Undistributed profits tax relief for small corporations

(Memo. from Mr. Shoup to Mr. Magill, November 13-15, 1937)

November 15, 1937

To: Mr. Magill

From: Professor Shoup

In my memorandum on undistributed profits tax relief to small taxpayers, I suggested that the exemption might be given in the form of an addition to the dividends-paid credit. If this is done, the carry-over of unused dividend credit should, of course, be restricted to the "true" part of the dividend credit -- the dividends actually paid.

In any case, the precise technical wording in which the $5000 exemption and the 10 percent relief might best be granted needs further study.

Memorandum to: Mr. Magill

From: Mr. Shoup

On Undistributed Profits Tax Relief for Small Corporations.

These comments have chiefly the result of studying the statistical exhibit concerning the undistributed profits tax paid by 144,790 corporations on 1936 income.

Corporations Under $5,000

The under -- $5,000 group of profitable corporations for 1936 shows several characteristics that may make advisable a complete exemption of this group from the undistributed profits tax:

1) The average net income for income tax computation (this includes dividends received, see No. 3 below) is only $1,300 (to nearest $100) and the average of total assets in only $74,000, (to nearest $1,000). It seems unlikely that much of this net income would go to individuals whose incomes reach beyond an 8 or 9 per cent individual bracket rate. Hence, even if none of the profits were distributed at all, the lack of individual tax would usually be more than compensated for by the corporation normal tax alone, from the point of view of comparing corporations with unincorporated concerns, especially when it is considered that later some of the earnings may become taxable to the individual through dividend declaration or capital gains. This statement holds even if the capital stock tax and the excess profits tax are repealed.

2) Only 9 per cent of the outstanding capital stock of this class of corporation is in the form of preferred stock. /1/ Since some preferred stock must be outstanding if the device of dividend- in-preferred-stock to common stockholders is to be used to avoid the undistributed profits tax, these figures indicate that a considerable amount of trouble and perhaps some real difficulty would attend most attempts by this group of corporations to use that device.

3) The ratio of dividends-received to adjusted net income is much lower for this group than for the groups above $50,000. The greater the share of a corporation's income that consists of dividends, the greater is likely to be its ability to pay out most of its income without harming itself. Even if the dividends come from wholly-owned subsidiaries, the fact that they are declared shows that the operating companies can afford to part with this segment of their assets for a while at least. Where 95 per cent of the adjusted net income, on the other hand, is non-dividend income -- the case with the under-$5,000 corporations -- there is likelihood that a large part of the net income will be in a form -- e.g. notes receivable -- that is not easily to be broken off from the business, even temporarily.

4) The aggregate accumulated balance sheet deficit reported by those under-$5,000 firms was 51 per cent of the aggregate surplus. This is far above the ratio reported for any of the groups. It suggests that among these small corporations there are many that will be embarrassed by the laws of certain states that prohibit payment of dividends while a balance sheet deficit exists.

5) In this group, the undistributed net income was 63 per cent of the adjusted net income. The law is clearly not fulfilling its prime purpose, with this group -- i.e., to force earnings out and through individuals' tax returns. Perhaps this figure signifies a desperate determination of these small concerns to hold on to their earnings at all costs -- but since the only rate of undistributed profits tax that they pay, regardless of how much they withhold, is 7 per cent, it is more likely that this large amount of withholding simply reflects a feeling that 7 per cent is not a very stiff rate. It seems, in other words, an in-between rate -- enough to weight the tax system definitely against the corporate form for those small businesses, compared with the partnership and proprietorship, but not enough to force much of the earnings out to stockholders. It is thus a poor compromise, and might better be either reduced to zero or raised to a rate where it would be really effective in foreign out earnings.

6) If the figures now at hand represent about two-thirds of the complete data, the corporation surtax revenue lost by reducing the rate on the $5,000 corporations to zero would apparently be about $8,000.000. As to individual tax money lost or postponed because of the decline in dividends, the amount involved seems small. Even if no dividends at all were paid and if the average individual rate on them would have been as high as 5 percent, the loss would be only 5 per cent of, say, $60,000,000, or $3,000,000.

