and who has capital gains of
$5,000 and capital losses of $8,000, has a net income, for tax
purposes, of $8,000. (in the example, it is assumed that the property
has been held less than one year; if it has been held longer, only a
part of the gain and/or loss is taken into account, but this does not
affect the principle here under discussion.)

Suppose that the capital gains and losses have been incurred by
a partnership in which the taxpayer has a half interest, and suppose
that the gains were $10,000, then losses $16,000, and the income from
business operations $20,000: If the individual partner were treated
in the same manner as the individual proprietor, his net income would
be the same as in the example above. It appears, however, (Section
183) that the rule restricting capital loss deduction is applied to
the partnership as such. Thus the partnership has a net income of
$18,000, and the individual's one-half share gives him a net income
of $9,000, instead of $8,000 as above.

Business in the corporate form is handicapped in the same
manner.

The point is not of great quantitative significance; at the most
it can make only a difference of $2,000 in the net income of the
taxpayer, If the figures in the first paragraph were multiplied by
four, on the assumption of a four-man partnership, the partner's net
income would become $9,500, and so on, until, if the number of
partners and the size of the partnership approach infinity, the
individual's net income approaches $10,000.

If, however, the present law were liberalized so as to allow a
more nearly complete deduction of capital losses, the problem would
of course grow in importance.

 
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