To avoid an abrupt jump at the $5,000.000 level, the exemption could be made to vanish gradually from the $5,000,000 level to the $10,000.000 level. The exemption would be inserted in the law by adding a sentence to section 27(a): "In no case shall the dividends paid credit be considered to be less than the amount obtained by subtracting the adjusted net income from $10,000.000 (this provision does not apply when adjusted net income is $10,000.00 or more)."

     On the tax form, three new lines would be necessary: 

                                                 $10,000

     Subtract adjusted net income                  - - -

                                                  _______
     Minimum dividends paid credit                  - - -

Of course it would be possible to let every taxpayer, large or small, use a $5,000 exemption, but this would have to be as a substitute for the existing specific credit (the device notes just above would not) and even the would probably give too much relief to the $5,000 -- $50,000 groups and not enough to the $50,000 -- $100.000 groups.

Corporations from $5,000 to $25,000

The data show that the average corporation in each of the sub- groups in this group is paying out more than half its adjusted net income -- in contrast to the under $5,000 group. But are these corporations nevertheless stopping this distribution at a point where hey still have to pay a substantial rate of undistributed profits tax on the remainder? In other words, are they facing so much difficulty in declaring dividends that they are preferring to pay one of the higher-bracket rates of the undistributed profits tax? The answer apparently is no. The average corporation in the $5,000 -- $10,000 groups, the $10,000 -- $15,000 group, the $15,000 -- $20,000 group, and the $20,000 -- $25,000 group appears to be paying out enough to get into the lowest undistributed profits tax bracket -- the 7 per cent bracket. /1/ In other words, to the average firm it apparently seems worthwhile to pay out enough earnings to keep out of the 12 per cent bracket. There may be differing conclusions that can reasonably be drawn from this, but one seems to be that on the average the paying out of some 60 or 70 per cent of earnings is not very inconvenient, since only a 7 per cent tax -- or further back a 12 per cent tax -- would be saved by paying out somewhat less. Of course there are AVERAGES, and averages always hide the "hard" cases -- but any relief provision, on the other hand, must probably be cast in terms of an average. On the whole, the figures for the groups between $5,000 and $25,000 seem to argue against the granting of further relief at this time.

Corporations from $25,000 to $5,000,000

The average corporation in the $25,000 -- $50,000 group shops its distribution at 12 per cent undistributed-profits-tax bracket level, and in the $50,000 -- $100,000 group and the $100,000 -- $250,000 group, stops at the 17 per cent level (but very close to the 12 per cent level). Likewise, in the next three larger groups ($250,000 -- $500,000, $500,000 -- $1,000,000, and $1,000,000 -- $5,000,000), the average corporation stops at the 12 per cent level. It is in these groups that relief problem seems particularly important. Twelve per cent is a fairly stiff "financing charge" to pay for the use of capital, and the fact that the average corporation in these groups is willing to pay it indicates that the dividend flow has reached some important barrier. Perhaps the barrier is simply the controlling interests' disinclination to route earnings through their individual returns where rates are high. If that is the fact, no occasion for relief exists -- rather, the rates of the undistributed profits tax should be raised. But in all likelihood there are other important factors operating -- state laws against dividends, fear of inability to get the money back from stockholder (most of these concerns, except possibly in the $1,000,000 -- $5,000,000 group, can probably not appeal to the market for capital funds), disinclination to use the preferred-stock-dividend device, etc.

However, any substantial relief to these groups strikes deeply at the principle of the undistributed profits tax. Such relief is likely to play into the hands of those who have large other incomes and are in control of the dividend policies of these corporations. Also, the loss in revenue would be substantial -- certainly in the tens of millions, possibly in the scores of millions.

My judgment tends to be against granting relief at this time. Further study of the returns should be made to see how much use is being made of the dividend-in-preferred-stock and stock-rights devices. Also, it would be very helpful to split each income group down so that we could know what per cent of the group were paying out less than 40 per cent, for example; from 40 to 60 per cent; and so on.

Permission to carry over business losses and to offset capital losses against ordinary incomes will be in themselves substantial reliefs to these corporations.

If relief is to be extended, the most feasible ways seem to be:

1) Reword the existing relief provision so that $10,000 is substituted for $5,000 and $100,000 for $50,000. This however, is but mild relief for the groups under consideration, and increases the relief in the lower groups, ($5,000 to $25,000), where it may not be needed.

2) Remove the existing relief provision and substitute one that reduces the undistributed net income by a certain amount -- say 10 per cent of the adjusted net income.

Probably in no case need any relief be granted to the corporations in the $1,000,000 -- $5,000,000 group.

If the suggestion to exempt all corporations in the under-$5,000 group is accepted, the wording given above in the discussion of that group, could be changed and amplified as follows: To the existing sentence in Sec. 27(a) add: ", plus whichever is the greater of the following, (a) the amount obtained by subtracting the adjusted net income from $11,000, or (b) 10 percent of the adjusted net income; except that if the adjusted net income is more than $100,000 [or $500,000] the amount added shall instead be that obtained by subtracting the adjusted net income from $110,000 [or $550,000]. This subsection has no application to corporations with a net income of more than $110,000 [or $550,000]."

This kind of an exemption does three things: It tapers off the 100 percent exemption at the $5,000 level to a 10 percent exemption at the $10,000 level; it maintains the exemption at 10 percent until the $100,000 level [or $500,000 level] is reached; it then tapers off this 10 percent exemption to a zero exemption at the $110,000 level [or $550,000 level]. This second tapering-off process can, of course, start at any point other than the two just mentioned, but to preserve the simplicity of the tapering plan, the end of the taper should come at a level 10 percent beyond the start of the taper.

This 10 percent formula would increase the existing degree of relief for all corporations with adjusted net income of than $25,000.

Under the present relief provision, the specific credit is always less than 10 percent if the adjusted net income if the adjusted net income is over $25,000. (The credit is the excess of $5,000 or the undistributed net income, whichever is lower, over 10 percent of the adjusted net income. Ten percent of the adjusted net income will in this group always be more than $2,500; and the balance left by subtracting from $5,000 will therefore always be less than $2,500, and hence less than 10 percent of the adjusted net income.) Moreover, the specific credit, after being taken out of the top of the undistributed net income, is taxed at 7 percent. Hence any relief plan that takes 10 percent of the adjusted net income off the top of the undistributed net income and exempts it will increase the existing relief to corporations with adjusted net income of more than $25,000.

For corporations from $5,000 to $25,000, the system of 10 percent off the top of the undistributed net income increases the relief compared with the existing credit, when the corporation pays out a large share of its earnings. That is, the 10 percent plan makes it easier for the corporation to keep a moderate reserve in the business. But if the corporation tries to retain much of its earnings, the 10 percent plan given it less relief than the existing plan.

The reason for these results is basically this: The present plan removes a part of the undistributed income -- sometimes a large part, much more than 10 percent of the adjusted net income -- from the top brackets and puts it in at the 7 percent bracket. The 10 percent plan removes a part of the undistributed income and exempts it altogether - - but this part can never be more than 10 percent of the adjusted net income.

For example, if a corporation has an adjusted net income of $10,000, the following results occur with different amounts of undistributed net income: /1/

          Undistributed      Surtax under        Surtax under
           net income       existing plan       10 percent plan

            $ 10,000          $ 1,250              $ 1,780
               4,000              280                  360
               2,000              140                   70

If the result of the 10 percent relief is thought too severe on corporations withholding a large part of their earnings, perhaps a 12 percent or 14 percent figure would not be too large.

3) Allow a flat $5,000 exemption to all corporations. This is simpler than plan (2) above, but probably gives more relief than is needed to the $5,000 -- $50,000 groups, and does not do very much for most of those in the $50,000 -- $1,000,000 range.

Corporations above $5,000,000

These corporations, like those in the $5,000 -- $25,000 range, are on the average paying out enough to escape the 12 percent bracket and land in the 7 percent bracket. Since most of them can appeal to the capital market, relief seems unnecessary.